Ominous signs that China’s economic recovery may be slowing from an initial surge fueled by pent-up demand among consumers has analysts and bankers alike pondering whether continued loose monetary policy can underpin the revival, as a rise in risk aversion leads people to save more and shy away from borrowing.

China’s gross domestic product (GDP) grew by just 3% in 2022 amid lengthy pandemic-related lockdowns, but accelerated to 4.5% in the first quarter, the fastest pace in a year. The official target for this year is around 5%. But a swathe of negative economic data for April, which included the manufacturing sector unexpectedly contracting and retail sales missing forecasts, indicates the recovery remains lopsided, with production lagging a rebound in consumption.

It’s not a question of whether there is enough money being pumped into the economy to fuel the recovery, but instead where that money is going and why people aren’t availing themselves of more credit?

Since the second quarter of 2022, the year-on-year growth rate of broad money supply (M2) has maintained double-digit growth, reaching as high as 12.9% in February, indicating that individuals and businesses have ample money for investment, which is supposed to boost economic growth.

“Monetary supply data are running ahead of economic data, and the first quarter data reflected the mismatch between supply and demand recovery,” Zou Lan, director of the monetary policy department of the People’s Bank of China, said on April 20 at a regular press conference to discuss first-quarter financial data.

While M2 money supply growth accelerated, M1 grew at a slower pace, a sign of muted business activity and precautionary saving by households. At the end of March, M2 grew 12.7% year-on-year. In contrast, M1 only grew by 5.1%.

M1 and M2 are both measures of the money supply in an economy, but they differ in terms of the types of assets they include. M1 consists of physical currency held by the public and in circulation as well as deposits held by individuals and businesses at banks, representing the total amount of money that can be spent in the economy.

M2, on the other hand, is a broader measure of the money supply. In addition to the components of M1, M2 also includes less liquid assets like savings deposits and money market funds, reflecting the change of social aggregate demand and inflationary pressure in the future.

The bigger growth of M2 than M1 indicates money isn’t going to the real economy, but just circulating within the financial system, analysts said.

Liquidity trap

But given the worrying economic indicators, there are concerns about what that money is being used for, giving rise to additional worries about deflation, idle funds and even the possibility of a “liquidity trap.” This is when consumers and investors hoard cash rather than spending or investing, curtailing the impact of loose monetary policy.
Despite the continuous monetary easing, the real economy has insufficient appetite for loans, multiple bankers and researchers told Caixin.

Amid the downturn in the real estate market and sluggish income expectations, Chinese residents have become more risk averse, resulting in weak growth in mortgage loans.

Private businesses also lack enthusiasm for expanding investment, with a large proportion of credit consequently allocated to state-owned sectors. Both private and state-own companies along with local governments are using funds to repay debt and make interest payments, a practice which is expanding, they said.

Some businesses didn’t use the loans they received from banks for production, but instead put the money into wealth management products or savings, which limited the effect of expanding M2 on boosting economic growth, analysts at Huachuang Securities Co. Ltd. said in a report published May 19.

This was evidenced by Caixin’s Purchasing Managers’ Index, a composite indicator designed to provide a single-figure snapshot of operating conditions in the manufacturing economy, which slipped from the neutral level of 50.0 in March to 49.5 in April. This was the first deterioration in the health of the manufacturing sector in three months, it said.

“Softer demand conditions were a key factor weighing on the performance of the sector, with total new orders falling slightly for the first time in three months,” it said.

So, how to break this stalemate of prolonged loose monetary policy yet insufficient effective demand?

After the April data pointed to a slowdown in the recovery, market expectations for the government to introduce policies to stabilize growth have increased. These policy tools include interest rate cuts, pledged supplementary lending (PSL) and policy-driven financial instruments.
It’s even been rumored that China will issue 5 trillion yuan ($706 billion) of special government bonds to boost growth, according to a report by Jiemian News, without citing anyone.

A combination of fiscal and monetary policies can play a role in boosting total demand, but demand has a structural nature and the main issue China currently faces is insufficient consumer demand, Wang Xiaolu, deputy director of the National Economic Research Institute under the National Development and Reform Commission, told Caixin.

Stimulus, such as loose monetary policy, is primarily used to boost investment, which could result in an increasingly imbalanced demand structure and expansion of nonperforming debt, the economist warned.
The current issue of insufficient demand cannot be solved solely through short-term policies, and some deep-seated institutional issues need to be addressed, said Wang.

For instance, there are significant shortfalls in housing, unemployment insurance, pension and healthcare insurance, particularly for the middle and lower-income population, including migrant workers in urban areas, Wang said.

If these issues can be resolved promptly, not only can their living conditions be improved and social equity increased, it can also stimulate consumption, he suggested.

Meanwhile, private-sector fixed-asset investment only grew 0.6% year-on-year in the first quarter, considerably lower than the 5.1% growth of total fixed-asset investment. This reflects the private sector’s lack of confidence in the future and concerns over an unfair business environment for private companies, Wang said.

Large Chinese state-owned enterprises dominate many strategic sectors, such as energy, telecommunications and banking, while SOEs also benefit from cheaper financing, which gives them advantage over private-owned companies.

“Not addressing these critical institutional and policy issues and relying solely on short-term stimulus to solve immediate problems is like trying to stop water from boiling by ladling it out of the pot,” Wang said.

Show me the money

In the first four months of 2023, Chinese banks extended 11.3 trillion yuan of new renminbi loans, mostly to businesses. This was 2.3 trillion yuan more than the same period in 2022, a 25% jump, and nearly 60% more than the pre-Covid level in the same period in 2019. These loans were mostly given to state-owned enterprises at low interest rates, multiple bankers told Caixin.

Even though banks earn very little interest from these medium-to-long-term loans extended to state-owned enterprises, they can obtain other high-margin businesses from these companies, such as underwriting their financial market transactions, so lenders compete to offer them loans, a person from a state-owned large bank explained to Caixin.

In contrast, household loans decreased by 241.1 billion yuan in April. In the first quarter, mortgage loans only increased by 0.3% year-on-year, 0.9 percentage points lower than the growth over the three months at the end of 2022.

Chinese homeowners are rushing to pay off home loans ahead of schedule amid a downward spiral in housing prices, poor returns on investment alternatives and a sharp fall in mortgage rates.

In China, mortgage rates can be either fixed or pegged based on the loan prime rate (LPR). Those choosing early repayment have LPR pegged rates, which have fallen, meaning they can pay less interest now.

Companies and local governments also use the additional funds to repay existing debt, which further reduces the effectiveness of monetary easing in driving economic growth.

The macro leverage ratio, which measures total outstanding nonfinancial debt as a share of nominal GDP, climbed 8.6 percentage points to 281.8% at the end of March, according to a report by the National Institution for Finance and Development (NIFD). Nonfinancial debt refers to the borrowings of households, companies and the government, but excludes entities in the financial sector such as banks and insurance companies.

Deeper in debt

The leverage ratio of nonfinancial enterprises reached a record high of 167% at the end of March. But companies didn’t put all of the borrowed money into investments, but instead used a larger portion of new debt to pay older debts as revenue and profit declined, the NIFD report said.

“Debt risk is one of the main challenges facing China's economic recovery,” said Yan Yan, chairman and CEO of China Chengxin International Credit Rating Co. Ltd., at a credit risk outlook seminar on May 23. In 2022, 14% of GDP was spent on interest payments, Yan said.
Local governments, which are important sources of funding for infrastructure investment, also face high interest payments. In 2022, interest payments on local government bonds increased by more than 20% to 1.12 trillion yuan.

This is just explicit debt. If hidden debt through bonds issued by local government financing vehicles (LGFVs) and other entities is taken into account, the interest payment pressure is even greater.

These liabilities are estimated by some to be almost $10 trillion, roughly double the GDP of Japan.

Demand is key

Whatever the reasons for the apparent shortcomings of monetary easing, the consensus is that the biggest problem plaguing China’s economy today is weak effective demand. Retail sales climbed 18.4% in April, missing a median forecast for a 21.9% gain.

At an on April 28 meeting of the Political Bureau of the Central Committee, the Communist Party’s top decision-making body, the policy makers pointed out that restoring and expanding demand is the key to a sustained recovery in the current economy.

So, how can China boost demand? One suggestion being floated is to cut interest rates, although that idea is not embraced by all.

“The effect of monetary policy is limited,” said Sheng Songcheng, the former head of the statistics and analysis department at the People’s Bank of China. Big rate cuts are out of the question, and small cuts may not be enough to boost consumption and investment, Sheng told Caixin.

Lower interest rates will prompt households to put their money into wealth management products with higher returns rather than spending, Sheng said. Businesses mainly consider risk and return, and small changes in interest rates will have little impact on investment decisions, he said.

With the limited effects of monetary stimulus, others have suggested that the central government borrow more to boost demand. The State Council, China’s cabinet, set a deficit-to-GDP ratio of 3% for 2023, which is 0.2 percentage points higher than that in 2022. But the increased borrowing is more reflected in more special-purpose bonds for local governments, not by the central government.

The fiscal authorities may consider breaking the 3% deficit ratio limit, while reducing the proportion of local special bonds and issuing more national bonds and local government general bonds, the NIFD suggested.

Long-term solutions

An expansionary fiscal policy needs to find the right direction for investment, warned Yu Yongding, an economist at the Chinese Academy of Social Sciences. He suggested increasing investment in infrastructure and core technology breakthroughs.

Researchers including Yu and Wang from the National Economic Research Institute agree that short-term macro-control and stimulus policies alone cannot solve the problem of insufficient demand, and medium-and long-term reforms are needed.

What should be done now is to stabilize the confidence of private enterprises and foreign investors, Yu said. China should send a message to private entrepreneurs and foreign investors on the rule of law, improving the investment environment, protecting property rights and fostering a spirit of innovation, he suggested.

This article was written by Yu Hairong, Wang Shiyu, and Denise Jia. It was originally published by Caixin Global and has been republished here with permission.

(Header image: Visitors take in the view from the observation deck of the Shanghai Tower, April 9, 2023. Qilai Shen/Bloomberg via VCG)