special report...mar 10, 2016 · special report – economics: money supply – the forgotten...

l Global Research l

Important disclosures can be found in the Disclosures Appendix

All rights reserved. Standard Chartered Bank 2016 https://research.sc.com

Enam Ahmed +44 20 7885 7735

[email protected]

Senior Economist, Thematic Research

Standard Chartered Bank

Samantha Amerasinghe +44 20 7885 6625

[email protected]

Economist, Thematic Research


Chidu Narayanan +65 6596 7004

[email protected]

Economist, Asia

Standard Chartered Bank, Singapore Branch

Acknowledgements

We would like to acknowledge the contribution of

John Calverley, Chief Economist,

Calverley Economic Advisors Ltd.

Special Report – Economics

Money supply – The forgotten indicator

Highlights

Theory and historical evidence suggest that broad money and GDP

growth should be closely linked. But the link has weakened in the

face of financial innovation. We examine an alternative measure of

money, Divisia, and believe it can resurrect money as an indicator.

Standard money supply data simply sums the components included.

Divisia money weights components by their usefulness in transactions.

We find support for studies that show Divisia money growth to be a

good indicator of the stance of monetary policy and a useful predictor

of GDP growth. Our Divisia measures are also based on broad

measures of money which has a bigger impact on economic activity.

We provide our own in-house estimates of Divisia money for China,

the euro area, India and Japan. For China we produce our own

estimates of broad money supply, M3 and M4. Our global index also

includes the US and UK. We plan to provide regular updates on all

six major economies.

Divisia money growth is higher than two to three years ago, except

in the UK; but it remains slower than pre-2008, except in Japan,

suggesting that monetary conditions are still not buoyant. We

believe this supports our view that the global upswing will continue

but stay disappointing and that further stimulus will be necessary.

http://app.brainshark.com/standardcharter/vu?pi=zGuzVT7BBzGrsSz0

Special Report – Economics: Money supply – The forgotten indicator

10 March 2016 2

Contents

Infographic 3

Executive summary 5

Why look at Divisia money? 5

What Divisia money growth says 5

Conclusion – Add Divisia money to your dashboard 6

Why money supply is important 8

Theory and history 8

Money supply and quantitative easing 9

How Divisia money is calculated 10

Why Divisia money is superior 12

Country studies 14

Global – Picking up but still lacklustre 14

China – Fastest rate in three years 15

Euro area – A strong bounce in 2015 16

India – Running slowly since 2012 17

Japan – Up with Abenomics 18

UK – Slower recently 19

US – Stuck in low gear 20

Why don’t central banks use Divisia? 22

Conclusion – Add Divisia to your dashboard 22

Appendix 1: The quantity theory of money 25

Appendix 2: Calculating Divisia money 27

Practical problems in calculating Divisia money 30

Global Research Team 32


10 March 2016 3

Infograph ic

DIVISIA MONEY TRENDS

Latest rates, % Change in last 2 years Change since 2007

Japan

US

UK

Euro area

India

China

OUR TAKE

Source: Standard Chartered Research

15.4

11.8

7.2

6.8

4.0

3.5

0 4 8 12 16 -4 -2 0 2 4 -12 -8 -4 0 4

Moderate, but down since 2013 UK

Strong, but much higher since 2013; growth surprise?

Euro

area

Moderate, well down on pre- crisis India

Slow but higher than pre-crisisJapan

Slow but up since 2013; supports our below-consensus

growth forecast

US

Moderate, up since 2013; supports our above-consensus

growth forecast

China


10 March 2016 4

CALCULATING DIVISIA MONEY

*Based on a benchmark rate of 4% and a time deposit rate of 2%

WHY DIVISIA IS BETTER


M2

Divisia

M2

30

25

Time deposits

10

Time deposits

5

½

Adjusted for usefulness in transactions*, then…

Checking accounts

10

Checking accounts

10

Cash

10

Cash

10

It captures the relative ‘moneyness’ of each component

It can better accommodate new instruments

It is a theoretically consistent approach

It provides a more reliable signal of GDP trends


10 March 2016 5

Executive summary

Why look at Divisia money?

Economic theory suggests that growth in broad money supply is a good gauge of

monetary policy stance and likely GDP trends. In practice, financial innovation has

made ‘simple sum’ (SSM) measures of money unreliable as an indicator in recent

years. Divisia (named after French economist Francois Divisia, 1889-1964) money

uses a sophisticated weighting mechanism to adjust for the relative ‘moneyness’ of

different components, so it can take account of substitution between them, and the

emergence of new instruments. This makes it a more trustworthy money indicator

than official series. We find it performs much better as an indicator, and did so

especially during the 2008-09 global financial crisis (GFC).

We present data unavailable elsewhere

In this report we present Divisia money growth estimates for six major countries.

Currently neither the US nor China publish a money indicator broader than M2, but it

is important to look at broad measures to gauge liquidity properly. Our data covers

M4 for China, India, the UK and the US, and M3 for the euro area and Japan (though

definitions vary). We use the official Divisia series for the UK, the only country to

publish regular estimates, while US data is calculated by the Center for Financial

Stability. The estimates for China, the euro area, India and Japan are our own.

What Divisia money growth says

Money growth has been weak since 2008

Our measure of the global Divisia broad money supply (aggregating the six major

countries using GDP weights) illustrates the weakness of money growth since the

GFC, despite large-scale quantitative easing (QE). While central banks have been

adding money by purchasing securities, private-sector deleveraging has subtracted

money. Moreover, not all central bank purchases impact the broad money supply;

purchases from banks may only lead to higher central bank reserves.

Money is picking up, but is still lack-lustre

Divisia money growth picked up in 2015, led by acceleration in the euro area and

China. But the global measure, as well as the country measures (except Japan), are

still growing more slowly than pre-2008 (Figures 1-2). This supports our view that the

global upswing will continue but remain disappointing and more stimulus is needed.

Figure 1: Global Divisia money has been weak since 2008

Divisia and simple sum money, % y/y

Figure 2: Divisia money is turning up except in Japan and

the euro area, % y/y

Source: Standard Chartered Research Source: Standard Chartered Research

DM

SSM

0

2

4

6

8

10

2007 2008 2009 2010 2011 2012 2013 2014 2015

US

UK EA

JP

CN

IN

-10

-5

0

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013 2014 2015

Divisia money has been weak

despite QE

Divisia money uses a sophisticated

weighting mechanism


10 March 2016 6

China – The fastest rate in three years

Our measure of Divisia M4 has picked up over the last year to its fastest rate in three

years (Figure 3, page 7). We believe this pick-up reflects monetary easing, including

cuts in interest rates and reserve requirements as well as easing in macro-prudential

measures (see Special Report, 23 November, 2015, ‘Asian housing: Ride the cycle’).

This momentum supports our view that an imminent hard landing is unlikely and our

above-consensus forecast of 6.8% GDP growth for 2016.

Euro area – A strong bounce in 2015

Since late 2014 Divisia M3 growth has accelerated markedly, reaching 7.2% y/y

(Figure 4). This surge puts money growth only slightly below the 2003-07 average

and likely reflects both active QE and the recent rise in lending to the private sector.

But GDP growth has been lacklustre and most indicators suggest it will remain

modest: Our 2016 GDP forecast of 1.4% is close to consensus. In contrast, strong

Divisia money growth could be pointing to a growth surprise.

India – Running slowly since 2012

Trends in Divisia M4 fit well with the growth slowdown and the fall in the inflation rate

since 2012 (Figure 5). Divisia M4 has firmed slightly over the last year, suggesting

economic growth could pick up or at least continue at recent moderate rates.

Japan – Up with Abenomics

Growth in Divisia M3 has picked up since QE was expanded in 2013 as part of

‘Abenomics’ (Figure 6). But money growth is still only modest, suggesting QE is

struggling to boost broad money. That said, our analysis finds the relationship

between money and GDP in Japan is not as reliable as in other countries.

UK – Slower recently

In the UK, Divisia growth is a good match with GDP trends, much better than the

simple-sum M4 measure. Currently Divisia M4 is growing at 6.8%, below the 7-10%

growth rate seen pre-2008 and also down from the level in 2013 (Figure 7). GDP

growth has indeed slowed since 2013 from 3% to about 2%. This is consistent with

the Bank of England (BoE) remaining on hold, in our view.

US – Stuck in low gear

Our analysis finds that Divisia money fits better than official M2 with trends in GDP.

US Divisia M4 is expanding at 4% currently, well below the 6-7% rate prevailing

before the GFC and helping to explain why GDP growth remains disappointing

(Figure 8). Slow Divisia money growth supports our below-consensus 2016 GDP

forecast of only 1%, with GDP growth held down also by demand leaking abroad due

to the strong US dollar.

Conclusion – Add Divisia money to your dashboard

Our analysis, as well as academic studies, finds that Divisia money is a good

measure of monetary policy stance and a useful indicator for GDP trend. Divisia

money is not a magic crystal ball, but we believe analysts should add it to their

dashboard. It usually performs better than simple-sum measures. Divisia measures

will likely become more important in emerging countries as financial systems deepen,

widening the gap with simple sum measures. We plan to provide regular updates.

Divisia is not a crystal ball, but an

indicator worth watching

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10 March 2016 7

Figure 3: China DM4 and real GDP

% y/y

Figure 4: Euro-area Divisia M3 and real GDP

% y/y

Source: ChinaBond, Standard Chartered Research Source: Bruegel, Eurostat, Standard Chartered Research

Figure 5: India Divisia M4 and real GDP

% y/y

Figure 6: Japan DM3 and real GDP

% y/y

Source: India Central Statistical Organisation, RBI, Standard Chartered Research Source: Bloomberg, Economic and Social Research Institute Japan

China DM4

China real GDP (RHS)

0

2

4

6

8

10

12

14

16

0

5

10

15

20

25

30

2007 2009 2011 2013 2015

Euro-area DM3

Euro-area Real GDP

(RHS)

-6

-4

-2

0

2

4

6

0

2

4

6

8

10

12

2004 2006 2008 2010 2012 2014

India CPI

India Divisia M4

India real GDP

0

5

10

15

20

25

30

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

DM3

Japan real GDP (RHS)

-12

-10

-8

-6

-4

-2

0

2

4

6

8

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Figure 7: UK Divisia M4 and real GDP

% y/y

Figure 8: US Divisia M4 and real GDP

% y/y

Source: Bloomberg, BoE, Standard Chartered Research Source: Bloomberg, Centre for Financial Stability, BEA

UK DM4

UK real GDP (RHS)

-8

-6

-4

-2

0

2

4

6

-2

0

2

4

6

8

10

12

2000 2003 2006 2009 2012 2015

US DM4 incl USTs

US real GDP

-10

-5

0

5

10

15

1968 1971 1975 1979 1983 1986 1990 1994 1998 2001 2005 2009 2013


10 March 2016 8

Why money supply is important

Theory and history

For more than 200 years economic theory has recognised a close link between

money and GDP. One way of thinking of this is that for people to make transactions

they need to get the money together first. Another is that people try to keep the ratio

of their money holdings to other assets broadly constant, so if they accumulate more

money relative to other assets they will seek to spend it to restore equilibrium. That

said, economists since Keynes have often disputed the direction of causation

between money and GDP. And since the failure of the monetarist experiments in the

1980s, many have doubted the practicality of using money as an indicator,

particularly since financial innovation continues to generate new instruments that can

be used for transactions (see Appendix 1 for more on the historical context).

The quantity theory of money

The clearest formulation of the quantity theory is usually known as the Fisher equation

MV = PT

or

Money * Velocity = Prices * Transactions

Velocity (V) is the number of times money changes hands. Note that transactions (T)

include not just goods and services, i.e., GDP. It includes all transactions including

financial transactions. Hence a rise in money may portend an increase in stock or

house purchases. This effect can be seen in some of our analysis – e.g., the jump in

US money growth in 1987 ahead of the stock-market crash of that year and again

during the stock and housing bubbles around the turn of the century.

While strictly speaking the Fisher equation is an accounting identity, not a causal

relationship, classical theory (and monetarists) insists that a rise in M will flow

through to more transactions (and eventually higher prices). Some analysts argue

that an expanding money supply might have little effect because velocity may simply

decline to offset it. However, this view goes against more than two centuries of theory

and experience. That said, the links between money supply and the economy come

with what economist Milton Friedman called ‘long and variable lags’.

Simple sum money measures are unstable

The practical problem with using money supply as an indicator is that since the

1980s SSMs have proven relatively unstable and not well-correlated with GDP

trends. China is one of the few countries that still uses a money supply target for

reference; most central banks pay little attention to money supply. Modern financial

systems have too many instruments that have some degree of moneyness. Simple

sum aggregation can provide misleading signals.

Divisia may be the answer

The use of Divisia measures of money addresses these problems and provides more

confidence we are looking at a meaningful measure of money. This may be

especially important amid current low and even negative interest rates, as the

usefulness of interest rates as an indicator of the economy or policy stance is in

question. For example, few people now are confident that low rates mean that

monetary policy is super-stimulatory and that growth will surge. We need an

alternative way to look at monetary conditions.

For transactions, people need

money

Divisia money could overcome

some of the shortfalls of SSMs


10 March 2016 9

Money supply and quantitative easing

Another reason for looking at money supply is that central banks are now employing

QE as a stimulus technique. Many of them view QE primarily as a way to signal their

intention to keep interest rates low for a long time by bringing down long-term interest

rates. But its success as well as the inflation risk involved can also be judged by what

happens to money growth. If broad money growth picks up to a healthy rate the amount

of QE is probably about right. What is a healthy rate? For a developed economy

somewhere in the 4-7% range is probably about right, in our view. For China and India

a range of 10-15% may be enough to support GDP growth of 6-8%, moderate inflation

and some financial deepening.

QE does not necessarily boost money supply

There is a more or less 1-1 relationship between central bank purchases and M0 or

so-called central bank money. But broader measures of money from M1-M4 only

include money in circulation, which is what affects GDP. And reserves tucked away

at the central bank (included only in M0) are not in circulation. This is why the big rise

in M0 since 2009 in the US and other developed countries has not brought either an

economic boom or higher inflation.

Unfortunately, when central banks purchase securities from banks there is no direct

impact on the money supply beyond M0. Banks simply substitute reserves at the

central bank for the securities they have sold. QE only raises money in circulation if

the securities are purchased from non-bank institutions such as pension funds or

insurance companies. The central bank directly credits those institutions’ bank

accounts with newly created money.

QE may have been inadequate

We believe our Divisia estimates give us a good way of assessing whether the right

amount of QE has been done. Evidence suggests that if anything, quantitative easing

has been less than required since 2009. Money growth in the US, UK and euro area

remains far less buoyant than pre-GFC. This is likely partly because too much was

purchased from banks. Also QE needed to be enough to compensate for

deleveraging. Especially in the immediate aftermath of the GFC, the private sector

was paying down debt and banks were raising capital and trying to reduce their

balance sheets. These actions have the effect of reducing the money supply.

The good news is that money growth has picked up in the past year, notably in the

euro area where QE began in Q1-2015. But the euro area and Japan will likely need

to continue QE for a long time yet, and we cannot rule out further QE from the US

and UK if growth disappoints. Money growth in the US is at the low end of our

‘healthy’ rate of 4-7%.

Figure 9: Money supply components as a share of GDP

% of nominal GDP, 2015

M0 M1 M2 M3 M4

China 8.7 56.0 198.4 215.4 219.8

India 10.6 17.4 17.8 80.4 81.7

Euro area 10.3 99.7 136.6 148.0 NA

Japan 18.2 126.4 237.2 245.1 NA

United Kingdom 4.0 - - - 84.7

United States 7.6 17.1 69.0 - -

Source: Bloomberg, IMF, Standard Chartered Research

QE needs to be enough to take

money growth to a healthy rate

QE was not enough to compensate

for deleveraging


10 March 2016 10

How Divisia money is calculated

Weighting money components by their usefulness as money

Conventional measures of money supply are calculated by simply adding together

the components, ranging from currency and demand deposits in M1, time deposits

and money market funds in M2 and instruments such as CDs, commercial paper

and short-term debt securities for broader measures such as M3 and M4 (see

Appendix 2). The moneyness of each asset is assumed to be the same.

In reality the degree of moneyness varies, depending on ease and convenience of

use and reliability as a store of value. Currency and checking accounts are the

purest form of money and are mostly held for transactions. Using time deposits for

payments may incur a penalty or a delay or involve some inconvenience (such as

visiting a branch). Often time deposits are intended to be held for the longer term.

Securities such as commercial paper or short-term bonds can usually be sold

easily but may require time for settlement and their value could change due to

market or credit conditions.

A theoretically robust method

Divisia money is a theoretically robust method for weighting the components of

money supply according to their degree of moneyness. The technique is named

after French economist Francois Divisia (1889-1964) and has been developed and

championed primarily by US economist William Barnett. The weights are calculated

according to the interest rate paid on each component; those which are less useful

for transactions will enjoy a higher rate. Cash and checking accounts which pay

zero interest have the highest weight while relatively illiquid assets that earn closer

to the benchmark rate have the lowest weight. The weights will change as the

structure of interest rates change, allowing Divisia money to compensate for shifts

among components.

How to construct a Divisia money index

To calculate a Divisia index for money requires the following:

The amounts outstanding, and interest rates earned for each component.

A ‘benchmark’ interest rate against which the rate for each component can be

compared. This benchmark asset should enjoy the typical interest rate return in

the economy but be relatively illiquid and not be used for transactions.

The infographic on page 4 includes a simple illustration of how to calculate M2,

assumed to consist of cash, checking accounts and time deposits, where the first two

earn zero interest, time deposits earn 2% and the benchmark rate is 4%. M2 simply

sums the three components. Divisia M2 includes only half the time deposits

(calculated by taking 4/2). In practice the calculation is made using growth rates, so

the weighting of the growth of time deposits is cut in half.

If interest rates fell to 1% on time deposits and 3% on the benchmark asset, a higher

weight is given to the growth of time deposits, two-thirds. So is the money supply

suddenly larger? It depends, because people will respond to different interest rates

by moving assets from one component to another. When interest rates fall people

hold relatively more in demand deposits, because there is less advantage to keeping

money in time deposits.

Simple sum measures have been

found to be unstable

Divisia money assesses the degree

of ‘moneyness’ of different

components

A theoretically robust weighting

methodology


10 March 2016 11

A comparison of trends in US M1 and M2 with the federal funds target rate shows

this behaviour clearly: M1 and M2 move in opposite directions when interest rates

shift, more in M1 when rates go down and more in M2 when rates go up (Figure 10).

This shift in money supply measures is one of the key reasons why simple sum

money was found to be unstable in the past. The other was new instruments, which

could be used for money.

Choosing the benchmark rate

In practice it is hard to find an asset that exactly matches the requirements for the

benchmark asset; most assets have some degree of liquidity, while those that have

less, such as small stocks or private equity, involve high risk and volatility and are

hard to value. Moreover, since the benchmark rate must not be below the rate paid

on the money components (as negative moneyness makes no sense), this rules out

using a long-term bond yield as the yield curve can sometimes be inverted.

One approach is to use a bank lending rate (as we do for India). Another approach

formerly used by the BoE is to arbitrarily add a spread to a rate, in this case local

government bills plus 200bps. Yet another technique, which the BoE now uses,

assumes that the benchmark asset is the component of money supply that pays

the highest interest rate at any given time.

Despite these difficulties, research suggests that the choice of benchmark rate is less

important than it may appear because it is primarily used to measure the relative

moneyness of different components. The trend of Divisia growth rates turns out to be

not much affected by the choice of benchmark rates (Barnett 2011).

Figure 10: M1 and M2 go in opposite directions when rates change

US M1, M2 less M1 % y/y, and the federal funds target rate %

Source: US Federal Reserve, Standard Chartered Research

M1

M2 - M1 FFTR

-10

-5

0

5

10

15

20

25

1990 1994 1998 2002 2006 2010 2014

The benchmark rate must be higher

than the rates on all the

components


10 March 2016 12

Why Divisia money is superior

Better in theory

In summary, Divisia monetary aggregates are better in principle than simple sum

counterparts for four reasons:

1. The simple sum approach implies that all components of money stock are

substitutes or alike in their moneyness, which is plainly not true.

2. Simple sum fails to take into account substitution effects in the event of a change

in the relative interest rates on different monetary assets (as discussed in the

example above). Simple sum aggregates especially do not cope well with

extreme situations such as inverted yield curves or QE policies.

3. Using Divisia instead of simple sum overcomes many of the distortions of new

monetary instruments because the degree of moneyness of the new instruments

is automatically taken into account.

4. Using relative interest rates to derive the weights is a theoretically consistent

approach.

Better in practice too

Studies covering at least 10 countries have found that Divisia money aggregates are

better than simple sum (Figure 11). Divisia money is not a magic crystal ball but it is

generally found to be more reliably correlated with GDP than simple sum aggregates.

Moreover, several studies find that it adds useful information for forecasters and now-

casters (gauging the state of the economy ahead of other indicators). Our

investigations also find that Divisia money performs better than simple sum

aggregates for most countries, though the stories vary.

Our approach

In our country analysis, we focus on the linkages between changes in money growth

and changes in real GDP. This is a simplification of the theory that suggests that the

linkage should be between nominal money growth and nominal domestic demand

(GDP plus imports less exports). We present this data in Figures 28-33 for those

interested. But gauging nominal trends in demand does not tell us the breakdown

between real demand and prices. We believe it is better to view money growth as first

influencing real growth, then after time it may influence inflation. For example weaker

money growth is likely to first slow real demand growth, then lower the inflation rate.

What about the distinction between domestic demand and GDP? This matters

periodically, when a country sees a big change in its net export picture. For example, it

is likely to be important for the US this year because the strong USD means that

aggregate demand will likely be higher than GDP. But the difference is usually fairly

small. Some analysts prefer to compare real money growth (after subtracting inflation)

with real GDP (see Figures 34-39).

Divisia money performs better than

simple sum aggregates for most

countries


10 March 2016 13

Figure 11: Past studies suggest Divisia is better than SSMs

Country Year

Studies producing Divisia Monetary Aggregates

Summary

United States

1980

1984

2011

Economic Monetary Aggregates: An

Application of Aggregation and Index

Number Theory – William Barnett

The New Divisia Monetary Aggregates –

William Barnett, Edward Offenbacher

and Paul Spindt

How Better Monetary Statistics Could

Have Signaled the Financial Crisis –

William Barnett and Marcelle Chauvet

Barnett’s pioneering derivation of the Divisia money formula and

computation and discussion of the use of Divisia monetary

aggregates.

First empirical comparisons of Divisia monetary aggregates with

SSM in policy applications; Divisia money, especially at higher levels

of aggregation, usually performs better than simple sum when tested

against conventional policy-relevant criteria.

Most recessions in the past 50 years were preceded by

contractionary monetary policy, which is better indicated by Divisia

than by SSM data. Divisia monetary aggregate growth rates were

generally lower than SSM growth rates in the period preceding the

mid-1980s and higher since.

United Kingdom 2005 Divisia Money – Matthew Hancock BoE produces an improved measure of UK Divisia money and argues

for its usefulness.

Euro area 2014

Does Money Matter in the Euro Area?

Evidence from a New Divisia Index –

Zsolt Darvas (Bruegel)

Money matters for output, prices and interest rates and the ECB can

influence monetary developments. VAR models reveal significant

euro-area output and price responses to Divisia money shocks.

Divisia money reacts to user costs. Most of these results are not

significant when SSM is used.

China 2015

Chinese Divisia Monetary Index and

GDP Nowcasting – William Barnett and

Biyan Tang

Divisia monetary aggregates contain more indicator information than

SSM aggregates; factor model produces the best available now-

casting results. Divisia money showed that China’s money supply

declined at the beginning of 2010 after which the growth rates of

Divisia M1, M2, M3 and M4 all steadily decreased, reflecting the

tightened monetary conditions in China.

India 2010

The Divisia Monetary Indices as Leading

Indicators of Inflation – M.

Ramachandran, R. Das and Binod Bhoi

Empirical evidence suggests that Divisia monetary aggregates might

have an edge over SSM in a liberalised financial market regime in

predicting inflation. As countries such as India continue to liberalise

their interest rate structure and deepen their financial systems,

Divisia measures will become more important.

Japan 2009

Comparison of Simple Sum and Divisia

Monetary Aggregates Using Panel Data

Analysis – S. Celik and S. Uzun

Divisia monetary aggregates are superior over SSM in that they

perform better for the financial innovation period of the early 1980s

and 1990s. Divisia seems to overcome simple sum aggregates’

inability to react to financial innovation and provide a stable money

demand function.

Indonesia 2010

Financial Liberalisation and Money

Demand in Indonesia: Implications for

Weighted Monetary Aggregates – Hiew

Lee Chea

Looks at Indonesia’s monetary regime changes and the significance

of Divisia monetary aggregates in shaping monetary policy in

Indonesia from 1981-2005. Empirical findings indicate that Divisia

monetary aggregates have proven to be superior to SSM as a useful

measure of money for Indonesia.

Malaysia 2008

Revisiting Money Demand in Malaysia:

Simple-Sum Versus Divisia Monetary

Aggregates – Chin-Hong Puah, Choi-

Meng Leong et.al

Attempts to determine whether Divisia monetary aggregates are

superior monetary instruments in Malaysia where monetary targeting

has been replaced by interest rate targeting due to the inadequacy of

SSMs in predicting economic activities.

Germany 2015

The Information Content of Monetary

Statistics for the Great Recession:

Evidence from Germany – Wenjuan

Chen and Dieter Nautz

Introduces a Divisia monetary aggregate for Germany. Divisia money

and SSM are highly correlated in normal times but began to diverge

before the 2008 crisis, suggesting that Divisia was a better predictor

of the crisis.

UAE 2012

Divisia Monetary Aggregates for the

GCC Countries – Ryadh Alkhareif and

William Barnett

Divisia indexes are superior to the officially published SSM

aggregates in monitoring business cycles. Divisia money provides

critical information to policy makers regarding liquidity conditions.

Turkey 2009

An Empirical Study of Simple Sum and

Divisia Monetary Aggregation: A

Comparison of their Predictive Power

Regarding Prices and Output in Turkey –

Dogan Karaman (PhD thesis, University

of Kansas)

Uses several models and methods to compare SSM and Divisia

aggregates in predicting Turkish inflation and output growth in the

last two decades; overall, money provides a good amount of

information in predicting inflation and output in Turkey. In high-

inflation periods, Divisia aggregates clearly provide better information

than SSM, while in low-inflation periods simple sum aggregates are a

better predictor.

Source: Centre for Financial Stability, Standard Chartered Research


10 March 2016 14

Country studies

Global – Picking up but still lacklustre

Our aggregate is heavily influenced by China

We aggregate the six major countries in this study to create a global index and

compare it with a global index using simple sum money in each country and also with

GDP trends (all using the same aggregation methodology, see below). We find that

Divisia matches GDP trends better than SSMs especially during the global financial

crisis. In 2008-09, when Divisia money growth declined sharply in line with the

economic slowdown, simple-sum money actually accelerated, reflecting quantitative

easing (Figure 12).

From 2009-11 Divisia money growth was weak, in line with the weak global recovery.

It briefly approached a 7% growth rate in 2012 before slowing again. The most recent

reading shows Divisia money growth of 7.6% y/y, the fastest since 2008 (Figure 13).

That said, a comparison with 2008 needs to allow for the hugely increased weight for

China: 21% in 2015 versus 8% in 2007. With China’s Divisia money growing at 15%

compared with developed country rates of 4-6%, the aggregate rate of growth is

hiding big changes in composition. (Calculated at China’s 2006 weight, global Divisia

money would be growing at only 6.2%). This is another reminder of the increase in

importance of policy and performance in China compared with less than 10 years

ago. Still, we view the acceleration in our global Divisia aggregate since 2014 as

positive, as it reflects a significant pick-up in the euro area and China.

A note on the aggregation methodology

The six countries here cover 68% of world GDP and all the major reserve currencies.

To weight countries, we use market exchange rates but smooth changes over three

years to avoid sharp exchange rate moves dominating money supply moves.

Otherwise a sudden change in the euro (EUR) could significantly affect the global

money supply in a way that we doubt makes sense in analysing the relationship

between money growth and GDP. This method still allows us to capture broad shifts

in economic gravity. Since 2007 the euro-area weight declined from 31% to 25%, the

US from 39% to 35% and China increased from 8% to 21%. The rise of China

reflects mainly its GDP growth and to a lesser extent exchange rate appreciation.

The EUR exchange rate changes little over the period using our smoothing method.

The large decline in weight reflects its poor GDP performance.

Figure 12: Our global Divisia estimate

Divisia and simple sum money

Figure 13: Global Divisia and GDP growth

% y/y

Source: Standard Chartered Research Source: Standard Chartered Research

DM

SSM

0

2

4

6

8

10

12

2007 2008 2009 2010 2011 2012 2013 2014 2015

Divisia

Global GDP growth index

-6

-4

-2

0

2

4

6

8

10

2007 2008 2009 2010 2011 2012 2013 2014 2015

We smooth exchange rate moves to

avoid confusion

Our global index shows weak

money growth during 2009-11


10 March 2016 15

China – Fastest rate in three years

We publish new broad money statistics

Official money supply statistics from the Peoples Bank of China (PBoC) provide data

for M1 and M2. We construct new broad money measures for China covering M3 and

M4 based on a research paper by Barnett (2015). The official M2 aggregate includes

currency in circulation and corporate, personal and other deposits. Our wider

definitions take into account debt instruments up to three years, including commercial

bank bonds, corporate bonds, commercial paper, local and central government

bonds and also money market funds. The broader definitions are comparable to the

broader definitions available elsewhere, including in the UK, US, and euro area.

Divisia is a better fit with GDP than official M2

For China, official M2 and our calculations of Divisia M4 mostly track fairly closely but

there is one major exception, in 2012 (Figures 14 and 15). Official M2 bounced

strongly in that year, yet GDP did not, suggesting that official M2 gave an inferior

signal. Barnett’s analysis also found that Divisia aggregates contain more indicator

information than simple sum aggregates and were better at now-casting China GDP.

Divisia M4 differs comparatively little from simple sum M4 (both calculated by us). But

China has liberalised interest rates only recently and plans further financial-sector

liberalisation. We expect this to lead to more flexibility and eventually bring the

potential for greater divergence between Divisia and SSMs. That said DM4 was

stronger than simple M4 in 2009-10, which probably more accurately reflected the

strength of the economy then. In general as financial markets deepen in emerging

markets, we expect Divisia money to diverge more from SSMs. For this reason it will

be increasingly important to monitor Divisia.

Divisia money is picking up

Money supply growth, both the official M2 and our Divisia M4 estimate, has picked up

since the middle of 2015, suggesting that the economy may stabilise this year. This

supports our view that a hard landing is unlikely and our above-consensus GDP

forecast of 6.8%. The government has cut interest rates and reserve requirements,

as well as stoked fiscal policy and we expect more stimulus in coming months. China

has also relaxed macro-prudential policies, bringing a rise in housing-market activity

(see Special Report, 23 November 2015, ‘Asian housing: Ride the cycle’).

Figure 14: China Divisia M4 vs official M2

% y/y

Figure 15: China Divisia M4 vs real GDP

% y/y

Source: ChinaBond, Standard Chartered Research Source: ChinaBond, Standard Chartered Research

China DM4

China M2

5

10

15

20

25

30

2007 2009 2011 2013 2015

China DM4

China real GDP

China M4

0

5

10

15

20

25

30

0

5

10

15

20

25

30

2007 2009 2011 2013 2015

Type your side comments here, no

full stop

We present estimates for simple

sum and Divisia M3 and M4 not

published by the authorities

China’s Divisia money growth has

picked up since mid-2015,

suggesting the economy may

stabilise

https://research.sc.com/Portal/Assets/DownloadReport/2236-84427-1


10 March 2016 16

Euro area – A strong bounce in 2015

Divisia money grew very slowly during 2010-14

Divisia euro-area money supply at times differs quite markedly from its SSM

counterpart, in terms of both profile and growth rate (Figure 16). In the 2004-07

period Divisia M3 did not accelerate as much as official M3, making it a better fit with

real GDP growth, which was only mildly up (Figure 17). The European Central Bank

(ECB) raised rates in 2006-07 and even hiked again in July 2008, despite the

worsening financial crisis. The main fear was that higher oil prices would feed into

inflation expectations, but the double-digit growth in simple M3 may have been a

concern too. The Divisia measure, in contrast, peaked at 10% in September 2007

and slowed significantly by mid-2008.

Both measures did decline significantly during and after the GFC. This is different to

the experience in the UK and US, where simple sum surged initially and could be

because the ECB did not do quantitative easing at the time. During 2010-14 Divisia

money grew slowly, especially compared with pre-GFC growth, underlining the

weakness of monetary conditions. This sluggishness suggests that the ECB should

have begun QE long before it did in January 2015.

Divisia is now growing at 7%

Both measures of M3 have accelerated in the past 18 months, with Divisia money

now growing about 7%. This puts money growth only slightly below the 2003-07

average and likely reflects both active QE and the recent rise in lending to the private

sector. But GDP growth has been lacklustre and most indicators suggest it will

remain modest: Our 2016 GDP forecast of 1.4% is close to consensus. In contrast

strong Divisia money growth could be pointing to a growth surprise.

ECB studies (2001 and 2010) and others have concluded that Divisia monetary

aggregates display favourable econometric properties. The Bruegel Institute

publishes quarterly estimates of euro-area Divisia M3. Its analysis comparing Divisia

money with simple-sum measures reaches a number of conclusions: Divisia

aggregates have impacts on euro-area output and prices, output is impacted three to

nine quarters after a Divisia-money shock, the output shock is temporary, and the

ECB in practice reacts to developments in monetary aggregates. When measured via

SSM, the results are less meaningful.

Figure 16: Euro-area M3 vs Divisia M3

% y/y

Figure 17: Euro-area M3 vs real GDP

% y/y

Source: Bruegel, Standard Chartered Research Source: Bruegel, Eurostat, Standard Chartered Research

Euro-area DM3

Euro-area M3

-2

0

2

4

6

8

10

12

14

2004 2006 2008 2010 2012 2014

Euro-area real GDP

Euro-area DM3

Euro-area M3

-6

-4

-2

0

2

4

6

8

10

12

14

2004 2006 2008 2010 2012 2014


full stop

Euro area Divisia grew slowly

during 2010-14, underlining weak

monetary conditions


10 March 2016 17

India – Running slowly since 2012

Divisia M4 diverges significantly from simple M4

Our analysis finds that Divisia M4 (DM4) shows a closer correlation with GDP than

does simple M4 (published by the Reserve Bank of India, ‘RBI’). The two series

diverge in four periods (Figure 18). From late 2006 to 2008 signs of overheating in

India’s economy are better captured by the Divisia measure, which was running

higher. During this period India sustained GDP growth at over 8.5% and the RBI

tightened policy to control inflation.

In 2008-09 the growth of Divisia money fell sharply, which seems to fit well with the

sharp economic slowdown at the time. In contrast, simple M4 remained high during

the crisis, giving misleading signals. It likely picked up the effects of the RBI’s policy

actions (multiple cuts in the cash reserve ratio and interest rates) to inject liquidity

and arrest India’s declining growth rate. In April 2009 the growth in DM4 started to

pick up, reflecting the economic recovery, before falling sharply when India’s growth

slowed again. In contrast, simple sum M4 only rose and fell slightly.

Divisia picks up trends in inflation too

India differs from the other countries in this study in that there was a major change in

the inflation rate during the period. Wholesale price inflation of 10-11% in 2010-12

came down to the 5-6% range in 2014 before falling even more in response to lower

commodity prices. Consumer price inflation, the central bank’s target now, has also

fallen significantly from 10-12% in 2009-13 to 5-6% now (Figure 19). We believe our

Divisia index is broadly consistent with this trend. Moreover the volatility in our

measure of DM4 seems to pick up the volatility of consumer prices during 2011-14,

falling sharply, then spiking then falling again.

Since 2012 both measures have moved broadly sideways in line with GDP, though

DM4 has been on a slight strengthening path while simple M4 has been slowing a bit.

Divisia is signalling an improvement in economic growth or at least suggests a

continuing moderate pace.

Figure 18: India M4 and real GDP growth

% y/y

Figure 19: India Divisia M4 and headline inflation

% y/y

Source: RBI, Bloomberg, CEIC, Standard Chartered Research Source: RBI, Bloomberg, Standard Chartered Research

Real GDP

DM4 M4

0

5

10

15

20

25

30

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

India DM4

India CPI

0

5

10

15

20

25

30

2005 2007 2009 2011 2013 2015


full stop

Divisia suggests an improvement in

India’s economic growth


10 March 2016 18

Japan – Up with Abenomics

Divisia differs little from simple money

Data limitations and the flatness of Japan’s yield curve mean that when we estimate

Divisia money differentiation between assets is limited. The series therefore differs

little from simple money (Figure 20). That said, the trends in Japanese money are

hard to interpret. Japan’s economy grew quite solidly during 2003-07 (averaging

about 1.75% p.a. despite the declining labour force) and deflation even eased up,

with core CPI climbing to zero in early 2008. Yet money growth slowed in this period

and even went negative in 2007 (Figure 21).

The expected relationship with GDP growth is missing

One possible reason for this weak money growth is that the Bank of Japan (BoJ)

ended its first QE programme in 2005 (it began in 2001) and cut the size of its

balance sheet in 2006). Still, the expected linkage to GDP is lacking for Japan. So,

while faster growth of Divisia money in the last two years is encouraging, it is

difficult to be confident that this points to stronger GDP growth or higher inflation.

Moreover, despite substantial QE, with the BoJ balance sheet much larger as

percentage of GDP than the that in the US or euro area, the fact that broad money

is still growing ‘only’ 4% suggests scope for an even faster pace of QE.

Figure 20: Japan DM3 vs M3

% y/y

Figure 21: Japan DM3 and real GDP

% y/y

Source: Bloomberg, Standard Chartered Research Source: Bloomberg, Economic and Social Research Institute Japan

DM3

SM3

-1

0

1

2

3

4

5

2004 2005 2006 2007 2008 2009 2009 2010 2011 2012 2013 2014 2015

Real GDP (LHS)

DM3

-1

-1

0

1

1

2

2

3

3

4

4

5

-12

-10

-8

-6

-4

-2

0

2

4

6

8

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015


full stop

We are not convinced that faster

growth in Japan’s Divisia points to

stronger GDP growth


10 March 2016 19

UK – Slower recently

In the UK Divisia money seems to fit much better with economic trends than SSMs

such as M4 (Figures 22 and 23). During the early 2000s upswing DM4 remained

solid in the 7-10% range from 2001 until late 2007. In contrast, simple M4 showed a

distinct uptrend in 2005-07. Yet economic growth did not accelerate in this period.

Headline inflation and wages picked up a little but house-price growth slowed. It is

not clear that the acceleration in simple M4 was a useful signal. The base rate was

raised significantly in 2006-07 but monetary policy may have been too lax throughout

the period, as is implied by DM4 growing at a high 7-10%, rather than that monetary

tightening was especially warranted in 2006-07.

Divisia has performed especially well since 2007

Since 2007 DM4 has been a much better indicator than simple M4. DM4 growth

began to slow in 2007 and slumped to near zero well ahead of the Lehman

bankruptcy, correctly signalling the recession. In contrast, simple M4 slowed slightly

in 2007 but remained high and then soared during 2008-09, giving misleading signals

as it picked up the effects of liquidity provision and quantitative easing.

In 2010 DM4 recovered to growth of about 5%, reflecting the initial economic

upswing, before falling back again when UK growth slowed during the 2011-12 euro

crisis. Simple M4 slumped to below zero in early 2011, again distorted by financial

conditions. Since then it has roughly followed the same profile as DM4 but whereas

DM4 has averaged growth around 6%, consistent with the solid recovery since then,

simple M4 has ranged around 0%. The most recent Divisia growth rate is slightly

lower than two years ago, again consistent with the slowdown to around 2% GDP

growth currently from 3% previously.

Figure 22: UK Divisia M4 vs real GDP

% y/y

Figure 23: UK Divisia M4 vs real GDP

% y/y

Source: Bloomberg, BoE, Standard Chartered Research Source: Bloomberg, BoE, Standard Chartered Research

UK DM4

UK real GDP

-8

-6

-4

-2

0

2

4

6

8

10

12

1991 1994 1997 2000 2003 2006 2009 2012 2015

UK Divisia M4

UK M4

-10

-5

0

5

10

15

20

2000 2005 2010 2015

Since 2007, DM4 has been a better

indicator in the UK


10 March 2016 20

US – Stuck in low gear

Money supply is largely ignored

In the US simple money aggregates like M2 have proven unhelpful in understanding

the economy especially in the short and medium term, and neither the Federal

Reserve (Fed) nor most private economists pay much attention to these measures.

The Fed no longer even publishes broader measures of money, such as M3.

Yet Divisia M4 (DM4) calculated by the Centre for Financial Stability does seem to

perform much better than M2 historically (see Barnett 2011). In particular, the two

measures diverged sharply during two crucial episodes: the monetarist experiment in

1979-82 and the GFC (Figures 24-25).

DM4 correctly signalled the double-dip recessions in 1980-82

The US monetarist experiment beginning in November 1979 aimed to bring inflation

down gradually without a recession by targeting reduced money growth. It was

abandoned in November 1982 after two recessions in two years, which occurred

despite buoyant M2 growth. But DM4 did signal both recessions, suggesting that by

focusing on simple money measures, the Fed erred with overly tight policy.

Simple M2 growth gave false signals in 2008-09 and 2012

The most recent big divergence has been since 2007 (Figure 26). At the height of the

crisis in late 2008, M2 soared, reflecting the various emergency liquidity measures

taken by the Fed and the first round of QE beginning in November 2008. But DM4

collapsed, reflecting the economic slump, a much more useful signal. M2 surged to

show growth of almost 10% in the first half of 2012, suggesting a robust recovery and

even supporting some inflation concerns. DM4 was much weaker, particularly in H1

2012, correctly signalling the sluggish nature of the recovery and the need for QE3,

which duly began in September 2012.

Divisia money is still growing slower than pre-2008

In the past two years DM4 has picked up a bit but at 4% y/y is still at the floor of our

suggested healthy range of 4-7%. It is also well below the 6-8% range prevailing pre-

2008. The recent pick-up suggests a new recession, as some have feared, will likely

be avoided. But the strength of the US dollar means that some spending in the US

will leak abroad. Overall the weakness of Divisia money growth combined with the

strong USD supports our below-consensus GDP forecast of 1% for 2016.

Figure 24: US official M2 vs Divisia M4

% y/y

Figure 25: US official M2 vs Divisia M4 since Jan 2006

% y/y

Source: Bloomberg Source: Bloomberg

US DM4 ex- USTs SA

US M2

-10

-5

0

5

10

15

1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

US DM4 ex- USTs SA

US M2

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

The strength in US DM4 suggests

economic growth will continue

in 2016


10 March 2016 21

Divisia and the USD

We find a good relationship between money trends and the major multi-year swings

in the US dollar over the past 40 years (Figure 27). When money growth is

accelerating, the trade-weighted index tends to be rising and vice-versa. The intuition

here is straightforward. Accelerating money supply growth occurs when the economy

is strengthening; this also tends to be when the US dollar is strong.

However the relationship between money growth and exchange rates is complex

because it depends on whether the change in money growth is caused by

increased money demand (as in the US case) or increased money supply (as in

the case of Japan in recent years). Japan’s QE programme, promising faster

money growth, led to a sharp fall in the exchange rate. Because of these

complications and also because a full analysis of exchange rates requires

looking at relative money growth between different countries, we leave the

subject for future discussion.

Figure 26: US Divisia M4 vs real GDP growth

% y/y

Figure 27: US Divisia M4 vs USD trade-weighted index

Source: Bloomberg, Centre for Financial Stability, BEA Source: Bloomberg, Centre for Financial Stability, BEA

US DM4 excl Treasuries

US real GDP

-10

-5

0

5

10

15

1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

US real TWI

US DM4 incl USTs 2 yr mov

avg (RHS)

-10

-5

0

5

10

15

0

20

40

60

80

100

120

140

1973 1976 1980 1984 1987 1991 1995 1998 2002 2006 2009 2013


10 March 2016 22

Why don’t central banks use Divisia? Despite the evidence for its usefulness, only the UK’s central bank regularly

publishes Divisia data. While others have looked at it, Divisia has yet to catch on in a

major way either in central banks or academic circles. Money supply is out of fashion.

We think there are six reasons for this:

1. Modern economic theory, the so-called Keynesian-Neoclassical synthesis, uses

only a short-term interest rate to link the financial sector to the real economy,

(though this proved hopelessly inadequate in 2008 when models based on this

theory had no way to incorporate a financial crisis).

2. When theorists go beyond the interest rate they tend to focus on credit more

than money. Former Fed Chairman Bernanke based his prior academic career

on the case that credit rather than money is the key to the economy. And the

Bank for International Settlements, which is critical of standard theory, also

emphasises the credit cycle rather than money trends.

3. The monetarist experiments in the late 1970s and early 1980s left an institutional

distaste in many central banks for focusing on money. They believe that the

inflation-targeting regime, perhaps supplemented by macro-prudential

measures, is the best approach. And, with fears that money trends can be

misleading, especially in the short and medium run, central banks are reluctant

to draw much attention to money.

4. Concerns remain that financial innovation can confuse trends and that Divisia

money might not neutralise the effect.

5. Calculations of Divisia money can be hard to explain and may appear to be a

‘black box’. See Appendix 2 for a further discussion of this issue

6. Even if Divisia money has outperformed in the past, it remains to be seen

whether it can still work well with low or negative interest rates and flat yield

curves. Our research suggests that it is effective, but it is early days. The case of

Japan is a concern.

Conclusion – Add Divisia to your dashboard Our findings suggest that using Divisia estimates instead of simple-sum measures

significantly improves money growth as an indicator. The method of estimating

makes it a theoretically more trustworthy indicator of trends in money growth and it

can be used as a guide both to monetary policy stance and GDP trend.

Significant acceleration or deceleration in Divisia growth rates (2-3ppt or more) seem

to presage moves up or down in the GDP growth rate. Particularly slow money

growth, of 4% or below, seems to correlate with disappointingly slow GDP growth,

while fast growth rates of 7% or more in developed countries (as prior to 2008) or

rates of 20% or more in China and India are associated with overheating economies.

Divisia is not a magic crystal ball, but it looks like a useful indicator to monitor

alongside the usual closely watched activity and survey data. We hope central banks

will pay more attention as more data on the components of money supply and the

interest rates they earn could improve the precision of Divisia estimates. We plan to

provide regular updates and keep a close eye on Divisia.

Central banks should pay more

attention to Divisia money


10 March 2016 23

Figure 28: China Divisia and domestic demand

% y/y, annual avg Divisia growth rate

Figure 29: Euro area Divisia and domestic demand

% y/y

Source: ChinaBond, National Bureau of Statistics, Standard Chartered Research Source: Eurostat, Standard Chartered Research

Figure 30: India Divisia and domestic demand

% y/y, INR bn

Figure 31: Japan DM3 and nominal aggregate demand

% y/y

Source: RBI, Bloomberg, Standard Chartered Research Source: Ministry of Finance Japan, Standard Chartered Research

DM4

Domestic demand

0

5

10

15

20

25

30

2008 2009 2010 2011 2012 2013 2014

Euro area DM3

Domestic demand

-15

-10

-5

0

5

10

15

2004 2006 2008 2010 2012 2014

India DM4

Domestic demand (RHS)

0

500

1,000

1,500

2,000

2,500

0

2

4

6

8

10

12

14

16

18

2011 2012 2013 2014 2015

DM3

SM3


-1

0

1

2

3

4

5

-10

-8

-6

-4

-2

0

2

4

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Figure 32: UK Divisia and domestic demand

% y/y

Figure 33: US DM4 and domestic demand

% y/y

Source: Eurostat, Standard Chartered Research Source: Bloomberg, Standard Chartered Research

UK DM4


-20

-15

-10

-5

0

5

10

15

20

-2

0

2

4

6

8

10

12

2000 2003 2006 2009 2012 2015

US DM4 incl Treasuries

Domestic demand

-10

-5

0

5

10

15

2000 2001 2002 2003 2005 2006 2007 2008 2010 2011 2012 2013 2015


10 March 2016 24

Figure 34: China real Divisia and real GDP

% y/y

Figure 35: Euro-area real Divisia and real GDP

% y/y

Source: ChinaBond, Standard Chartered Research Source: Bloomberg, Standard Chartered Research

Figure 36: India real Divisia and real GDP

% y/y

Figure 37: Japan real Divisia and real GDP

% y/y

Source: India Central Statistical Organisation, RBI, Standard Chartered Research Source: Bloomberg, Economic and Social Research Institute Japan

Real Divisia

Real GDP

0

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013 2014 2015

Real Divisia

Real GDP

-8

-6

-4

-2

0

2

4

6

8

10

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Real Divisia (using WPI)

Real GDP

-5

0

5

10

15

20

25

2005 2007 2009 2011 2013 2015

Real Divisia

Real GDP

-12

-10

-8

-6

-4

-2

0

2

4

6

8

2004 2006 2008 2010 2012 2014

Figure 38: UK real Divisia and real GDP

% y/y

Figure 39: US real Divisia and real GDP

% y/y

Source: Bloomberg, BoE, Standard Chartered Research Source: Bloomberg, Centre for Financial Stability, BEA

Real Divisia

Real GDP

-8

-6

-4

-2

0

2

4

6

8

10

2000 2003 2006 2009 2012 2015

Real Divisia

Real GDP

-10

-5

0

5

10

15

1968 1973 1978 1983 1988 1993 1998 2003 2008 2013


10 March 2016 25

Appendix 1: The quantity theory of money

Quantity theory used to be central to economics

Until the 1930s the quantity of money was a major focus of economics. Famous

monetary theorists including Hume, Ricardo, Marshall, Fisher and Keynes (in his

earlier writings) argued that a rise in the money supply led to increased economic

growth in the short run, though in the long run GDP would fall back leaving only a rise

in the price level. The workings of the Gold Standard were much studied and seen as

operating through changes in the money supply and in wages.

The publication of Keynes’ ‘General Theory’ in 1936 transformed economic theory by

suggesting that, at least in times of inadequate aggregate demand, wages might not

adjust properly and even active monetary policy (freed from the constraints of the

Gold Standard) might be incapable of restoring growth (Keynes 1936). Instead

expansionary fiscal policy would be needed. Theory after Keynes has continued to

emphasise the key role of aggregate demand. Changes in interest rates, which would

influence aggregate demand, became both the instrument and measure of monetary

policy, in place of the quantity of money.

The monetarist revival

For a brief period in the 1970s and early 1980s the quantity theory came back to the

forefront of economics during the monetarist experiments. Central banks in the US,

UK and Europe tried to target the growth of money supply with the aim of gradually

bringing down high inflation without a recession. For a few years money supply

releases became the most-watched economic indicator, moving markets in a way

that employment or purchasing managers indices do today.

Inflation did come down (under the guidance of Paul Volcker at the Fed and Margaret

Thatcher in the UK) but only at the expense of severe recessions and high

unemployment. Meanwhile the targeted quantities (principally M2 in the US and

Sterling M3 in the UK), proved unpredictable and unstable. Within a few years

monetarism was abandoned and mainstream theory shifted back to the focus on

interest rates, increasingly ignoring money supply trends.

Why did monetarism fail?

There were several reasons for the failure of monetarism. If a particular measure of

money is targeted it becomes unreliable as an indicator of economic trends (known as

Goodheart’s law after monetary theorist Charles Goodheart). This is because investors

know it is targeted and seek to make money from the expected central bank response,

which distorts the outcome. Meanwhile, during the monetarist experiments interest

rates were high and volatile, again changing money demand and supply in ways that

models were unable to predict. Finally the 1970s and 1980s was also the beginning of

a period of rapid financial innovation, partly due to deregulation but also in response to

high interest rates, high inflation and monetary targeting itself. New liquid assets

appeared and holdings grew rapidly, including money market funds and various short-

term securities. Central bankers lost faith in the meaning of simple measures of money

supply and concentrated instead on interest rates.

In the 2010s interest rates are no longer a reliable signal

In past cycles, low interest rates were a clear signal that monetary policy was

expansionary and the economy should strengthen. Today, amid fears that demand is

so weak that interest rates cannot be pushed low enough, low interest rates are not

necessarily a signal of coming expansion, or a reliable policy instrument.


full stop

Central bankers lost faith in the

simple measures of money supply


10 March 2016 26

QE and the money supply

Although central banks have actively used quantitative easing, they have generally

understood this in terms of interest rates not the quantity of money, despite the

name. (QE is only the modern name for what used to be called ‘open market

operations’, a standard policy in the past.) In the US QE1 was widely seen as an

exercise to bring down credit spreads, particularly on mortgage securities, as a way

of boosting growth. It is generally seen as a major success.

QE2 and QE3, introduced when credit spreads were more normal, have been heavily

criticized and remain controversial, as does ongoing QE in Japan and the euro area.

Standard theory takes it that the driver of spending decisions is expected future real

short-term interest rates. So QE is seen as a tool to help drive down expected future

interest rates and is used alongside inflation targets and explicit forward guidance, as

the BoJ and ECB do today.

Central banks have therefore looked at the impact of QE on long-term interest rates

as an indicator of success, since long-term rates can be seen as the sum of future

short term rates. But if QE is expected to boost growth prospects and future inflation

then it should raise long-term bond yields, not cut them. So trying to gauge the

success of QE by looking for a fall in bond yields is flawed.

Using money supply to judge QE effectiveness

Since bond yields are misleading, a better approach theoretically is to look at the

impact on money supply. Here some analysts made a basic mistake. They saw the

rise in the monetary base, which is caused by QE (on essentially a one-for-one

basis), as hugely inflationary. But the monetary base consists largely of reserves

tucked away at the central bank. These excess reserves have no influence on the

economy (and are not included in money supply measures such as M1 to M4).

Classical theory is quite clear that these broader measures, that is money in

circulation, are what matters.

QE only directly increases the money supply (M1 upwards) in two circumstances.

One is if the bonds are purchased from non-bank entities such as pension funds or

insurance companies, in which case the central bank pays the seller in newly created

money. The other is if the bonds are purchased from banks and the banks respond

with new lending and/or purchases of securities from non-banks. Unfortunately, if

central banks purchase bonds from banks who simply replace them with reserves at

the central bank, there is no increase in broad money and no economic effect.

In principle, a good way to measure whether QE is effective is to see whether broad

money is expanding. Bear in mind that if the private sector is deleveraging or banks

are ultra-conservative, broad money could decline. As people repay bank loans or

banks raise their capital ratios banks shrink both their assets and liabilities. Hence

QE has to be enough to offset this if money supply is to rise. As discussed above,

our findings are that money supply growth, properly measured by Divisia, has picked

up but remains well below pre-2007 levels. This suggests that QE has played an

important role but more may be needed.

QE has played an important role but

more may be needed


10 March 2016 27

Appendix 2: Calculating Divisia money

Calculating Divisia

Divisia money is calculated as a weighted average of the growth rate of the different

components of money supply. The weights for the components are determined by

their usefulness for making transactions, which is proxied by the user cost of holding

these assets.

The user cost of a component is measured by the difference between the benchmark

rate, which is the post-tax interest rate paid on balances with no use for transactions,

and the post-tax interest rate paid on the component balance. Divisia money supply

growth is therefore calculated as follows:

∆Dt Dt–1

=

N

∑

i=1

1

2

∆Mi,t Mi,t–1

(Wi,t + Wi,t–1)

Where:

Mi = the level of the ith money holding

Wi = the weight on the ith component

rB = the rate on the benchmark asset

ri = the rate on the ith asset.

Figure 40: Definitions of money supply

Lowest measure of money supply that includes component

Component China Euro area India Japan UK US

Currency in circulation M0 M0 M0 M0 M0 M0

Demand deposit/other checkable deposits

M1 M1 M1 M1 M4 M1

Savings deposits M2 M1 M1 M4

Time deposits M2 M3 M1 M4 M3

Foreign currency deposits M3

Other deposits

M2 (deposits redeemable at a period of notice up to 3 months)

M2 (quasi-money) M4

Money market funds M3 (SC) M3

M2 (money market accounts, retail money market funds), M3 (institutional money market mutual funds)

Repurchase agreement M3 M4 M3

Postal savings deposit

M2 (post office savings deposits), M4 (other post office deposits)

Certificate of deposit M3 M4 M2

Debt instruments

M3 (SC): Central bank bonds, Policy bonds, Commercial bank bonds, corporate bonds, commercial paper, T-bills), M4 (SC): Treasury bonds, local government

M3 (debt securities up to 2 years)

M4 (bonds, commercial paper, FRNs, instruments of up to and including five years original maturity, bank bills)

M4-(commercial paper), M4 (Tbills)


Wi,t

= Mi,t (

rB,t – ri,t)

N

∑

i=1 Mi,t (

rB,t – ri,t）


10 March 2016 28

Divisia money growth produced by Standard Chartered Bank (SC)

Figure 41: China

Money supply Components Interest rate for Divisia calculation Source

M0 (official) Currency in circulation Assumed zero People’s Bank of China

M1 (official) M0 Corporate demand deposits

Corporate demand deposit

People’s Bank of China

M2 (official)

M1 Corporate deposits Personal deposits Other deposits

3-month time deposit People’s Bank of China

M3 (SC)

M2 Central bank bonds Policy bank bonds Commercial bank bonds Corporate bonds Commercial paper Money market funds

Central bank bill rate Inter-bank policy bank bond yield Inter-bank commercial bank bond yield Chinabond corporate bond yield Inter-bank commercial paper yield One-day interbank repo-rate

China Central Depository and Clearing Corporation Limited WIND Bloomberg

M4 (SC) M3 Treasury bonds Local government bonds

Inter-bank treasury bond yield Chinabond local government security yield

China Central Depository and Clearing Corporation Limited

Benchmark rate Short term corporate bond yield + 100 bps


Figure 42: India


M0 (official) Currency in circulation Assumed zero Reserve Bank of India (RBI)

M1 (official)

M0 Deposit money of the public (includes demand deposits with Banks and other deposits with Banks)

Prime lending rate RBI

M2 (official) M1 + Post Office Savings Deposits

Post Office savings Bank account rate

RBI

M3 (official) M1 + time deposits with banks

1 year time deposit rate Average of 1yr and 3 yr time deposit rates 3 yr time deposit rate 5 yrs and above time deposit rate

State Bank of India

M4 (official) M3 + total Post Office deposits Post Office time deposit account rate RBI

Benchmark rate Prime lending rate


Figure 43: Euro area


M1 (official) Currency in circulation Overnight deposits

Currency rate assumed zero Overnight deposit rate

European Central Bank (ECB)

M2 (official)

M1 Deposits with agreed maturity of 2 years Deposits redeemable at a period of notice up to 3 months

The rate on deposits with agreed maturity of 2 years The rate on deposits redeemable at notice of up to three months

ECB

M3 (official)

M2 Repurchase agreements Money market funds Debt securities up to 2 years

The rate on repurchase agreements Eonia rate BofA Merrill Lynch 1-3 year Euro Financial Index

ECB Bloomberg

Benchmark rate BofA Merrill Lynch 1-3 year Euro Financial Index + 100 bps



10 March 2016 29

Figure 44: Japan

Money supply Components Interest rate for Divisia

calculation Source

M0 Currency in circulation Assumed zero

Bank of Japan M1 Currency in circulation + demand deposits Assumed zero

M2 M1 + quasi-money (household) Quasi-money (corporate)

2-3 yr deposit rate 3m deposit rate

M3 M2 + CDs CD rate

Benchmark rate Average rate on short-term loans, city banks


Divisia money growth produced by others

Figure 45: UK

Money supply Components Divisia

M0 (official) Currency in circulation Banks operational deposits with the Bank of England

Divisia M4 produced by Bank of England

M4 (official)

M0 Deposits (including certificate of deposits) Commercial paper Bonds FRNs and other instruments of up to and including five years of original maturity issued by UK MFIs Repos Bank bills


Figure 46: US

Money supply Components Divisia

M0 (official) Currency in circulation

Centre for Financial Stability produces Divisia M1, Divisia M2, Divisia M3 and Divisia M4

M1 (official)

M0 Demand deposits Travellers’ checks Checkable deposits

M2 (official)

M1 Money market accounts Retail money market funds Certificate of deposits

M3 (Centre for Financial Stability)

M2 Large time deposits Institutional money market mutual funds balances Deposits of euro dollars Repurchase agreements

M4- (Centre for Financial Stability)

M3 Commercial paper

M4 (Centre for Financial Stability)

M4- T-bills



10 March 2016 30

Practical problems in calculating Divisia money

While we have made every effort to calculate useful data there are some practical

difficulties in estimating Divisia, where more central bank data could help:

1. Data availability issues. Full breakdowns of different instruments and their

interest rates are not always available, especially for long time series.

Sometimes simplifying assumptions have to be made, for example applying the

interest rate on one-year time deposits to all time deposits.

2. Bundled services. The interest rate may not always be the full return on a

particular instrument. For example checking accounts often provide free

transaction services and automatic overdraft facilities. Time deposits sometimes

have complex introductory teaser rates or even gifts (from toasters to telephone

minutes).

3. Choice of the benchmark interest rate. The Benchmark interest rate is often

difficult to choose or not easy to fully justify. That said, Divisia growth money

trends (if not rates) are not unduly sensitive to this because what matters is the

relative moneyness of each asset.

4. No allowance for adjustment time and costs. As discussed above, when

interest rates change, Divisia money automatically changes the weights on

components but in practice, asset holdings are only adjusted over time,

which may be partly due to inertia and partly to costs of switching. Divisia

assumes that assets holdings are always at their desired values. This means

that trends in Divisia can only be watched over time; short-term moves may

be misleading.

Figure 47: Divisia and our forecasts

% y/y

Divisia money growth (latest)

Divisia money growth 2012-14 average

GDP forecast 2016 Consensus forecast

2016

China 15.4 14.2 6.8 6.5

Euro area 7.7 3.5 1.4 1.6

India 11.8 10.3 7.6 7.4

Japan 3.5 2.9 1.0 0.9

United Kingdom 5.4 5.2 1.9 2.1

United States 3.8 3.3 1.0 2.2



10 March 2016 31

References

Barnett W and Chauvet M, Financial Aggregation and Index Number Theory, World Scientific, 2011.

Barnett W and Biyan Tang, ‘Chinese Divisia Monetary Index and GDP Nowcasting’, University of Kansas and

Centre for Financial Stability, New York, October 2015.

Darvas Z, ‘Does Money Matter in the Euro Area? Evidence from a New Divisia Index’, Bruegel Working Paper

2014/12, November 2014 (updated April 2015).

Hancock M, ‘Divisia money’, Bank of England Quarterly Bulletin, 2005.

Ramachandran M and Rajib Das et. al., ‘The Divisia Monetary Indices as Leading Indicators of Inflation’,

Department of Economic Analysis and Policy, Reserve Bank of India, 2010.


10 March 2016 32

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Document approved by

Marios Maratheftis Chief Economist

Document is released at

14:12 GMT 10 March 2016

https://www.sc.com/in/india_result.html

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