How does financial deleveraging impact monetary conditions:HSBC China Monetary Conditions Indicator

The HSBC China Monetary Conditions Indicator (MCI) tightened further in April, to levelslast seen in late 2015. A number of factors led to the incremental tightening since late lastyear: a less weak RMB on a real effective exchange rate (REER) basis and softer CPIinflation, for example. But tighter liquidity and tougher regulations also played a part. Inthis report, we take a closer look at the potential scope of ‘financial deleveraging’ policiesand ways to monitor their impact on the economy on an ongoing basis.

    The so-called ‘regulatory storm’ has caught the financial market off-guard. Regulators aretrying to manage the risks from the rapid expansion in banks’ exposure to the non-bankfinancial sector over the past few years. Out of the RMB29trn bank-issued wealthmanagement products, around RMB6-8trn may be funded by inter-bank lending andpotentially at risk from toughing regulations. But regulators are also looking at other risks,from ‘channel business’ to the irregularities in the fast expanding ‘wealth managementproducts’, which suggest a potentially broader regulatory scope. Until the exact scope anddetails of regulations are determined, the market will remain watchful.

    How can we gauge the impact on monetary conditions on an ongoing basis? Usingdata from the past ten years, we found that the transmission from short-term interestrates to bond yields and bank lending rates has increased, likely a reflection ofinterest rate liberalisation and market development. We also look at the compositionof the banking sector use of funds to identify the drivers of broad money creationwhich may be at risk from new regulations. The exact growth impact, both in terms ofprice and quantity, will depend on how sustainably tight funding remains and howbroad the scope is for the new regulations.

    Compared with 2015, the overall growth backdrop has improved. The economy hasmoved away from deflation and private sector business has rebounded. The privatesector-led recovery is less reliant on debt (particularly shadow-banking debt) andshould be less impacted. Moreover, fiscal policy stance and external demand havealso improved, providing more legs to the recovery. Nonetheless, if monetaryconditions tighten too much too quickly, there will inevitably be a growth impact.

    Policy makers will need to play a careful balancing game, to better regulate the‘shadow’ part of the financial system, but also to ensure a stable and neutral policystance in order to help sustain the private sector growth recovery.