Three Arrows for Efficient Credit Expansion
This article analyzes the reasons for the decline in M1 growth and its impact mechanisms, proposing that fiscal pro-cyclical contraction is an important reason for the deep negative growth of M1.
The central government has made it clear that it will increase the intensity of fiscal counter-cyclical stimulus and will introduce the largest local government debt resolution plan in history. As a result, the pressure on the repayment of principal and interest of fiscal expenditures and debt resolution is expected to be alleviated, and the support for the real economy is expected to be enhanced.
In addition to increasing the financial strength of local governments, the expenditure speed of allocated funds should also be accelerated, enhancing counter-cyclical regulation in terms of expenditure intensity and progress, promoting the stabilization and recovery of M1, and unblocking the bottlenecks in the internal economic cycle.
Efficient credit expansion requires the "three arrows" — Revisiting the scissors difference between M1 and M2
Currency from "idle rotation" to "no rotation"
In our sharing at the beginning of the year, we focused on the high growth of M2 and used the three inefficient forms of currency expansion, "large banks lending, small banks buying bonds", enterprises borrowing new money to pay interest, and wealth management returning to the table, to explain the scissors difference between M1 and M2. Based on this, we proposed that moving from inefficient currency expansion to efficient credit expansion requires the coordinated cooperation of fiscal and monetary policies, diluting credit targets, rationalizing the interest rate system, solving the "idle rotation" problem, and improving the quality and efficiency of financial services for the real economy (for details, see "From Inefficient Currency Expansion to Efficient Credit Expansion").
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Since the beginning of this year, regulatory authorities have intensified the regulation of fund idle rotation arbitrage, bank manual interest supplementation, and other behaviors, and the deposit interest rate has started a new round of cuts in July, compressing the space for fund idle rotation arbitrage. With multiple policy measures, the effect of "squeezing water" in financial data continues to be evident, with M2 growth declining from a high of 8.7% at the beginning of the year and recently stabilizing around 6.5%, and the M2 "idle rotation" problem has been alleviated.
However, a new phenomenon has emerged in the operation of currency, and the problem of M1 "not rotating" has become more prominent. In September, the year-on-year growth rate of M1 dropped to -7.4%, a historical low. Admittedly, the negative growth of M1 in China is not unique internationally; in 2023, the M1 in the United States and Europe also experienced negative growth, which can be traced back to the large-scale fiscal subsidies by governments during the pandemic period, which once rapidly increased M1. Once these funds are consumed, M1 will naturally decrease. The low growth rate of China's M1, on the other hand, reflects the current poor internal economic cycle and new challenges in economic operation.
Why do we need to pay special attention to M1? M1 is the narrow money supply. According to the IMF's monetary statistics manual, M1 is the sum of currency in circulation and transferable deposits that can be used for payment, and its essential characteristic is that it is a financial instrument that can be directly used for payment. M1 is a rare leading indicator for observing the vitality of economic operation. Most macro indicators are synchronous indicators (such as PMI and industrial production) or lagging indicators (such as employment and inflation), while M1 leads the manufacturing PMI by about half a year, providing a window for predicting economic operation.From a macro perspective, the balance of M1 has slid from a peak of 68.6 trillion yuan in March of this year to 62.8 trillion yuan in September, with the year-on-year growth rate turning negative in April and further declining to -7.4% in September, marking the lowest in history. It is a normal phenomenon for M1 growth to slow down during a downswing of the economic cycle. However, a deeply negative M1 growth rate reflects the potential risk of the economy "losing speed."
Structurally, China's M1 includes M0 (cash in circulation), corporate demand deposits, and demand deposits of government agencies and organizations. This statistical approach does not include residents' demand deposits. This differs somewhat from the current international statistical approach, due to the fact that when China introduced this statistical approach in 1994, the banking system's network was not well-developed, and check accounts were not widespread, making it difficult for residents' demand deposits to be directly used for payments, hence they were not included in the M1 statistical category.
Now, with the rapid development of financial service convenience, financial market, and mobile payment, and other financial innovations, discussions and suggestions about timely adjusting the M1 statistical approach have also gradually increased. However, even if residents' demand deposits, daily cash management financial products, and reserve funds are included in the M1 statistical category, the overall trend still shows negative growth.
Setting aside the statistical approach, the current main composition of M1 is the demand deposits of government agencies and organizations. As of September, China's M1 balance is close to 63 trillion yuan, of which government agencies and organizations' deposits account for 31 trillion yuan, nearly half. Next is corporate demand deposits, with a scale of about 20 trillion yuan. M1 has decreased by more than 5 trillion yuan year-to-date, mainly due to the decline in corporate demand deposits.
The "non-turn" is just a facade, with multiple factors intertwined behind it. First, there is insufficient risk appetite, with residents and enterprises preferring to save with fixed terms, while the adjustment of the real estate market weakens the transformation of M2 to M1; second, there is low inflation expectation, with relatively high real interest rates, which suppress credit expansion and promote the regularization of deposits; the particularly crucial marginal change is the pro-cyclical fiscal tightening since the second quarter of this year, with the decline in land transfer income and the increase in debt repayment pressure, forming a double squeeze on fiscal resources, and the circulation of money from the government to the private sector is not smooth, further leading to a negative M1 growth rate.
(1) Decline in risk appetite
As mentioned earlier, the main reason for the negative growth of M1 is the increasing trend of corporate deposits being regularized. When corporate risk appetite declines and investment willingness is low, they choose to deposit more funds in fixed-term deposits rather than keeping them in demand accounts, causing M1 growth to slow down. The proportion of corporate demand deposits has dropped to a historical low of 25.5%.
The decline in corporate demand deposits is closely related to the cyclical adjustment of the real estate market. The real estate market traditionally adopts a high-turnover, high-leverage business model, which is an important way to activate funds. When the real estate cycle is rising, residents' deposits (M2) quickly convert into pre-sale funds of real estate companies, included in the statistical category of corporate demand deposits (M1). With the adjustment of China's real estate cycle, the high-turnover model of real estate companies has come to an end, and the national commercial housing sales area has decreased from a high of 1.8 billion square meters in 2021 to 1.1 billion square meters in 2023, significantly weakening the mechanism of M2 transforming into M1 through real estate sales, which drags down the growth rate of M1.
(2) Low inflation expectationsMeasuring the cost of borrowing should be based on the real interest rate, not the nominal interest rate. The real interest rate is equal to the nominal interest rate minus expected inflation. Since expected inflation is unobservable, a stopgap measure is to use realized inflation as a substitute for expected inflation. Different inflation expectations apply when calculating the real interest rates for different industries; businesses use the Producer Price Index (PPI), which has been negative on a year-over-year basis for 24 consecutive months. For residents, some argue whether the price of second-hand housing should be used to calculate the real interest rate.
A more precise estimation of inflation expectations requires considering numerous factors. We have emphasized that expectations for asset (real estate) price adjustments also affect inflation expectations ("New Macro Strategy Research (III): Understanding the Divergence of Inflation at Home and Abroad: From the Perspective of Inflation Expectations"). Overall, the current nominal interest rate has declined, but the real interest rate (10-year government bond rate - GDP deflator) remains relatively high, which is due to low inflation expectations. China's GDP deflator has been negative for six consecutive quarters, with the longest historical period being seven consecutive quarters from 1998 to 1999.
Low inflation expectations have two impacts on M1: On the one hand, due to the high real interest rate, even though the deposit interest rate seems very low, its actual return is not low because of the low inflation expectation, which further encourages the regularization of deposits. On the other hand, low inflation expectations and high real interest rates can suppress credit expansion, leading to a slowdown in credit creation and a reduction in M2 growth.
Combining the regularization of deposits with the decline in M2 growth further slows down the growth of M1. The Politburo meeting held on September 26 set the tone for "promoting the stabilization and recovery of the real estate market." Recently, various departments have jointly introduced a package of policies, including bulk adjustments to existing mortgage interest rates and the cancellation or reduction of restrictive measures on housing purchases, to support residents' rigid and improved housing needs. These measures send a strong signal of stable growth and stable housing market, which is expected to play a positive role in stabilizing inflation expectations.
(III) Fiscal Countercyclical Contraction
The aforementioned two reasons can explain the slowdown in M1 growth but cannot explain the negative growth of M1. In fact, China's real estate cycle began to adjust in mid-2021, and although the real interest rate was high this year but has declined, the growth of M1 accelerated its decline starting in the second quarter of this year, with the growth rate in September reaching a historical low. An important change that cannot be ignored is the unexpected countercyclical contraction of fiscal policy since the second quarter, which has accelerated the contraction of M1 on the margin.
Firstly, on the denominator side, fiscal revenue declines countercyclically. To understand the countercyclical nature of China's fiscal policy, it is important to emphasize the uniqueness of China's fiscal revenue composition, namely the characteristic of China's land finance. There are two types of fiscal revenues: one is current revenue, such as taxes. If current revenue cannot meet current expenditure, a deficit will be formed. To make up for the deficit, the fiscal needs another type of revenue, namely financing revenue, such as government bonds. The issuance of government bonds is countercyclical, so the fiscal is also countercyclical.
However, in China, the source of fiscal financing revenue, in addition to government bonds, is more importantly land revenue. The proportion of land revenue is not lower than that of national debt, and its volatility is greater than that of national debt. Therefore, the dominant factor in the actual financing revenue of the fiscal is land revenue, which means that China's fiscal has a strong countercyclical nature. Data from the Ministry of Finance shows that local government land transfer income has fallen from a high of 8.7 trillion yuan in 2021 to 5.8 trillion yuan in 2023. Starting in February of this year, the decline in local government land transfer income further deepened, with a year-on-year decrease of 25.4% in the first eight months.
Generally speaking, when the economy is declining, policy should carry out countercyclical adjustments, expand fiscal expenditure, and offset the economic decline. However, the significant reduction in land transfer income has weakened the countercyclical nature of the fiscal. Specifically, the reduction in land transfer income has led to a rapid decline in the ratio of local government expenditure to GDP. Central government expenditure has been relatively stable over the past decade, with a ratio close to 4% of GDP. After the epidemic, the ratio of local government expenditure to GDP decreased from 32.1% at the end of 2020 to 25.6% in the first half of 2024, showing that local government expenditure is more countercyclical than the overall economy. This 6.5 percentage point decline can be attributed to about half of the decline in land transfer income and government revenue.
Secondly, on the numerator side, the pressure of debt repayment is heavy. The local government debt issue has a long history, and the 2020 COVID-19 epidemic further formed an exogenous shock to local finance. Referring to the calculation by Bai Chong'en (2024), during the three years of fighting the epidemic, localities additionally generated a deficit of 6.8 trillion yuan, of which 1.2 trillion yuan was partially compensated by the central government's additional transfer payments; the remaining 5.6 trillion yuan, of which 1.9 trillion yuan was compensated by the local issuance of special bonds, and 3.8 trillion yuan was solved by local self-financing, which had a certain impact on the financial strength of local governments.Since the beginning of this year, local governments have been facing increasingly pressing deadlines for debt resolution, while the debts accumulated in the past are maturing one after another, requiring some fiscal revenues to be reallocated to repay the principal and interest of maturing debts. In terms of explicit debt, according to the Ministry of Finance, as of August this year, the local government debt balance is approximately 43.6 trillion yuan, and the pressure to repay the principal and interest is not significant for this part; maturing government bonds can be smoothly rolled over and refinanced. The main pressure lies in implicit debt, for which there is currently no official statistics on the scale of local government implicit debt. However, judging from the debt swaps in previous years, the annual repayment pressure of implicit debt may be over a trillion yuan.
In summary, on the revenue side, the decline in land revenue has already reduced the strength of fiscal expenditure; on the expenditure side, the local government's debt resolution efforts need to be intensified, leading to a significant portion of expenditure being used for debt resolution. The simultaneous impact on both the revenue and expenditure sides forms a negative shock to the fiscal impulse, creating a double squeeze on fiscal resources that can be used to support the real economy. Insufficient fiscal support and a weak real economy, in turn, lead to a further slowdown in fiscal revenue growth, with the revenue and expenditure sides mutually reinforcing, forming a "fiscal accelerator" effect.
The impact of insufficient fiscal support on M1 is the most direct. Starting with the mechanism by which fiscal austerity affects M1, fiscal expenditures directly form corporate demand deposits without going through the banking system. If the pressure to resolve local government debt increases, and more fiscal revenues are used to repay bank loans instead of being paid to enterprises, it will lead to a decline in M1.
In addition to the intensity, the pace is also crucial. A slow pace of fiscal spending within the budget will also reduce M1. The fiscal deficit accumulates in fiscal deposits. Fiscal deposits are not included in the deposits of residents and enterprises, and are neither counted in M1 nor M2. The process of fiscal net expenditure is reflected in the conversion of fiscal deposits to M1. When the pace of fiscal expenditure is slow, fiscal deposits continue to accumulate, leading to a decline in M1. Therefore, the growth rate of M1 is generally negatively correlated with the growth rate of fiscal deposits.
Since April of this year, the year-on-year growth rate of fiscal deposits has continued to rise, reaching 14.9% in September. The slow progress of budgeted expenditures is an important reason for the negative turn of M1 growth in April. If the expenditure of fiscal deposits can be accelerated, whether for paying corporate accounts receivable or for the "three guarantees" (basic livelihood and basic security), it can curb the rapid decline in M1.
Finally, the regularization of deposits by government agencies and organizations will also lead to a decline in the growth rate of M1. As mentioned earlier, the demand deposits of government agencies and organizations are the largest source of M1. Government agencies and organizations can be considered quasi-fiscal departments, and after the pandemic, their demand deposit ratio has been maintained at over 90% for a long time. However, the deposits of government agencies and organizations have recently shown a clear trend towards regularization. As of September this year, the ratio of demand deposits of government agencies and organizations has dropped to 83.9%, which will also drag down the growth of M1.
In summary, in addition to the decline in risk appetite and low inflation expectations, fiscal procyclical contraction is an important reason for the marginal acceleration of M1 decline. This is partly due to the decline in land transfer income and partly due to the increase in debt repayment pressure, including principal and interest payments and the approaching debt resolution deadlines, requiring local governments to invest more financial resources in debt resolution. The dual squeeze on the revenue and expenditure sides has caused the contraction of M1.
Breaking the deadlock requires the "three arrows" strategy. The negative growth of M1 is just a manifestation, reflecting the blockages behind the operation of the economy. In response to the current economic operation, it is necessary to adopt a "three arrows" strategy, using multiple approaches to support the economy.
The first arrow is monetary policy, which has been launched in advance, including the announced interest rate cuts and reserve requirement ratio reductions, as well as potential future reserve requirement ratio reductions. However, due to the rapid decline in inflation expectations, the real interest rate is still at a relatively high level, so there is still a need for monetary policy to be relaxed in the future.More importantly, the second arrow is fiscal easing. The previous analysis indicated that the deep negative M1 growth stems from the pro-cyclical fiscal tightening, which, during the decline in land transfer revenues, further squeezes the expenditure space due to debt repayment pressures. Therefore, fiscal easing could consider timely adjustments to debt repayment targets, such as extending the debt maturity, promoting the rollover of local government debt, and expanding the expenditure space for local governments. Although some argue that debt repayment is not an economic stimulus measure, according to the previous analysis, if debt rollover for local governments can be achieved, it would reduce the annual pressure of repaying trillions in principal.
Simultaneously, if the central government issues low-interest explicit debt to replace the high-interest implicit debt of local governments, it would effectively reduce interest expenditures, freeing up space to support the real economy. According to our estimates, the average interest rate of urban investment bonds is 1.4 percentage points higher than that of local government debt (although different calculations may vary), thus saving at least hundreds of billions in interest expenditures. If a complete replacement were to be carried out, the scale would be larger, and interest savings could reach over a trillion. If the repayment period for the principal is further postponed, more financial resources could be released to support the real economy.
On October 18th, the General Office of the Central Committee of the Communist Party of China and the General Office of the State Council issued the "Opinions on Solving the Problem of Arrears in Enterprise Accounts Receivable," making a systematic deployment to advance the resolution of the arrears issue. In recent years, enterprises have increased their advances to local governments, which has significantly impacted their operational and profitability capabilities. By expanding local government financial resources through debt repayment, the arrears problem can be addressed, effectively alleviating the cash flow situation of enterprises, enhancing their potential for asset expansion, and unblocking the circulation of money from the government to the private sector.
The third arrow is structural reform, promoting innovation, and increasing total factor productivity. There are differences in the international M1 statistical口径, such as the United States including resident deposits in M1 statistics. Historical experience shows that during prosperous capital markets, resident demand deposits increase as they are readily needed for transactions. To achieve innovation through structural reform to support the real economy, the prosperity of the capital market is crucial. Innovation in the capital market relies on a good ecological environment, with upstream being high-quality research institutions and downstream being a favorable institutional environment, with the main body including entrepreneurs and financial markets, which are closely connected and inseparable. An active capital market can unblock each link of "raising, investing, managing, and exiting" in the innovation process, thereby unblocking the entire economic cycle.
In summary, this article, by analyzing the reasons and impact mechanisms of the decline in M1 growth, suggests that pro-cyclical fiscal tightening is an important cause of the deep negative M1 growth. The central government has clearly stated that it will increase the intensity of counter-cyclical fiscal stimulus and will introduce the largest-scale local government debt resolution plan in history. In this way, the pressure of principal and interest repayment and debt repayment on the fiscal expenditure side is expected to be alleviated, and the support for the real economy is expected to be enhanced. In addition to increasing the financial resources of local governments, the expenditure speed of allocated funds should also be accelerated, enhancing counter-cyclical adjustment in expenditure intensity and progress, promoting the stabilization and recovery of M1, and unblocking the internal economic cycle.
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