A different "Anti-Air Turn"

The fluctuation of credit data in April is related to the financial "squeezing out excess liquidity", reflecting the implementation of the requirement to "prevent funds from idling and circulating aimlessly". Unlike before, the focus of this round of "preventing idle circulation of funds" is on credit circulation, targeting the arbitrage of funds circulating between financial institutions and enterprises.

Based on this, the monetary authorities' management approach will also be different: in terms of incremental changes, they will no longer unilaterally pursue credit expansion, while maintaining a reasonable level of narrow liquidity; in terms of existing stock, efforts will be made to activate financial resources that are inefficiently utilized, in order to prevent credit circulation.

For the market, whether it is no longer pursuing credit expansion unilaterally, ensuring reasonable liquidity, or lowering deposit rates, it will be beneficial for the bond market. However, attention needs to be paid to the potential risks arising from the disappointment of interest rate cut expectations.

Key Points

• Fund circulation involves two levels: circulation between financial institutions and financial institutions-enterprises. From the recent statements of the monetary authorities, it can be seen that the focus of this round of "preventing circulation" will mainly be on the level between financial institutions and enterprises.
• After the epidemic, multiple macroeconomic indicators indicate the possibility of fund circulation in the market. Among them, the widening gap between M2 and M1 last year was pointed out as a sign of circulation. However, unlike before, the formation of the M2-M1 gap this time is due to M1 declining faster than M2, reflecting factors such as the downturn in real estate and scar effects. Therefore, the monetary authorities do not simply equate the M2-M1 gap with fund circulation, and will not adjust monetary policy directly due to changes in the gap.
• Examining the four common fund circulation models (interbank circulation, wealth management circulation, bill circulation, and credit circulation), this round of circulation is mainly focused on credit circulation. The main reasons for this are the asymmetrical changes in deposit and loan interest rates and insufficient actual loan demand, while the significant deviation between industrial enterprise liabilities and loan growth is a specific manifestation. In addition, the possibility of loan diversion and illegal lending cannot be ruled out. In response to this, the central bank pointed out "enterprise loan transfer and lending", which is a concentrated summary of this round of credit circulation.
• Because this round of fund circulation mainly manifests as credit circulation, compared to previous prevention of circulation measures, the regulatory strategies this time are also different: on one hand, the central bank has not significantly tightened liquidity; on the other hand, regulatory measures against credit circulation have been initiated, with the prohibition of "manual interest supplementation" being an important measure to prevent enterprises from taking advantage of the interest rate spread between deposits and loans.
• Looking ahead, under the background of "preventing circulation", regulators may focus on the following aspects to regulate arbitrage activities such as credit circulation: 1) in terms of incremental changes, no longer unilaterally pursue credit expansion; in terms of existing stock, efforts will be made to activate financial resources that are inefficiently utilized, in order to prevent credit circulation. 2) In addition to focusing on credit "quantity", accelerating the market-oriented reform of deposit interest rates and lowering deposit rates is also an important measure to compress the arbitrage space of credit circulation. As for loan rates, the central bank stated, "to prevent excessively low rates, intensify internal competition, or fund circulation, further reduce prices, and fall into a negative cycle".
• For the market, whether it is no longer pursuing credit expansion unilaterally, ensuring sufficient liquidity injection, or lowering deposit rates, it will be beneficial for the bond market. However, the current market's expectations for a rate cut in June are slightly optimistic, with the reason being that the political bureau meeting at the end of April proposed to "flexibly use policy tools such as interest rates and deposit reserve ratios, and increase support for the real economy" It seems to imply the possibility of reserve requirement ratio cuts and interest rate cuts. However, as mentioned in this article, in the new situation, the ways to increase support for the real economy may be more reflected in revitalizing financial resources and improving the efficiency of fund utilization. Therefore, the logic of interest rate cuts based on "flexible use of interest rate tools" may not hold true.

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1. Same Expression, Different Meanings

Since this year's "Government Work Report" emphasized "smooth transmission mechanism of monetary policy to prevent idle funds from circulating aimlessly," the central bank has repeatedly stated the importance of preventing idle funds from circulating aimlessly (referred to as "preventing idle circulation" below). However, unlike before, during this period of "preventing idle circulation," there has been no significant increase in funding rates, and monetary authorities have not significantly tightened liquidity. However, the significant decline in money supply (M1, M2) in April reflects the effectiveness of measures under the train of thought of "preventing idle circulation" (such as prohibiting manual interest rate adjustments). So, how should we understand the policy implications of the current "preventing idle circulation"? What kind of impact will "preventing idle circulation" have on the market in the future? This article attempts to answer these questions.

In fact, preventing idle funds from circulating aimlessly is not a new requirement. Historically, the country has corrected the situation of idle funds circulating aimlessly three times from 2008 to 2013, 2014 to 2017, and 2018 to 2020. Based on past experience, "preventing idle circulation" involves at least two levels of meanings:

1) Idle circulation of funds between financial institutions. For example, from 2014 to 2017, financial institutions used interbank businesses to evade regulation in a financial nested pattern, achieving idle circulation of funds. In response to this, the former China Banking Regulatory Commission issued the "Document No. 46" in 2017, launching a special rectification action on "regulatory arbitrage, idle circulation arbitrage, and related party arbitrage." The central bank also reduced idle circulation behavior by including off-balance sheet wealth management products in the MPA assessment.

2) Idle circulation of funds between finance and enterprises. For example, from 2018 to 2020, financial institutions and some enterprises used "structured deposits" as a tool to achieve fund arbitrage through credit circulation. In response to this, the former China Banking Regulatory Commission issued "Document No. 204" in 2019 to regulate structured deposit business. The central bank also issued notices to include the guaranteed return rate of structured deposits in self-discipline management, leading to a decline in the scale of structured deposits. Therefore, although defined as "idle circulation of funds," due to different forms of manifestation, the targets and market impacts of subsequent policy efforts are significantly different. So, what kind of scenario does the "preventing idle circulation" emphasized by the regulation refer to?

Reviewing the statements of regulatory authorities on "idle circulation of funds" on various occasions since 2022, it can be found that this time, the "preventing idle circulation" mainly targets the phenomenon of idle circulation between financial institutions and enterprises.

For example, at the press conference held in March, the deputy governor of the central bank emphasized the issue of "idle circulation of funds," stating that "we will continue to closely monitor situations such as enterprise loan transfers and lending, coordinate with relevant departments, improve management and assessment mechanisms, and promote the improvement of fund utilization efficiency." At the briefing in April, the director of the Monetary Policy Department further pointed out: "Some enterprises take advantage of their own positions to use low-cost loans to buy wealth management products, deposit fixed-term deposits, or lend to other enterprises. The main business does not make money, and finance has become the main source of profit, which easily leads to idle circulation and idle funds, reducing the efficiency of fund utilization." It can be seen that this focus of this round of tightening may be concentrated on the "finance - enterprise" level, which is similar to the rectification carried out in 2018.

II. Fund Rotation "Comprehensive Examination"

Regarding fund rotation in two scenarios, regulatory authorities have summarized various arbitrage patterns that financial institutions may engage in. Notably, bill rotation, interbank rotation, wealth management rotation, and credit rotation are the key focus areas of regulatory attention in terms of "fund rotation". In the following, this article will search for clues of fund rotation starting from the "Financial Institution Balance Sheet" and "Credit Income and Expenditure Statement".

Multiple macro indicators point to the existence of fund rotation

From a macro perspective, there is evidence of fund rotation:

1) M2 growth rate does not match nominal GDP growth rate. Since 2022, the M2 growth rate has been consistently higher than the nominal GDP growth rate. Although the growth rate difference has narrowed since 2023Q2, it still remains above 4%. As a derivative indicator, the leverage ratio of the financial sector can also be used to observe the situation where the financial sector is detached from the real economy. During the fund rotation period of 2014-2016, the leverage ratio of the financial sector rose rapidly, with the liability side leverage ratio reaching 67.4%. By the end of 2024Q1, the leverage ratio of the financial sector exceeded 68%;

2) The proportion of value added by the financial industry to GDP is relatively high. According to traditional statistical methods for the value added by the financial industry, if the proportion of value added by the financial industry is too high, there may be a phenomenon of fund rotation. For example, during the previous two rounds of fund rotation, the proportion of value added by the financial industry once reached 8.4%. In 2023Q4, this indicator once again exceeded 8%.

3) M2-M1 scissor difference remains high. Combining the two historical periods of "fund rotation" in 2014-2016 and 2018-2020, the M2-M1 scissor difference was above 5% during both periods, and significantly decreased after rectification. After the pandemic, the average value of M2-M1 scissor difference rose to around 7.5%, in line with the regulatory judgment on the empirical regularity of fund rotation.

It is worth mentioning that, compared to the previous two rounds of "fund rotation", the formation of the M2-M1 scissor difference "gap" this time is due to M1 declining at a faster rate than M2, while during the previous two rounds of "fund rotation", there were no significant trend changes in both M1 and M2 Therefore, the divergence between M2 and M1 may be broadened or influenced by multiple factors, rather than solely attributed to the "idle funds" as a single factor.

In fact, the central bank has discussed the issue of the M2-M1 divergence many times and analyzed the reasons behind the significant fluctuations in M1. In summary, the central bank believes that the growth rate of M1 is influenced by multiple factors such as corporate deposit behavior, real estate market conditions, local debt replacement, and the transmission intensity of macro policies, making it prone to significant fluctuations. The M2-M1 divergence reflects the changes in the distribution and activity of money between different sectors (a responsible person from the central bank mentioned this in August 2016 when answering questions about credit data in July). Therefore, it is evident that the monetary authorities do not simply equate the M2-M1 divergence with idle funds and will not directly adjust monetary policy based on changes in the divergence.

Credit idling is the focus of this anti-idling measure

After identifying the phenomenon of "idle funds" in the market, it becomes crucial to recognize the patterns of idle fund arbitrage. From the arbitrage patterns mentioned above, the idle fund transactions between financial institutions mainly involve interbank idling and wealth management idling, while the idle fund transactions between financial institutions and enterprises mainly involve bill idling and credit idling.

Wealth management idling: Observe the two common patterns of wealth management idling: one is wealth management connecting with non-standard assets (the most famous being the bank-trust cooperation model). Historically, the "non-standard" business represented by entrusted loans, trust loans, etc., was the main way of idle fund transactions from 2014 to 2017. However, since the implementation of the "new capital regulations," the scale of "non-standard" assets has rapidly shrunk. As of the end of April 2024, the total balance of "non-standard" assets was 17.89 trillion, a decrease of nearly 10 trillion from its peak, with a year-on-year growth rate remaining around 0.

Another type of wealth management idling requires the assistance of interbank wealth management. This was more common in 2015 when interbank wealth management rapidly developed in an environment where banks had ample liquidity but lacked assets. Large banks achieved returns by purchasing interbank wealth management products from small and medium-sized banks, while the latter increased returns through leverage and duration extension through self-operated or outsourced means. However, under regulatory constraints, interbank wealth management rapidly decreased, dropping from nearly 6 trillion at its peak to 540 billion by the end of 2021, and has not expanded since then.

Interbank Capital Circulation: Interbank business refers to the fund transactions between commercial banks and other financial institutions (such as wealth management and insurance). In 2013, interbank business was the second largest channel for providing monetary supply after credit extension. Depending on the counterparty, interbank business can be divided into interbank banking and non-bank financial interbank, with the former reflected in the purchase and resale of assets through interbank direct investment, while the latter connects "non-standard" through interbank channels.

After the epidemic, there was no significant increase in interbank business between banks and non-bank financial institutions, but there were significant fluctuations in interbank business among commercial banks. Observing the "Claims on Other Depository Corporations" and "Claims on Other Financial Corporations" in the "Balance Sheet of Financial Institutions," the former had a rapid growth rate from 2021Q4 to 2023Q1, while the latter remained relatively stable. In terms of entities, nationwide large banks are the main suppliers of funds, while medium and small banks are the recipients of funds. In terms of targets, policy bank bonds and commercial bank bonds were issued in large quantities during this period and were subscribed and held, which may be related to this.

The overall growth cannot be directly equated to fund circulation, as it may reflect regulatory requirements for "counter-cyclical" adjustment and bank capital replenishment. However, the expansion of net interbank debt claims is worth paying attention to. Data shows that the trend of "Claims on Other Depository Corporations - Liabilities to Other Depository Corporations" has been on the rise since the outbreak of the epidemic, especially since the end of 2022, showing an accelerating trend. As the claims on other depository corporations/liabilities to other depository corporations record the situation of interbank fund lending and depositing, the two should generally match. However, in the case of credit circulation, the "Claims on Other Depository Corporations" item will continue to be higher than the "Liabilities to Other Depository Corporations" item. For example, during the period from 2008 to 2013, this difference continued to increase, corresponding to the fund circulation phenomenon driven by the "shadow banking" at that time.

Bill Circulation: A typical "bill circulation" model is: a company deposits margin deposits, applies for bank acceptance bills, and the payee is often a related company. The related company discounts the bills, returns the discount funds to the drawer, who then deposits it back into the bank as margin, issues bank acceptance bills again, and the cycle of discounting continues. In this process, the issuing bank completes the deposit task, while the applicant company can divert funds and seek interest rate differentials (for example, in November 2023, the 3-month deposit rate was 1.1%, while the 3-month bill discount rate was 0.85%). During the fund circulation period from 2008 to 2014, bank margin deposits grew significantly, with an average growth rate of 11.5%. In comparison, from 2020 to 2023Q1, margin deposits also showed significant growth. However, regulatory measures were implemented at the end of 2023 to restrict this behavior, leading to a net decrease in commercial bank margin deposits for three consecutive months from December 2023 to February 2024. In the first four months of this year, the deposit has decreased by approximately 300 billion yuan compared to the balance at the end of last year

Credit Funds Idle: First of all, the volume of structured deposits has not increased significantly, indicating that the arbitrage between "loans - structured deposits" has not resumed. The significant feature of fund idling from 2018 to 2020 was that low-cost credit funds flowed into high-yield structured deposits. However, since March 2020, the People's Bank of China issued the "Notice on Strengthening Deposit Rate Management" (Yin Fa [2020] No. 59), which included the guaranteed returns of structured deposits in self-regulation, and incorporated the implementation of deposit rate management regulations and self-regulatory requirements by banks into the MPA assessment. As a result, the balance of structured deposits rapidly declined from its peak of 12.1 trillion yuan to 4.6 trillion yuan by April 2024. Among them, the balance of structured deposits at national large banks and small and medium-sized banks decreased by 2.79 trillion and 4.8 trillion respectively.

Secondly, the practice of borrowing new funds to repay old debts is also considered as credit idling. As major borrowers, the growth rate of industrial enterprises' liabilities and loans has significantly deviated in recent years. Since 2022, the growth rate of industrial enterprises' liabilities has started to trend downwards, while the growth rate of medium and long-term loans provided by financial institutions to industrial enterprises has rapidly increased from 2022 to the second quarter of 2023. During this period, as the interest rates for new loans to enterprises were reduced by 60 basis points, it is expected that many enterprises applied for low-interest loans in a way of borrowing new funds to repay old debts, reducing financial costs but also leading to inflated credit. Finally, apart from the first two methods, loan diversion and illegal lending also fall under the category of credit idling. The People's Bank of China previously pointed out that "enterprise loan transfers and lending" are a concentrated summary of credit idling.

III. Next Policy Measures and Market Impact

As this fund idling mainly manifests as credit idling, the regulatory response strategy this time is different from previous measures to prevent fund idling.

On one hand, the People's Bank of China has not significantly tightened liquidity. In the first five months of this year, the People's Bank of China withdrew a net of 2.6 trillion yuan through reverse repurchase agreements, injected a net of 53 billion yuan through MLF, and the excess reserve ratio at the end of the first quarter was 1.5%, higher than the level during the "fund idling prevention" period of 2018-2019 (1.3%); the average spread between DR007 and reverse repurchase (7D) is only 12 basis points, much lower than the nearly 2 percentage points spread level during 2018-2019, indicating that the phenomenon of tiered liquidity is gradually disappearing in the funding market It can be seen that the central bank is still maintaining a loose liquidity stance.

On the other hand, regulatory measures to address credit idling have been initiated, with the prohibition of "manual interest supplementation" being an important measure to prevent enterprises from taking advantage of the interest rate spread between deposits and loans. On April 8th, the interest rate self-discipline mechanism issued the "Initiative on Prohibiting High-Interest Deposit Gathering through Manual Interest Supplementation to Maintain Order in the Deposit Market Competition," requiring banks not to promise or pay interest supplements that exceed the authorized upper limit of deposit rates to customers in any form. Subsequently, the high-interest deposits that were previously supplemented began to flow out, with a decrease of RMB 3.7 trillion in new deposits that month (residents + enterprises).

Looking ahead, under the background of "preventing idling," regulators may focus on the following areas to regulate arbitrage activities such as credit idling:

In terms of incremental changes, there will no longer be a unilateral pursuit of credit expansion. Since the foundation of credit idling lies in insufficient real financing demand in the real economy + banks deliberately pushing credit issuance, regulatory emphasis on the significance of credit growth is not meaningful until financing demand recovers. Since the end of last year, the central bank has repeatedly emphasized the need to "correctly understand the changes in the relationship between credit and economic growth, shift away from the traditional mindset of pursuing scale unilaterally, and align credit issuance with the needs of high-quality economic development" (Q1 "Monetary Policy Implementation Report").

In terms of existing stock, efforts are being made to activate financial resources that are inefficiently utilized, in order to prevent credit idling. The Central Financial Work Conference held at the end of last year proposed to "activate financial resources that are inefficiently utilized and improve the efficiency of fund utilization." Subsequently, the Q3 "Monetary Policy Implementation Report" opened a column, conveying a signal to replace incremental credit expansion with activating existing funds to support high-quality economic development. In the first four months of this year, new RMB loans amounted to RMB 10.2 trillion, a decrease of RMB 1.1 trillion compared to the same period last year. However, in terms of structure, while reducing real estate loans, loans to high-tech enterprises (13.6%), inclusive finance (24.6%), green finance (35.1%), and other financial new chapters have maintained rapid growth.

In addition to focusing on the "quantity" of credit, accelerating the market-oriented reform of deposit interest rates and lowering deposit rates are important measures to compress the arbitrage space of credit idling. In the process of interest rate marketization reform, the marketization of loan interest rates is faster than that of deposit interest rates, which has led to the emergence of credit idling. Especially after the epidemic, the tendency of entities to deposit funds for fixed periods has intensified, coupled with the unchanged belief of banks in "deposit-taking as a priority," making it easy to engage in illegal operations such as "manual interest supplementation." As for loan interest rates, the central bank made it clear at the April State Council meeting that "nominal interest rates should be kept at a reasonable level based on changes and trends in prices, to consolidate the positive trend of economic recovery, and also fully consider the needs of high-quality development to avoid reducing the momentum of structural adjustments, prevent excessively low interest rates, intensify inward competition, or fund idling, further reduce prices, and fall into a negative cycle."

For the market, whether it is no longer unilaterally pursuing credit expansion, ensuring sufficient liquidity injection, or lowering deposit rates, it will be beneficial for the bond market. However, the current market's expectation of a rate cut in June is slightly optimistic, with the reason being that the political bureau meeting at the end of April proposed to "flexibly use policy tools such as interest rates and reserve requirements, increase support for the real economy, and reduce the comprehensive financing cost of society," seemingly implying the possibility of reserve requirement ratio cuts and interest rate cuts However, as mentioned above, in the new situation, the ways to increase support for the real economy may be more reflected in revitalizing financial resources and preventing idle funds from circulating aimlessly. Therefore, the logic of interest rate cuts based on "flexible use of interest rate tools" is not obvious.

This article is derived from the report "A Different Approach to Preventing Idle Funds" published by analysts Zhang Jingjing (SAC license number: S1090522050003) and Ma Ruichao (SAC license number: S1090522100002) from CMSC on June 3. Some content has been edited by Wall Street News