Chinese industrial output is expanding respectably, nothwithstanding a negative market reaction to March data released earlier this week.

Annual growth in output fell to 8.9% last month, below market forecasts and the lowest since August 2012. The annual number, however, continues to be depressed by weakness in spring / summer 2012. Output is estimated* here to have risen by a seasonally-adjusted 5.1% in the six months to March, or 10.4% annualised.

Both new order flows and monetary trends suggest that growth will be sustained at around its recent pace into the second half – see chart and Friday’s post respectively.

*The estimate also adjusts for the timing of the Chinese New Year.

Global industrial output is conservatively estimated* to have risen by 2.6% in the six months to March, or 5.2% annualised. This would be the fastest six-month growth rate since March 2011 and compares with a small contraction in September 2012 – see chart.

Recent stronger output validates the “monetarist” forecast here that the global economy would regain speed in early 2013, notwithstanding ongoing fiscal tightening, in lagged response to faster real money supply expansion between spring and autumn 2012.

Global six-month real narrow money expansion has slowed since October 2012, with the decline estimated** to have continued in March. This suggests that industrial output growth will moderate in mid 2013 but real money trends remain respectable by historical standards, with a temporary fall in inflation providing support, courtesy of lower commodity prices.

The gap between real money and output expansion is a summary measure of “excess” liquidity available to boost asset prices. The gap remains positive but narrowed further in March, consistent with the liquidity backdrop becoming less favourable at the margin – a development possibly explaining recent choppier markets.

*”Global” = G7 plus emerging E7. The March estimate uses data for the US, China and Russia and an official survey forecast for Japan, with output elsewhere assumed to be unchanged from February.
**The estimate uses data for the US, Japan, Brazil, China and India and assumes unchanged six-month growth elsewhere.
 

Japanese money supply growth has been firming gradually, partly reflecting the already-significant QE programme introduced by the previous Bank of Japan (BoJ) leadership. This trend continued for the broader measures in March but the six-month rate of expansion of narrow money M1 fell back – see first chart. Monetary trends remain consistent with an improving economy but have yet to suggest any step change in prospects.

Global markets have risen since last week’s BoJ announcement of additional easing as speculative investors have “front-run” an expected “wall of money” leaving Japan in a desperate search for yield and inflation protection. The latest weekly capital flow numbers, however, show continued Japanese net selling of foreign bonds, although this may reflect seasonal factors – second chart.

Chinese monetary statistics for March were moderately encouraging, showing rises in six-month growth of the key real money and lending measures – third chart. Real M1 expansion remains slightly below its long-run average but may climb further in April / May – base effects are favourable. Economic prospects, in other words, may be improving modestly.

Korean industry is a bellwether of the global cycle and manufacturers became notably more optimistic about export prospects in March, despite a recent yen-driven surge in the won effective exchange rate – fourth chart. Korean export expectations usually track the G7 manufacturing purchasing managers’ survey – a small decline in the new orders component of the survey last month may be reversed in April.

Monetary trends and leading indicators continue to suggest that global industrial output expansion will moderate from a peak to be reached in the second quarter of 2013. These forecasting measures have yet to warn of serious economic weakness.

The chart shows six-month growth rates of global industrial output and real narrow money together with a leading indicator derived from OECD data*. Real money growth and the leading indicator typically signal economic changes about half a year in advance. The latest data points in the chart are for February 2013.

Output expansion has recovered in early 2013, consistent with a pick-up in real money growth and the leading indicator from spring 2012. The real money measure, however, peaked in October 2012, falling modestly through February 2013. This downshift has been confirmed by a decline in the leading indicator since December 2012. Allowing for the half-year lead, these developments suggest that output expansion will reach a peak between April and June 2013 and moderate over the summer.

Real money growth and the leading indicator are currently still at respectable levels by historical standards. Monetary trends, however, bear close scrutiny – US weekly data suggest a sharp slowdown in March, which will pull down the global real money measure barring an offsetting rise in other countries.

Global economic slowdowns in 2011 and 2012 were associated with significant falls in equities and other “risk” assets. Liquidity support, however, may be greater now than then – real money growth remains above output expansion, suggesting that there is “excess” liquidity available to flow into markets, while ongoing US and Japanese QE programmes will provide additional policy stimulus.

*”Global” = Group of Seven (G7) major countries plus seven large emerging economies (the “E7”). The leading indicator is termed a “double-lead” measure because it is designed to provide earlier warning of cyclical turning points.

A post last week suggested that the Bank of Japan’s monetary blitz would boost the M3 broad money supply by less than 3% in 2013. Further analysis supports this conclusion.

Central bank bond purchases have a direct impact on broad money only if securities are purchased from domestic non-banks – their bank deposits swell as the transaction is settled.

When the central bank buys from the banking system, the banks swap securities on their balance sheet for reserves at the central bank. The money supply is unchanged unless the rise in reserves leads banks to increase lending or undertake other money-creating activities. Any impact, in other words, is indirect.

Buying from overseas investors also has no first-round impact since their bank deposits are excluded from the money supply.

A significant direct boost from the current programme, therefore, depends on BoJ purchases substituting for buying by non-banks. The distribution of holdings and recent behaviour, however, suggest that banks and foreigners will accommodate increased BoJ demand.

The table below is a simplified presentation of data from the BoJ’s flow of funds accounts, showing flows and stocks of government securities by sector. Note, first, that domestic non-banks accounted for 42% of the stock of securities held outside the BoJ at the end of 2012* (right-hand column). The share of the banking sector – comprising Japan Post, domestic banks and other private intermediaries – was higher, at 48%.

These shares imply that, if the BoJ buys from sectors in proportion to their existing holdings, the ¥51 trillion of purchases planned for 2013 will give a direct monetary boost of ¥21 trillion (i.e. 42% of ¥51 trillion). ¥21 trillion is equivalent to 1.9% of the M3 money stock.

Now consider changes in sectoral flows between 2010 and 2012. BoJ buying increased significantly between the two years, from ¥5 trillion to ¥24 trillion. Yet purchases by domestic non-banks fell only marginally, from ¥17 trillion to ¥15 trillion. The BoJ’s increased buying was more than offset by a slump in banking system demand (i.e. including Japan Post), from  ¥26 trillion in 2010 to -¥4 trillion last year.

One explanation for the negative correlation between BoJ and banking system transactions is that banks vary their government securities holdings to offset changes in central bank reserves. BoJ buying boosts bank reserves even when purchases are from non-banks or foreigners. If banks target stable overall liquidity, defined as reserves plus government securities, a rise in their BoJ deposits will automatically trigger a rundown of securities holdings.

A negative correlation between reserves and banking system transactions in government securities is also evident in the UK in recent years and is the basis for the view here that QE pass-through may have been as low as 20% rather than the 60% claimed by the Bank of England – see previous post.

As shown in the table, the BoJ is targeting government securities purchases of ¥51 trillion and ¥50 trillion respectively in 2013 and 2014 but current BoJ deposits are projected to rise by even more, i.e. ¥60 trillion and ¥68 trillion. This huge reserves boost is likely to trigger heavy bank sales of securities. The illustrative forecast in the table shows sales rising from ¥4 trillion in 2012 to ¥27 trillion per annum – smaller than the swing between 2010 and 2012 despite a much larger increase in reserves expansion. With overseas holdings and overall issuance assumed, conservatively, to be stable, this would allow domestic non-bank buying to continue at its recent pace.

On plausible assumptions, in other words, the direct monetary boost from the BoJ’s actions could prove miniscule. A significant overall effect depends on banks and foreigners deploying cash received from the BoJ to increase lending to or buy assets from the rest of the economy. The hope is that, by changing expectations, the policy shift will induce such behaviour but Japan’s prior QE experiment as well as recent US and UK experience argue for caution.

Japan’s economic outlook has improved but this trend was in place before last week’s “shock and awe”, which may have only a marginal further impact and has been pushed through at the cost of the BoJ’s independence, increasing the risk of its future use as a source of permanent monetary deficit financing.

*This compares with a share of domestic non-banks in UK gilt holdings of 61% at end-2008 before QE started in March 2009.