The All-China Federation of Pundits has been working overtime, interpreting central bank and State Council statements about the economy. A lot of the analysis has been overheated – maybe the summer weather and smog are to blame.
Much was made, for example, of the central bank dropping its earlier focus on tightening in favor of a “benign monetary environment for stable and fast economic growth.”
But official statements are not always what they seem.
The central bank huffed and puffed about tighter monetary policy at the end of last year but its objective was to reduce inflation expectations, not to do any actual tightening. As such, loan growth is up about 14% year-on-year – slower than last year’s 16% pace, but then bond issuances have been on the rise, which means credit flows have not slowed significantly. Where lending has slowed it is focused on sectors in which the government is promoting consolidation, while hikes in banks’ required reserve ratios are primarily intended to sterilize foreign exchange inflows.
We can expect to see only a few targeted policy adjustments in the second half of the year, both because there was little real tightening in the first half, and because Beijing is comfortable with the mild slowdown now under way.
After all, the two key drivers of Chinese economic growth – domestic consumption and investment – remain healthy. Real retail sales rose 13.5% in the first half, up from 12.2% a year earlier, while nominal fixed-asset investment growth came in at a solid 26.3%, comfortably above the 2007 full-year figure of 25.8%.
The slowdown is being driven primarily by the evaporation of net export growth and by manufacturing margin squeeze. Both trends will continue to deteriorate in the coming four quarters with demand in the US and EU certain to worsen and raw material and energy costs likely to remain high.
Overcapacity and competition mean that few producers can translate these increases into higher final goods prices, leading to the closure of even more small firms. After that point, consolidation will result in a bit of pricing power and margins should start to recover.
As manufacturers are unable to pass on rising costs to consumers, the consumer price index (CPI) is unlikely to come under too much strain and the pressures of earlier in the year are already easing. About 85% of price growth in 2008 has come from food prices, and about two-thirds of food price inflation has been the result of sky-high pork prices. Pork supply is now almost back to normal and the CPI rose 7.1% in June, its lowest level since January. Come December, it could be down to about 5%.
This means Beijing has little reason to veer from its current path.
Don’t read too much into the partial restoration of textile export tax rebates: It was a political gesture to an industry that employs tens of millions. The concurrent announcement of further rebate cuts for dirty and resource-intensive exports signals that Beijing is not retreating from its crackdown on those sectors.
Should growth start to drop off more sharply, the government has the financial means and the political will to spend its way out of trouble. There remains a huge need for better infrastructure – from subways in crowded cities to access to clean drinking water in the interior – and the party leadership has pledged to provide this.
The migrant workers who have lost their jobs in dirty Guangdong factories may not have to wait long for alternative employment.
The growth rate of electricity generation is a handy proxy to measure the pace and direction of industrial activity, and thus for macroeconomic growth. This is because industry accounts for 74% of power consumption and because the government does not appear to manipulate this data series.
The latest numbers seem to suggest that the Chinese economy is slowing sharply, with generation growth dropping to 8.3% year-on-year in June from 16.6% in March. Normally at this time of year, power generation would be accelerating, but this year June was flat compared to May.
However, the current slowdown is sending an unusually confusing signal because of supply side problems. This year, thermal coal supply is very tight and prices have risen sharply – by as much as 80% on the spot market – while power tariffs, which are controlled by Beijing, were only raised 4.5% in June.
With power plants either unable to obtain coal or losing a lot of money on every ton of coal they burn, many small independent producers have cut back on output or shut down.
Meanwhile, Beijing has initiated an ambitious plan to enforce safety standards in the small mines that account for about half of China’s coal production. Local officials are now held responsible for accidents and they have shut thousands of small-scale operators, causing national coal output growth to lag behind coal demand growth. Officials are now being encouraged to reopen these mines but they are moving cautiously.
These supply-side problems have conspired to rob China of about 3% of its national generating capacity, according to the State Electricity Regulatory Commission. Fourteen provinces are now imposing restrictions on industrial users in an effort to avoid blackouts.
China has experienced power shortages before, most seriously in 2004, but things are different this time. In the past, brownouts were due to demand for power outstripping installed generating capacity. Today, the shortage is due to the inability of the power system to operate at full capacity because of coal shortages and high coal prices.
While most of the slowdown in power generation is due to limited supplies of coal, some is due to softer industrial demand for electricity.
The ferrous metals sector accounts for 12% of China’s total electricity consumption, and output growth has slowed considerably this year. The overall industry is very profitable, but the shortage of coal – which has created a very tight market for coke – and tighter enforcement of pollution controls have pushed up operating costs. The overexpansion of steel capacity in recent years means it is difficult to respond by raising prices.
In 2006, crude steel production at small mills – those producing 3 million tons or less – rose by 33%. In the first half of 2008, growth at those mills plummeted to 3%. Demand for steel products shows little sign of shrinking and so the larger mills, which have the cash required to stockpile raw materials, have boosted output. Production at mills with a capacity of at least 10 million tons jumped 20% in the first half of this year from 12% in 2006. Steel prices have also risen.
It is a similar story in the nonferrous metals sector, which accounts for 7% of total electricity consumption. Output is down across the board due to a combination of smelting capacity expansion, pollution controls, rising input prices and the elimination of power subsidies and value-added tax rebates – but not a fall in demand for final products.
The impact of coal and power shortages is sufficient to warrant a re-examination of energy prices. Diesel is tipped to rise by as much as 20% and power by 5-10% – which should be enough to bring idled refining and generating capacity back on line.