By Tristan Kenderdine

China’s agricultural support policies are moving towards marketised institutions, after a decade of state subsidies for direct production resulted in oversupply. A new framework of indirect support will focus on two measures: developing crop insurance for farmers, and developing futures markets for price discovery.

These ‘Insurance plus Futures’ policy pilots currently underway in China represent a giant paradigm shift for global grain and oilseed production. China is simultaneously ending state procurement on much of its agricultural product, while also opening the processing industry to imports.

There are four systemic reforms currently underway to transform China’s agricultural production system from state-procurement to market-priced production: agro-industrial upgrading, agricultural credit, agricultural insurance, and futures price-setting on agricultural commodities.

Agro-industrial upgrading will remain state subsidised, and agricultural credit has proven too difficult to effectively reform. But insurance and futures reforms are soon to move out of the pilot stage and into mainstream policy.

The government will no longer purchase grain directly from peasants, instead replacing state procurement with a new form of agricultural crop insurance. Insurance reforms will gradually step in to replace the social policy function of state procurement guaranteeing peasant incomes. The alliance of peasants and workers is enshrined in the Chinese constitution, and the Chinese Communist Party has an overt yet derogated governance obligation to the peasantry.

As an interim price-setting measure, a ‘target-price’ mechanism is designed to work towards the development of futures contracts, commodities exchanges, and other price formation institutions in China. A target-price is a floor-price at the provincial level on a single commodity, such as corn. Each province may set different prices for the same commodity, introducing some variability into national pricing. However, a range of institutional upgrades are necessary for the upgrade to full-scale futures markets in order to be able to create and transmit credible price signals to buyers and sellers.

These previously hollow institutions, sidelined for decades from actual agricultural production, are to become effective agents in the new pseudo-market model. The government will support the development of futures exchanges to attract technical transfers in human capital and know-how from foreign institutions in order to promote effective institutional integration with global markets.

However, rapidly developing the market institutions necessary to form and transmit commodity price signals will take time.

On the international front, opening to imports does not mean a wholesale opening to foreign capital. China’s Pacific Ocean market-import strategy will be markedly different to its Indian Ocean state-import strategy. Kazakh oilseeds and grains and African fish will come under a very different trade arrangement than rapeseed and soybean imports from North America.

This all means that in the area of international commodities, the gravity of institutional legitimacy is shifting to China, as China’s leaders move the country towards becoming a net importer in a range of commodities. Just as institutions such as the Chicago Board of Trade or the London Metals Exchange have enjoyed institutional legitimacy before it, China hopes that the commodities exchanges in Dalian and Zhengzhou could entice global markets to take signals from China.

This is part of a wider move in China towards greater imports – not just in agriculture. For China, the incentive is not a sudden urge to align with global agricultural commodity trade institutions and practice. Rather, increasing imports is a way for China to expand its leverage over the price-setting institutions of global commodities.

The gravity of China’s agricultural trade is also shifting to the Indian Ocean trade arrangements and away from the Pacific. China opening to more Pacific imports will really be liberalisation after the geo-economic paradigm has already shifted.

While the short-term Trump tariffs will dominate soybean news this year, China ending its policy of state procurement on staple crops is a paradigm shift for global agricultural commodity production.

The long-term move to a market model on domestically produced agricultural commodities and the opening of China’s consumer markets to imports of agricultural commodities would be a massive benefit to China as it sources cheaper grains and oilseeds to service its food needs. For agricultural exporting countries though, if China does open to greater imports, future political risk lies in the institutional legitimacy of price-setting, indices, and exchanges.

Global political factors will likely slow down China’s international import strategy for agricultural commodities. These include the ongoing trade dispute with the United States, exclusion from the Trans-Pacific Partnership, and wider institutionalised global trade uncertainty. However, China is genuinely moving to open agricultural markets while maintaining control of an agro-industrial policy complex.

This is quite an extraordinary situation for China’s agro-industrial development, as it is the opposite of the pattern of other rapidly industrialising East Asian economies. Historically, state-capitalist economies tend to open their manufacturing sector before agriculture.

However, the end game is not convergence with open market economies, but establishing the legitimacy of institutions. Bringing China’s domestic agricultural commodities into market-based production systems should be applauded, yet the financial and social vacuum of doing so while maintaining an essentially peasant population must still be questioned.

Tristan Kenderdine is Research Director at Future Risk and lecturer in Public Administration at Dalian University.

By Maximilian Kärnfelt

Since 2015, the specter of capital flight has been haunting the Chinese economy. In that year, faced with the threat of a currency devaluation and an aggressive anti-corruption campaign, investors and savers began moving their wealth out of China. The outflow was so large that the central bank was forced to spend more than $1 trillion of its foreign exchange reserves to defend the exchange rate.

The Chinese government was eventually able to dam up the flow of capital out of its borders by imposing strict capital controls, and China’s balance of payments, exchange rate and foreign currency reserves have all stabilized. But even the largest dam cannot stop the rain; it can only keep water from flowing further downstream. There are now several signs that the conditions that originally led to the first massive wave of capital flight have returned. The strength of China’s capital controls might soon be put to the test.

Before listing the reasons why a second bout of capital flight is looking increasingly likely, let us first address the underlying question: is capital flight truly so damaging for a country that fighting it can be economically justified? In the case of China, the answer is probably yes, for the following reasons:

• First, a government’s ability to pay for its domestic and foreign expenditure can be affected by capital flow out of the country. Large flows out of the country reduce the tax base, potentially reducing government revenue. Outflow can also result in a currency depreciation, increasing the cost of foreign investments. The Chinese government has large commitments both at home and abroad, so this is naturally a great concern.
• Second, asset price bubbles need a constant supply of liquidity. If capital flight is severe, such bubbles are deprived of funding and can subsequently burst, potentially causing a damaging crisis. China’s real estate market is clearly vulnerable to this.
• Third, as the Mundell-Flemming trilemma states, a country can only choose two of the following three: independent interest rates, free capital flows and a fixed exchange rate. If a country tries to have all three at once, then once the country enters a depreciatory cycle, foreign currency reserves must be committed. And once they are depleted, the fixed exchange rate can no longer be maintained. The Chinese central bank’s controlling rate is not the same as the US Fed’s, and the country manages its exchange rate. Therefore, it must control the flow of capital.

These three reasons make it clear that without capital controls, the Chinese government could face considerable difficulties in meeting its obligations and ensuring stability.

Capital flight stems from a combination of fundamental and psychological factors. Interest rate differentials between foreign and domestic investment and savings opportunities, as well as differences in tax rates are fundamental factors than can lead to cross-border flows. Psychological factors are related to the anticipation of changes in the socioeconomic environment which could negatively affect wealth holders. Such anticipations can largely be distilled into the suspicion that if capital is not moved outside of the country’s borders a large portion of it will be soon be appropriated or lost. And since investors are somewhat like herd animals, if one scares, panic often follows.

There are currently both fundamental and psychological factors that point to the possible return of capital flight. The West seems to have finally emerged from the Great Recession that followed the Global Financial Crisis in 2008. Western economies are once more returning to their long-run economic growth trends.

On top of this, central banks in the United States, Europe and Japan have begun reducing their balance sheets and are increasing controlling rates. These factors are driving rates up, narrowing the interest rate differential. Chinese rates are still higher than those in the West, but regular savers do not have access to the returns in the interbank market. For complex reasons related to China’s developmental model, rates paid for regular bank deposits are instead purposefully kept below the rate of inflation. Tax cuts in the United States will also make it a more attractive investment destination.

There are also real or imagined economic and political risks that could cause investors to decide to move their money abroad. The Chinese financial system—and corporates in particular—have since 2009 rapidly become highly leveraged. This means that a bailout of the financial system, either through raised taxes or the printing press, is not out of the question.

Secondly, the existing capital controls ironically have resulted in the RMB appreciating close to the level that it reached in 2015, just before the devaluation. Exports have begun to fall and there have been reports that exporters see this as a greater problem than potential tariffs. If exports continue falling, policy makers might be tempted to devalue the currency to support exports. All the above risks could easily persuade wealthy Chinese that moving capital out of the country is the best insurance policy against potential future losses.

However, a key point remains: if a large enough group of investor-savers decide to move their capital out of the country, the currency will come under pressure. A relatively small number of actors can in this way cause an enormous chain reaction. As Chinese foreign exchange reserves equal only 10% of money supply, a large-scale capital exodus would quickly deplete liquid currency reserves.

There are many signs that the difficulties China struggled with in 2015 could return. Even in the current calm, few would doubt that outward capital flows would be immense if controls were completely relaxed. Perhaps the most likely cause of renewed capital flight would be a possible bailout of the financial system as a part of the ongoing deleveraging campaign. Few wealth holders would like to be subjected to the taxation or inflation that would have to follow and would try to move their wealth abroad if they suspected a bailout was imminent.

The dams are keeping the water in for now. But time has passed, and no one can be sure if they will hold once the rain begins anew.

Maximilian Kärnfelt is an economic analyst at the Mercator Institute for China Studies (MERICS), where his research focuses on China’s macroeconomy, monetary policy, and financial markets. Prior to joining MERICS, he worked as an economic consultant for several companies. In 2016, he received his master’s degree in economics from Peking University, where he also worked as a research assistant.

The United States and China have moved their game of chicken on trade up a gear over the past few days. While there is still a decent chance of the two sides avoiding a collision by thrashing out a deal of some kind, they now appear to be accelerating toward each other at quite an alarming pace.

On Wednesday, China announced its intentions to impose tariffs on $50 billion worth of imports from the US as a tit-for-tat response to a similar plan announced by the American side in late-March. This in turn drew an almost immediate reply from President Donald Trump, who ordered US Trade Representative Robert Lighthizer to consider expanding the existing protectionist measures by a further $100 billion a day later, citing “unfair retaliation” by the Chinese.

In both cases, the extra tariffs would only come into effect if the US decides to go ahead with its $50 billion round of tariffs first announced on March 22. These are not due to be implemented for several weeks, meaning that the US and China still have time to negotiate a deal that would avert a trade war.

But there is no doubt that the mood has darkened, with Chinese state media adopting a markedly more bellicose tone in its reporting. On Saturday, Xinhua claimed that “if the US says that it will pay any price, it must be firmly attacked,” whilst the hawkish Global Times said it was time for China to hit back with such conviction that America will “remember the pain.”

The Communist Party newspaper, People’s Daily, also joined in, claiming that “the White House has completely lost its sense of reality!”

Are the two superpowers now destined for a full-blown trade war? And how would this play out? Opinion among analysts remains sharply divided over both questions.

The US still has a number of cards it can play if it wants to escalate the conflict with China over trade. So far, it has confirmed tariffs on just $6 billion worth of Chinese imports—steel, aluminum, washing machines and solar panels.

The extra round of tariffs first proposed in March will affect a further 1,333 classifications of goods, the White House confirmed last week. The products selected are skewed mainly toward high-tech industries, which supports the US’s position that the tariffs are a response to China’s unfair practices over intellectual property, but also avoids having to place duties on products that will lead to raised prices in Walmart, such as clothing, footwear and consumer electronics.

Which products would be included in the most recent, $100-billion round of tariffs remains to be seen. Many of China’s largest exports to the US have yet to be hit—telephones, laptops, and modems & routers together made up around $100 billion of trade revenue for China in 2017, for example. Placing duties on these goods could inflict significant pain on Chinese manufacturers, but also on US consumers, and also the American, South Korean and Japanese suppliers who provide components to China-based contract manufacturers like Foxconn.

With a bilateral trade deficit of $375 billion, the US has significant scope to ramp up the conflict even further if it chooses. If China were to respond to the US’s $100 billion worth of tariffs in kind, on the other hand, it would mean placing duties on almost all American imports, which totalled $130 billion in 2017.

However, the US is likely to face domestic push-back if it chooses to escalate the conflict. US agricultural groups including the American Soybean Association, National Corn Growers Association and US Grains Council have already condemned the fact that the government is willing to risk China placing tariffs on soybeans, as China buys the majority of the US crop each year. Other industries are likely to lobby intensely to be exempted from tariffs, too.

The desired outcome for many is a return of the primacy of negotiations in resolving any trade disputes. Officials on both sides have offered some reassurance that this is likely. On Friday, White House economic adviser Larry Kudlow told reporters that talks are ongoing, and disputes could be sorted out within a matter of months. He added, nonetheless, that Trump’s rhetoric was “no bluff”.

Some analysts see the darkening of the mood in recent days as just part of the negotiation process. Mizuho Securities believe that both “China and the US will eventually scale back its list of reciprocal tariffs and we do not look for an all-out trade war between China and the US.”

Much could rest on what China offers the US in terms of increased access for American businesses to sectors of the Chinese market currently subjected to protections. Several senior White House officials have hinted that this issue is a deal-breaker in the negotiations.

China is likely to offer some opening in industries that it considers of little strategic importance, such as automobiles and finance, but whether it offers the more fundamental reforms that many in the US desire is another question. What could change the calculus for China’s government would be if other major economies, such as the European Union and Japan, lined up with the US in demanding changes from China.

Worryingly for China, there are tentative signs that this may be beginning to happen, as both Japan and the EU have recently filed complaints of unfair trade practices against China at the World Trade Organization.

President Xi Jinping is due to give a speech later today at the Bo’ao Forum focusing on reform and market liberalisation. This should provide a clear insight into how China plans to respond to the US’s pressure.

On Monday morning, Beijing time, the first-ever yuan-denominated oil securities went on sale on the Shanghai International Energy Exchange, creating a storm of interest among both Chinese and foreign investors due to speculation that this could be the start of a fundamental shift in the global oil market.

The ‘futures’ contracts – securities that allow investors to buy barrels of oil at a set date and price – are being interpreted by some market analysts as the first step towards establishing a new Asia-focused benchmark that would offer an alternative to the otherwise Western-dominated industry, characterised by London’s Brent Crude and New York’s West Texas Intermediate.

A Shanghai Crude benchmark, based in the Chinese currency, would give China and its domestic firms a crucial benefit when it comes to controlling the price of oil in the region. Market prices would be freer to respond to local supply and demand, without hanging on to swings in the dollar on the other side of the world. Yuan-denominated futures, more so, could act as a useful tool for Chinese companies hoping to hedge against volatility.

This is not a recently thought-up goal by China, but one they have attempted to pursue before. Eager to boost the global significance of the yuan, a premature attempt was made in the early 1990s but failed due to price instability. Given China’s current status as a strong, maturing economy, however, the timing is much more appropriate to give it another go.

Last year China overtook the U.S. as the world’s largest consumer of oil, so it makes sense that more attention be paid to local markets, by-passing the petrodollar when making deals. According to forecasts by BP, China’s oil demand will continue to increase by some 30% to 753 million tons per year in 2040, which will only help further the yuan’s prominence. The petrodollar could be joined by the petroyuan as a global trading unit.

This might be particularly appealing to other countries looking to shake-off reliance on the dollar. Russia, for instance, now the largest supplier of oil to China, has already shown commitment to this cause. As of October last year, following the launch of a new payment system by Beijing, all oil reaching China from Russia, some 60 million tons a year, can be paid for in either rubles or yuan.

The prospect that Shanghai Crude will pose a serious contention to the prevailing dollar-based system should be dampened in the short-term however. There is much that needs to be done before a benchmark of similar calibre can take shape, perhaps most notably foreign demand. The Shanghai oil futures have been made available to offshore investors, with big players like Glencore, Trafigura and Freepoint Commodities all trading early on.

But the Chinese securities will always have the undesirable risk attached of a government intrusion into the market and the currency, something that foreign investors will be wary of. On top of that there is the usual rigmarole of doing business in China: traders of Shanghai crude must first set up special Chinese bank accounts and cannot invest their profits elsewhere in China.

Asian oil will still be dependent on the dollar for some time, it seems. Just today, three days into trading, prices for the futures swung wildly as traders responded to Western markets, ultimately finishing lower than Monday’s opening price.

Ultimately, however, the realisation of China’s commitment to market openness will determine whether Shanghai Crude becomes a game-changer.

China’s Consumer Price Index (CPI) saw an unexpected jump in February, rebounding to 2.9% year-on-year from 1.5% in January, its highest rate since November 2013, according to data released by the National Bureau of Statistics last week.

This is in line with China’s official CPI target of 3% for 2018 announced last week during the opening of the National People’s Congress in Beijing. Actual inflation rates, however, have been considerably lower. In 2017, China’s CPI grew by 1.6% year-on-year, and in January of this year the index rose by a similar 1.5%. Over the past five years, the CPI has risen at an average annual rate of 1.9%. The Bloomberg consensus for 2018 is a monthly average of 2.3% year-on-year CPI growth.

The Producer Price Index (PPI), conversely, grew at its slowest rate in 15 months. The index, considered less sensitive to seasonal factors such as Chinese New Year (CNY), rose 3.7% year-on-year compared to 4.3% in January, possibly caused by the easing of the antipollution campaign, which had previously maintained higher prices despite weaker industrial output.

Analysts at Standard Chartered expect this lower growth rate to sustain for 2018, giving an annual forecast of 4% year-on-year from 6.3% last year, as “slowing domestic demand more than offsets upward pressure from continued capacity cuts.”

Much of the growth in consumer prices appears to have come from a normalising of food prices, which finally grew in February following 12 months of deflation. Food prices grew 4.4% year-on-year last month from -0.5% in January, compared to 2.5% year-on-year for non-food prices.

Analysts at Capital Economics forecast this upward trend to continue over the coming few months, mainly due to the “unusually sharp fall in vegetable and fruit prices after last year’s Spring Festival” providing a “flattering base for comparison.”

Standard Chartered, who have predicted 2018 CPI inflation of 2.7%, went one step further and think most of the inflation pick-up this year will come from higher food prices.

Mizuho, however, believe that robust demand in the services sector will maintain the CPI inflation rate at around 3% year-on-year over the course of the next few months, in addition to the base effect.

In terms of policy-making, sustained upward pressure on consumer prices would normally be expected to elicit a tightening of China’s monetary policy to reign in high demand. However, given the sharp jump between January and February, it is possible that last month was just a spike caused by food prices and CNY influences.

Slowdowns in credit and money growth over the past year may continue to slow down an already-decelerating economy, ultimately impacting wages. Driven by slowing inflation in healthcare and rental cost inflation, Capital Economics said that “past experience suggests that policymakers are more likely to loosen rather than tighten monetary conditions this year.”