Chinese stocks have taken a hit in the past few weeks. The Shanghai Composite Index tumbled by more than 9% in October and has shed 25% for the year. This equity market weakness reflects an anticipation that China’s economy might be cooling down.
To determine the probability of a cool down, one must look at the money supply, broadly measured. Indeed, for me, a monetary approach to national income determination is what counts. The relationship between the growth rate of the money supply and nominal GDP is unambiguous and overwhelming. For example, between 2003-17 China’s money supply grew at a rate of 14.92% annually and nominal GDP grew at a rate of 14.67% annually.
Let’s first determine the ‘golden growth’ rate for the money supply, and then compare this to the actual growth rate in China. To calculate the golden growth rate, I use the quantity theory of money. The income form of QTM states MV=Py, where M is the money supply, V is the velocity of money, and P is the price level, and y is real GDP (national income).
The QTM can be used to determine the money supply’s golden growth rate . This is the rate of broad money growth that would allow the People’s Bank of China to reach its inflation target. According to my calculations, the average percent real GDP growth between March 2013 (when Chinese President Xi Jinping took power) and September 2018 is 7.03%. For the same period, the average growth in total money supply (M2) was 10.26%, and the average change in the velocity of money was -1.83%. Using these values, and the People’s Bank of China’s inflation target of 3%, I calculated China’s golden growth rate for total money to be 11.86%.
So, the growth rate of money supply, which has been 10.26%, has lagged behind the golden growth rate. This suggests undue tightness on the part of the People’s Bank of China. Moreover, the growth rates of both the money supply and private credit have plunged since the end of 2012 and are far below their trend rates of growth.
China is undoubtedly cooling. It is unsurprising, in that case, that Chinese stock markets have been rattled. The cooling is having an impact beyond China’s borders. China has for some time been the biggest contributor to world growth. If China cools, the world economy cools, a bit. Moreover, China is a major driver in commodity markets. These sensitive markets have plainly anticipated a Chinese cool down. If you think Chinese equity markets have taken a beating in 2018, just look at some of the metal markets.
Steve Hanke is Professor of Applied Economics at Johns Hopkins University and Member of the OMFIF Advisory Board.