By Chen Daofu, Research Institute of Finance of DRC

Research Report No 25, 2013 (Total 4274)

I. China's Monetary Environment Has Experienced Profound Changes

Currency always plays its role in offering the financial services with the aid of a specific financial system. As China's economy is undergoing the critical restructuring in a transitional stage, its financial market is also rapidly reshaped under eased control. China's monetary environment has seen profound changes. Similarly, the currency supply and the relationship between currency and economy have been changed correspondingly. Therefore, China should pay close attention to these changes in its current monetary regulation and control. On the one hand, the effective monetary regulation and control tools, especially the price control tools, should be developed and improved to meet the needs of the new environment as soon as possible. On the other hand, the reliable estimate for the changed monetary environment and the adjustment to the former control tools and intensity should be made to ensure that the currency's performance is compatible with requirements of macroeconomic regulation.

1. A money supply mechanism driven by the domestic-oriented demand hasreplaced the import-oriented one

The exchange rate system is an important factor influencing China's monetary policy. With the exchange rate becoming more market-oriented, China's money supply has seen fundamental changes. Specifically, the increase of the funds outstanding for foreign exchange was almost the only channel for China to issue the basic currency from 2003 to 2009. During the period the ratio between the increase of the funds outstanding for foreign exchange and the basic currency increase kept over 100%; the ratio even reached 324% in 2005. In order to prevent high-powered money from creating more money, China withdraws and freezes the excessive basic currency in the market by using central bank bills and raising the mandatory bank reserve ratio respectively. Since 2010 when the ratio decreased lower than 100%, China started to supply the basic currency which had been withdrawn and frozen in the past. In the first 11 months of 2012, the increase of funds outstanding for foreign exchange was only RMB 281.5 billion yuan, accounting for 27% of the basic currency increase in the same period of the year. Meanwhile, the balance amount of central bank bills reduced to RMB 1.58 trillion yuan. The basic currency supply can help prevent the non-bank deposits from increasing and reduce the loan-deposit ratio of banks, hence restricting banks' capacity in money creation. Under this circumstance, banks are forced to intensify the expansion in non-credit assets and diversify the on-the-balance sheet items. The potential changes of bank behaviors need to be noted by the monetary control authority.

China's M2 money supply is mainly achieved through increasing the funds outstanding for foreign exchange and giving loans. Among the newly increased M2 during 2005-2008, the funds outstanding for foreign exchange accounted for 40%-70% and such percentage of loans fluctuated between 60% and 80%. The sum-total of the two percentage exceeded 100% of the increased M2 money supply. Through issuing central bank bills and other means, China withdrew some money supply in the market, raised the balance amount of central bank bills from RMB 1.1 trillion yuan by the end of 2004 to RMB 4.58 trillion yuan by the end of 2008, with an increase of RMB 3.48 trillion yuan. Before 2008-2011, the total-sum of the two percentages was around 100% and the balance amount of central bank bills kept relatively stable. As for the newly added M2 money supply in 2012, the newly increased credits accounted for about 80% while the increased funds outstanding for foreign exchange saw a substantial decrease, leaving the sum-total of the two factors less than 100% of the increased M2. Under such circumstances, China had to rely on more money supply means such as reducing the scale of central bank bills, increasing public money issue, and expanding non-credit assets. The balance amount of central bank bills reduced by RMB 1.72 trillion yuan and RMB 750 billion yuan and the net amount of central bank bills in the open market reached RMB 1.91 trillion yuan and RMB 1.44 trillion yuan in 2011 and 2012 respectively. The money supplied in terms of the funds outstanding for foreign exchange went directly to the foreign trade enterprises (small and medium-sized companies included). However, when the amount of the funds outstanding for foreign exchange decreased, the money supply returned to be driven mainly by loans and to be restricted by the credit distribution of the banking system.

2. The market-oriented financing has enjoyed a rapid rise in the changed socialfinancing structure

As the market-based interest rate and the eased market access facilitate the integration of different markets, China's financial structure is undergoing profound reforms. The ratio of the newly increased credits in the social financing continued to drop and went down to 52.1%, a record low, at the end of 2012. But the percentage of the trust and entrusted loans grew rapidly from a high level of 11.7% at the end of 2011 to a higher level of 16.3% at the end of 2012. Meanwhile, various asset management businesses swelled fast. With the rapid development of the non-banking financial system, the assets of trust companies exceeded RMB 7 trillion yuan. The similar business boom also happened to many non-financial institutions like small loan companies, guarantee companies, pawn shops, peer-to-peer (P2P) lending companies, and bill discounting companies. Although the stock financing ratio of the non-financial enterprises dropped from 3.4% at the end of 2011 to 1.6% at the end of 2012, the sum-total of the percentages in bond and stock financing of such enterprises continued to increase from 14% at the end of 2011 to 15.9% at the end of 2012. This indicates that the market-based financing has obtained an increasing importance in social financing. As the central bank's quantitative control tools become less effective, the price control tools will see a rise in significance. In view of the unsmooth transmission mechanism of the interest rate, China should make the market more sensitive to the interest rate and further develop the benchmark interest rate market.

Though the aggregate loans, money supply and social financing were relatively eased compared to the GDP and inflation in 2012, the small and medium-sized enterprises were challenged by more severe financing difficulties and higher financing cost. In the period when the market-based financing was not so advanced, large numbers of enterprises having trouble in cash flow could acquire high-cost funds through social lending channels, which would lead to the higher financing cost and the slower adjustment. In addition, the local government and state-owned enterprises with huge fund demands tended to crowd out some needs of the small and medium-sized companies. Among the RMB 2.25 trillion yuan of bond financing completed by non-financial enterprises in 2012, RMB 1.25 trillion yuan were the newly-issued municipal bonds. In the third quarter of 2012, the trust assets invested in infrastructure projects reached RMB 1.39 trillion yuan, accounting for 23%. Among the public and non-public issued credit bonds worth of RMB 3.67 trillion yuan, those issued by state-owned enterprises occupied RMB 3.38 trillion yuan. Restrained by the scale of loan, the loan-to-deposit ratio, and the capital adequacy ratio, banks tend to have a limited credit expansion capacity but a higher bargaining power and raised loan ratio. In short, the financing difficulty and the high financing cost confronting Chinese enterprises can be ascribed to various factors. In order to effectively reduce the financing costs, relevant departments should make joint efforts to lower the local government and state-owned enterprises' occupation for credit resources and carry out profound reforms for the financial system.

3. Real economy has seen changes in its internal tendency and leverage ratio

China's economy has stepped into a new development stage, which can be demonstrated in the outstanding structural (aperiodic) overcapacity. China has maintained the rate of fixed asset investment above 24% since 2002, but the rate dropped around 20% in 2012. This is especially true for the manufacturing industry which has seen a continuous decline. Meanwhile, the ratio of long- and medium-term bank loans also suffered a continuous drop to about 18% by the end of 2012 while the non-financial enterprises even saw a net reduction in the long- and medium-term loans in two consecutive months. In 2013, the capital demands in Chinese infrastructure and real estate will take on a downward tendency due to the capital restraints, which requires China to seek for new effective fund demands.

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