Inflation not yet a constraint on China's monetary policy

China's financial numbers have repeatedly come in better than expected this year.

The country's broad money supply, or M2, grew by 12.7 percent year-on-year by the end of March, reaching its highest level since April 2016.

Meanwhile, the outstanding aggregate social financing increased by 10 percent, up 0.4 percentage point from the end of 2022.

In the first quarter, new yuan-denominated loans totaled 10.6 trillion yuan ($1.51 trillion), an increase of 2.3 trillion yuan year-on-year.

On March 17, the People's Bank of China, the central bank, unexpectedly said that it would cut the reserve requirement ratio, proactively implementing stabilizing growth policies and on time.

The country's outstanding loans through central bank structural monetary policy tools increased by 375.4 billion yuan in the first quarter. That was mainly from a carbon reduction supporting tool, a relending facility for the clean and efficient use of coal and a relending facility to support technological innovation, which totaled 264.8 billion yuan and accounted for 71 percent of the total increase.

China's economy has made a good start this year amid supportive government policies and optimized COVID-19 control measures.

The economy grew by 4.5 percent year-on-year in the first quarter, higher than the market expectation of 4 percent.

Investment remains a key driver of stable domestic demand, with capital formation contributing 34.7 percent of economic growth in the first quarter. In the first three months, fixed-asset investment grew by 5.1 percent year-on-year, flat from the growth seen in 2022.

Infrastructure investment increased by 10.8 percent in the first quarter, down 0.7 percentage point from the full-year growth of 2022.Real estate investment fell by 5.8 percent year-on-year, with the drop narrowing by 4.2 percentage points from that in 2022.

In the first quarter, the consumption and service sector began to recover. China's final consumption expenditure contributed 66.6 percent to economic growth in the first quarter. Retail sales rose by 5.8 percent compared to the same period last year, 1.9 percentage points higher than the average compound growth rate from 2020 to 2022.

Despite the rebound in domestic economic development, there are mounting uncertainties, especially due to the changing overseas environment, which is vastly different from that of 2021.

In the first quarter, external demand made a negative contribution of 1.3 percent to China's economic growth. During the same period, private investment remained sluggish, with a year-on-year growth of 0.6 percent, down 0.3 percentage point from the whole year in 2022.

There has been a lack of rebound in "revenge spending", as the contribution of final consumption expenditure to the first-quarter economic growth decreased by 0.24 percentage point year-on-year. Enterprise operations remained difficult and the profits of China's large industrial enterprises fell by 21.4 percent year-on-year in the first quarter.

According to a meeting of the Political Bureau of the Communist Party of China Central Committee held in April, the improvement seen in the economy is mainly restorative with the endogenous driving force still weak and demand insufficient.

As per the meeting, it is important to give full play to the effectiveness of policies while boosting the vitality of business entities. It is also necessary to step up efforts in making proactive fiscal policy more effective and prudent monetary policy more targeted so as to create synergy for expanding demand.

The following are some predictions for China's monetary policy in the second half of the year.

First, inflation does not yet pose a constraint to monetary policy. In recent years, China's inflation has remained stable. Previously, given the experience of developed economies, there was a worry that China's pent-up demand could be released in the short term, leading to a significant increase in the economy above its potential growth rate, thus causing high domestic inflation.

However, with the limited rebound in the core consumer price index and the producer price index remaining in negative territory in the first quarter of 2023, there are concerns about the risk of hidden deflation in China.

This year is indeed significantly different from previous years, such as 2021, due to the anti-inflationary forces and the "scar effect" from the COVID-19 pandemic.

Developed countries, including the United States, did not experience sustained demand suppression in previous years, such as in 2021, and the pandemic did not significantly change consumer behavior in Europe and the US. But Chinese consumers are more conservative and cautious, and it is difficult to replicate the experience of Europe and the US.

Moreover, slightly higher inflation is not a bad thing. The key is that after enterprise income rises, it can form a virtuous cycle with labor, further consolidating the foundation of economic recovery. The PBOC has said that the overall trend of inflation in China this year will remain mild and inflationary pressure is controllable in the short term.

Currently, China's economy is in a process of recovery, and the main contradiction is still insufficient effective demand. In this sense, it is difficult for monetary policy to make a rapid transition from accommodative to tight during the year.

Next, the country will not resort to strong monetary stimulus, like the extreme monetary easing followed by extreme tightening by major economies' central banks.

Further, monetary policy is ultimately a debt instrument that can only address liquidity issues. In 2022, although M2 increased rapidly, it did not generate effective real economic growth, resulting in China's monetary velocity being not only much lower than that of the US, but lower than that of Japan during the same period.

It is estimated that by the end of the first quarter of 2023, the macro leverage ratio of China's real economy may have increased by 8.8 percentage points quarter-on-quarter.

Compared to the previous quarterly meeting, the monetary policy committee meeting in the first quarter of 2023 changed "strengthening cross-cyclical and countercyclical adjustments" to "effectively implementing cross-cyclical adjustments".

It also changed "maintaining effective growth in credit supply" to "maintaining a reasonable and steady growth in credit supply", while emphasizing that structural monetary policy tools should be reasonable, moderate and focused on key fields.

The next step should focus on the follow-up arrangements for structural tools, as well as innovative structural tools for key areas and weak links.

There may hardly be interest rate cuts in the second half of the year.

In 2022, China took measures such as multiple RRR and interest rate cuts to guide a reduction in financing costs of the real economy. This year, RRR cuts may be prioritized over interest rate cuts when necessary.

Ma Shuyuan is a postgraduate candidate at the School of Culture and Communication, which is part of the Capital University of Economics and Business. Guan Tao is the global chief economist of BOC International.

The views don't necessarily reflect those of China Daily.