The money supply data for May surprised many market participants. The growth rate of narrow money supply (M1) and broad money supply (M2) was -4.2% and 7% year-on-year, respectively, both record lows. How to understand this phenomenon?
First, let's review the definition. The central bank announces three types of money supply: M0, M1 and M2. Among them, M0 represents the currency in circulation, that is, banknotes and coins in circulation, M1 is roughly M0 plus corporate demand deposits, and M2 is roughly M1 plus resident savings deposits and corporate time deposits. In May 2024, M0, M1, and M2 were 11.7 trillion, 64.7 trillion, and 301.9 trillion, respectively.
In textbook theory, the money supply is usually what is known as an "exogenous variable", that is, given outside the model, such as the central bank printing a certain amount of money, which does not change due to economic activity. And to explain changes in the money supply, we need to make the money supply "endogenous".
In fact, "endogenous money" is more in line with the realities of the modern economy. Of the three money supplys, only M0 is printed by central banks, less than 4% of broad money M2. Moreover, the central bank will decide how many banknotes and coins to produce according to economic needs, for example, more brand new banknotes are often needed before the Spring Festival, so the change in M0 is strictly endogenous.
M1 and M2, on the other hand, are mainly bank deposits, which in turn are generated by loans, which in turn are determined by economic activities (e.g. investment). So we can say that money is mainly supplied by banks, and the money supply is endogenous. To deepen my understanding of this sentence, let me give a hypothetical example:
Let's say I decide to buy a new house and need to borrow a $1 million mortgage from the bank. After the bank lends money, the assets and liabilities of the bank increase by 1 million yuan at the same time, and the increased assets are counted by the central bank as the increase in "household loans", and the increased liabilities are counted as the increase in "household deposits" and are included in M2. Obviously, my assets (deposits) and liabilities (loans) also increased by $1 million at the same time.
Of course, because I was buying a house, the 1 million yuan deposit was transferred to the developer before it was hot. As a result, the deposit of 1 million yuan in my asset table became a new house, and the 1 million yuan of property for sale in the developer's asset table became a deposit of 1 million yuan, which was counted by the central bank as a "deposit of non-financial enterprises" (if it is a current account, it will be included in M1, and if it is converted to a fixed term, it will be included in M2).
When this process is completed, because my loan demand is matched with the bank's loan supply, the money supply (M1 or M2) rises by $1 million. It was my bank, not the central bank, that supplied the 1 million dollars. And because it's the result of economic activity (buying a house), it's an endogenous change.
It can also be seen from this example that the money supply is not only related to the willingness of banks to lend (supply side), but also to the demand for loans in the market (demand side). When both supply and demand are hot, loans can be realized and the money supply can be increased. If it's just a hot head, for example, if I want to take out a loan but the bank won't, or if the bank is enthusiastic but I don't want to, the loan won't be successful, and the currency won't be able to increase.
Of course, it's the worst at both ends, and that's what the credit market is all about. On the one hand, demand for loans from households and businesses is weak. On the other hand, although the monetary policy is relatively loose, because of the lifelong accountability system of bank lending, the willingness of banks to lend is very low, especially for private enterprises. In such a situation, the stall of the money supply is not unexpected.
On the supply side of loans, policy has begun to correct errors. At the regular policy briefing of the State Council on May 17, the relevant departments particularly emphasized that financial institutions should implement the "due diligence exemption" regulations on the financing of real estate enterprises. It is foreseeable that the effect of implementing "due diligence exemption" may exceed that of interest rate cuts.
But on the demand side, how can loan demand, especially corporate loan demand, be restarted? To explore this issue, it is necessary to analyze the mechanism by which the demand for loans is generated. We focus on corporate loans and distinguish between short-term and long-term loans.
Short-term loan needs of businesses
Short-term loans for enterprises refer to various loans issued by financial institutions to enterprises with a term of one year or less, which are mainly used for operating expenses, such as workers' wages, raw material procurement, project advances, etc.
It is important to emphasize that short-term loans are indispensable for the modern economy. Business operations are a continuous process, and maintaining operations requires maintaining operating expenses, and growing businesses need to continuously expand operating expenses. Without a short-term loan, businesses have to spend their profits on operating expenses. For business owners, it is easy to "earn inventory and receivables, but not cash flow". Without cash flow, there is no way to make long-term capital expenditures, including machinery purchases and technology research and development.
Short-term loans, on the other hand, "liberate" corporate profits and can be used for dividends and long-term capital expenditures. At the macro level, dividends are good for saving and consumption, and long-term capital expenditure is the foundation of economic development.
Business owners have short-term loan needs because they expect money to be made, and they don't have to wait too long, and they can't wait too long. In other words, the company's sales quickly cover operating costs, including labor costs. Here I emphasize labor cost, because it is the key to the connection between supply and demand - labor cost is also consumer income, the cost on the supply side and the purchasing power on the demand side.
At the micro level, the profit of a company has nothing to do with what it produces, and the production of daily consumer goods and machinery and equipment can make money. But at the macro level, if all firms produce products that workers consume, then the firms as a whole are not profitable. Why? Because labor costs are consumer revenue, the total labor cost is the ceiling of total sales after adding up the business.
So, at the macro level, if a company as a whole is to maintain positive profits, it must have a part of the company that produces for people other than workers, including entrepreneurs, foreigners, and the government. There are both exports (+ profits) and imports (- profits) for foreigners, and the size of the profits that the enterprise as a whole receives from foreigners depends on the difference between the two, that is, the foreign trade surplus. The government has both expenditures (+ profits) and taxes (- profits), and the profits that enterprises as a whole receive from the government depend on the difference between the two, that is, the fiscal deficit. In an economy where foreign trade and finance are basically balanced, if an enterprise as a whole is to maintain profits, it is necessary for a part of the enterprise to produce for the consumption and investment of entrepreneurs. Among them, the consumption of entrepreneurs is usually insignificant compared to the macroeconomic volume, so the investment of entrepreneurs, that is, the long-term capital expenditure of enterprises, must be the main force.
Therefore, we can understand that when the investment demand of enterprises is weak, the overall profits of enterprises will be thin. More importantly, when it is expected that the investment demand of other enterprises will tend to be weak, and the overall profits of enterprises will tend to be thin, entrepreneurs will realize that "money is becoming more and more difficult to earn", so the rational choice will be to reduce short-term loans, shrink the front, and put safety first. And, unfortunately, such choices are often self-fulfilling.
Long-term loan needs of enterprises
Long-term loans are mainly used for long-term capital expenditure (or long-term investment, the purpose of which is to form fixed or intangible assets), such as land purchase, production capacity construction, technology research and development, etc. Because capital expenditure brings new current purchasing power to the economy (such as the salary of R&D personnel), and at the same time does not produce and sell final goods in the current period, so it does not consume the current purchasing power of residents, so capital expenditure brings current profits to the enterprise as a whole.
Long-term capital expenditures generate long-term loan needs because, on the one hand, long-term capital expenditures often require large amounts of capital, far exceeding the retained earnings of enterprises. On the other hand, there is a great deal of uncertainty about the return on assets generated by capital expenditures, and the liquidity of assets is not guaranteed, so it is dangerous to use short-term loans to support long-term capital expenditures.
Because of the uncertainty of long-term asset returns, long-term capital expenditures require more confidence in the future for entrepreneurs than maintaining short-term operations. In fact, entrepreneurs often need to have irrational confidence in the future and "mysterious confidence" in their own judgment before they can make a long-term commitment to this uncertain real world. Once the economy falls into a depression and the self-confidence is poured cold water by reality, people have to rely on rational mathematical expectations to make long-term investment decisions, and the default choice is often to stand still and put safety first. It's not that the future is necessarily that bad, but as Keynes said, humans can't really form mathematical expectations about the distant future, because there is no basis for calculating such expectations (e.g., computing expectations requires probability distributions, but probability distributions are inherently uncertain).
Therefore, once the economy is bad, it is difficult to reverse it with its own momentum. The larger the scale of the existing debt, the weaker the incentive for itself to reverse, because the cold water of the debt explosion is particularly frightening. Not only do companies have no appetite for increasing debt (leverage), but they will "deleverage" as much as possible. But the problem is that if one company reduces leverage and shrinks the front, the revenue and profits of other companies will decline. Therefore, at the macro level, it is difficult for companies as a whole to reduce leverage when the economy is bad, and the overall leverage ratio (debt/income) may rise instead of falling. China's post-pandemic economic recovery has been much slower than expected, partly because some companies (such as property developers) are desperately reducing leverage, residents are prepaying their mortgages, and local governments are "under pressure" due to the sudden cooling of the land market.
So the central government has no choice but to take strong measures to prevent the economy from staying in a state of depression for too long, leading to a vicious circle of debt deflation and the exit of the unemployed from the job market......
How to restart
First, the central bank should continue to lower the short-term policy rate target (DR007), thereby reducing the cost of funds for banks to incentivize banks to lend. At the same time, the implementation of "due diligence and exemption" to let the bank's grassroots loan officers work with confidence. Only by removing the barriers to loan supply will corporate loan interest rates really fall. Interest expenses fell and corporate profits rose.
Second, we need to expand the central government's fiscal deficit and the issuance of treasury bonds, on the one hand, to continue to relieve local governments' difficulties and maintain local government public spending, and on the other hand, to spend on people's livelihood, including considering giving red envelopes directly to consumers. Widening the fiscal deficit is expanding corporate profits.
Finally, improve the business environment and minimize political and policy uncertainty. It should be constantly reiterated that "the mainland is in the initial stage of socialism and will remain so for a long time", and the impulse of local governments to dry up and fish should be restrained (for example, to stop the retrospective tax payment). After the catastrophe, we should recuperate, use the visible improvement and real money profits to persuade the company to stay and persevere, and wait for the "animal spirit" and "mysterious self-confidence" to be resurrected.