China’s Inflation Struggle

By John Richardson

LIKE the boy who cried Wolf the blog might not be believed as we once again warn about the risks ahead for China’s economy.

We have been worried for a long time that eventually China’s huge economic stimulus package, in response to the threat of social unrest, would cause some major problems.

As our fellow blogger Paul Hodges points out, Beijing had little choice but to pump-prime to such a huge degree because of the more-than 20 million migrant workers who had lost their jobs in early 2009.

Some of the money had to waste because it was so rapidly dispersed.

The state-owned banks, for example, have such close connections to the state-owned enterprises (SOEs). So the easiest and quickest way for the banks to follow the government order to go out and lend as much as possible was to lend to the SOEs.

We hear reports of a lot of this money going into unneeded industrial capacity and to arms-length trading companies that have greatly increased speculation in chemicals (for example, the story of an SOE official barred from trading who siphoned-off bank loans to his son so he could set up a chemicals and other commodities trading company).

But you didn’t need to be related to an official in an SOE to get access to plentiful and cheap credit during the 2009-2010 explosion in loan growth, as money was no object across many levels of society.

The greater importance of the Dalian Commodity Exchange in setting prices points to the increasingly speculative nature of polyethylene (PE), thanks to all this easy lending.

Anecdotal reports suggest that there as many more traders in PE than before the crisis as dabbling in the futures and physical markets have, until recently, carried very little risks.

The same applies to other chemicals and polymers, whether or not they have a future market.

“There are far more traders in mono-ethylene glycol (MEG) than before the crisis. Right now there is around 600,000 tonnes in storage in tanks in China compared with the usual 400,000 tonnes. This has been a common pattern since early 2009 because it is so easy to gamble,” a source with a major producer told us on the blog’s recent trip to Singapore.

Easy lending has, of course, not only led to greater confusion in chemicals and polymer markets as to the real strength of underlying demand. Far more importantly, it has led to asset-price bubbles, most notably in the property market, creating a new “have not” generation that is a major threat to social stability (the very problem the government was trying to avoid through the stimulus package!).

And so we have felt a correction had to take place because of these economic distortions. What we didn’t know (and if we did know we would be able to buy the odd yacht or two in the Bahamas) was the exact timing and extent of this correction.

We have, as a result, kept warning of the risks while being constantly surprised at the continued strength of growth – while occasionally losing our faith as we were sucked into the overall euphoria.

But now, believe us, the risks are greater than any time since late 2008 because of the battle to control inflation, the underlying causes of which are to do with the credit binge and the economic stimulus.

Will Freeman of Gavekal Dragonomics, an economic consultancy, said in the FT last week that the rising price of agricultural land and a surge in wages and input costs are behind the 11.7% year-on-year increase in food prices in March.

The government has blamed speculation, higher oil prices and hoarding for the rise in food costs, but Freeman argues that agricultural land has got more expensive because of the surge in demand for land for property. And as we have written about before, wages have been increased for rural workers (up 20% last year) and for factory workers in an attempt to tackle the inequalities created by the economic stimulus package.

The big worry now is whether inflation is out of control. Overall consumer prices rose 5.4% in March, the highest rate for 32 months, despite four interest rate rises since last October and six increases in the bank-reserve requirement to 20%.

More interest rate increases are expected later this year and very interestingly, Wen Jiabao, China’s premier, talked about using the exchange rate as mechanism to flight inflation for the first time last week.

Another reason why the battle to control inflation has yet to be won might be an increase in bank lending, despite instructions by Beijing to the state-owned banks to cut back on new loans. Financial institutions extended Rmb679.4bn in new loans in March – roughly a sixth higher than the median forecast from 13 analysts polled by Dow Jones Newswires, according to the Wall Street Journal. 

This was the result of what we talked about before – the “shadow banking system”.

But a new government statistic to capture this shadow system – total national financing – showed a 7.1% decline in Q1 over the first quarter of last year. This suggests that the rise in lending in March might be an anomaly.

Nevertheless, the struggle to deal with inflation will hang heavy over chemicals markets until or unless Beijing proves that it has achieved success. And as always with policies to deal with rising prices, there will be the constant worry of too heavy-handed action that sets growth back, as much as failure to be firm enough.





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