What does the Indicator M2/GDP stand for?

According to the 2012 monetary and financial data published most recently, China’s M2/GDP rate is close to 190% that is not only much higher than the one of America, but also is much higher than the rates of Japan, Euro zone and other BRICS countries. Thus, some people argue that the circulation of Chinese currency is too large, and it may cause serious inflation.

Since China’s reform and opening-up policy in the 1970s, the M2/GDP rate has kept increasing (although the magnitude decreased a bit in some years). In the new century, our M2/GDP rate is much higher than many countries in the world. But it is not reliable to connect this rate with excessive money supply and inflation. If we promote this point to the public, we will misguide them.

What does the indicator M2/GDP stand for?  From its basic conception, GDP is the indicator to measure the total volume of economic activities of one country. M2 is the vault cash and holding cash (M0) plus demand deposit (M1) and plus fixed deposit etc. Thus, obviously, this indicator measures the proportion of transactions using currency as the medium of exchange in the total economic activities of one country.

McKinnon, an American expert, first put forward this indicator in 1970s and considered it as an indicator to measure the degree of financial deepening of a country. But after 30-year research, this measurement has not been widely accepted. Based on the 1867-1975 data of America, Friedman, the Nobel Prize winner, found that the M2/GDP showed the trend of “first increase and then decrease”. And it reached the peak 0.8097 in 1947 and has gradually decreased. It has been stably kept in the level of 0.6-0.7. After 1990s, the cross-countries data shows that the rate in China, Japan, Malaysia, Korean and Thailand has been relevantly high. And the rates of America, EU zone, India and Indonesia have been relevantly low. On the other hand, the M2/GDP rate of each country has gradually increased after 1990s, especially after financial crisis. The experiences after 1997-1998 Asian financial crisis and 2008-2009 financial crises have demonstrated this point. It also reflects the fact that after financial crisis, each country adopts the expansionary monetary policy.

M2/GDP can hardly tell the financial deepening degree, and it also can hardly connect with inflation. Based on the basic theory, it’s the increasing rate but not the money stock that influences the inflation. The calculation of M2 differs between countries. And the financial system and consuming pattern of each country are also different. Thus, it is unreasonable to connect the cross-countries comparison of M2/GDP rate with inflation. Based on the experience of the reform and opening-up policy process of China, we passed through the high-speed inflation period in 1987-1988 and 1992-1993. But, obviously, the M2/GDP rates at those periods are much lower than the number right now.

Though M2/GDP can’t demonstrate the financial deepening degree and can’t demonstrate the inflation, we need to know the cause of this high rate in China. In terms of some explanation, there are two reliable reasons: first, it is the “indirect financing” theory –that is, the financial system still relies heavily on bank loans after rapid development of China’s capital market during the past 20 years. Under this circumstance, derived deposits will lead to a relatively huge money stock. In countries with the dominance of direct financing like US, there is limited money stock because currencies are just transferred between different economic agents. The second is the “saving” theory. This theory regards that although the M2 of China is high, savings of enterprises and households take up a large proportion. Few cash is really in the circulation. In order to meet the requirement of economic activities, the total amount of currency defined by M2 will be relevantly high.

In a word, we should not to jump to conclusions when facing high M2/GDP rate. Though it maybe not a big deal to confuse the public, it’s really awful to affects the economic policy-making.

Originally published on Time Weekly | 2013-2-28