The China Inflation Muddle

By John Richardson

THE fascinating, but also at the same time frustrating, complexity of the Chinese economy has been thrown into further relief this week in the debate over the implications of the June 6.4% inflation rate.

The rate, the highest in close to three years, was seen as especially worrying by some economists because it included the highest “core” increase in the cost of living for at least five years.

Two thirds of the increase in overall Chinese inflation has, however, been attributed to food prices (food prices rose by 14.4% from 11.7% in May), creating the hope that the heat will soon be taken out of inflation when food prices moderate.

The cost of pork, for example, has risen by 57% in the past year and is often subject to boom-and-bust cycles. So the hope is that once pork and other highly volatile food prices moderate during the next down cycle, everything will be fine.

But the June core inflation rate of 3% has increased the concern that the huge 2009-2010 economic stimulus has created strong underlying inflationary pressures that won’t easily be solved.

“Since Q4 2008, China has created the largest credit bubble in history,” writes fellow blogger Paul Hodges in this post.

“First, it doubled bank lending to $1.4trn in 2009 (one third of GDP), and then maintained it close to this level. Secondly, it added a stimulus package worth another 13% of GDP ($580bn), focused on providing cheap electrical goods and autos.”

As we discussed earlier this month, some of these stimulus packages are being unwound – for example, in autos – with important implications for chemicals and polymer demand growth.

But still, with all this money left over from the stimulus package sloshing around in the economy, some economists are becoming increasingly worried that inflationary pressures are going to persist.

This was one of the points made in this article from the Wall Street Journal.

Out of a poll of 13 economists conducted by the Dow Jones Newswire last Thursday, however, eight said that they believed there would be no further interest rate rises this year as inflation would soon peak.

The poll was taken before the weekend release of the June inflation number, which was not only close to a three-year high but was also sharply higher from the 5.5% increase in May.

But several economists, even after the announcement of the June figure, were quoted in the same article as still believing that inflation would ease later this year.

Worryingly, though, these same economists had predicted in June 2010 that the rise n the cost of living would moderate. Instead, inflation jumped to 5.1% last November, stayed at a high level for several months, and has now started to accelerate again.

This perfectly illustrates the point we made at the beginning – that figuring-out what is really happening with the Chinese economy remains incredibly frustrating.

Lack of clarity means that every comment made by senior politicians is analysed, perhaps over-analysed, as it is assumed that only they have the real inside-track on what is really happening.

A great case-in-point occurred earlier this week.

“Those still holding out for a policy loosening found some cause for hope in comments from Chinese Premier Wen Jiabao the day before the (June industrial production and second-quarter GDP) data were released,” wrote Aaron Back in another article from the Wall Street Journal.

“He declared that fighting inflation still is the government’s top priority, but also paid lip service to slowdown fears by pledging to prevent any ‘large fluctuations’ in economic growth.

“The domestic stock market, which fixates on official pronouncements, clearly detected dovish hints in this language, rising in early morning trading even before the data were announced.”

But then came the release of the data.

Second quarter GDP showed the country’s economy expanded 9.5% from a year earlier, down only slightly from the first quarter’s healthy 9.7%, adds Back.

On a sequential, seasonally adjusted basis, GDP accelerated, rising an annualised 9.1% in the second quarter, compared with 8.7% in the first.

Industrial-production growth rebounded strongly, rising 15.1% from a year earlier in June, the highest reading since May 2010. Economists had forecast a 13.1% rise, after 13.3% in May.

Australia’s ABC TV news last night interpreted these figures as a sign that China’s economy had further decoupled from the West, rather than discussing the implications for inflation.

This followed a rally in the Australian stock market on the argument that China was still booming.

But why exactly did industrial production rebound so strong?

“To meet the central government’s target of conserving energy and reducing emissions in the period of the 11th Five Year Plan (2005-2010), many factories were shut down, cut- off electricity or reduced production last year,” wrote the China Daily in this article.

“Since the beginning of this year, however, China has witnessed a sudden revival of the production of the heavy industries.”

(Apologies for the bad grammar as these are obviously direct quotes).

The China Daily adds that this is the reason for the power shortages that have afflicted China’s manufacturing heartland.

And so why, if industrial production has rebounded so strongly, has chemicals and polymers demand been so weak?

We think that “buying forward” was the reason and subsequently, the pressure of high chemicals and polymers prices (a global phenomenon) in a much-more restricted credit environment.

HSBC, in a report released late last month, estimates that polyethylene (PE), polypropylene (PP) and polyvinyl chloride (PVC) were more expensive that any other point in history in March this year, when inflation is taken into account.

Returning to the point about expectations of further monetary tightening, they might have dipped after Premier Jiabao’s statements – but have now increased following the release of the latest industrial production and GDP numbers.

But as the China Daily also points out in the article above, this year’s power shortages are still forecast to be the worst since 2004, perhaps limiting further growth in industrial production during the scorching summer months.

Could this, along with the restructuring of heavy industries the China Daily also discusses, take some of the heat out of inflation? What might this restructuring of energy-efficient industrial production mean for chemicals demand?

A further complication to ponder is what the Chinese government will do if inflation continues to increase.

Officially, it has said that it will stick to the conventional tools of raising interest rates and bank-reserve requirements, writes Karen Maley in this excellent article in Business Spectator.

But she adds: “Analysts note that further rises in the reserve ratio penalise the banks even more, and will only encourage both lenders and borrowers to seek out new ways to sidestep the official banking system.”

As we wrote last week, the small and medium-sized enterprises, which make up the bulk of chemicals and polymers buyers in China, have been increasingly forced to side-step the official lending system. This has greatly increased their cost of trade finance, restricting their purchasing.

The alternative of further interest-rate rises would not only hurt the SMEs even further; as Maley points out, it would also raise government financing costs.

A stronger Yuan might therefore be the only solution. China’s currency has risen by only 2% against the US dollar so far this year and has fallen in value against other currencies, she adds.

Increasing the value of the Yuan woud inflict extra pain on the SMEs as they struggle both with more expensive credit and higher wage costs.

All of these complications illustrate that the straight-line growth we saw in chemicals and polymers demand over the last two-and-a-half years, post the 2008 economic crisis, is no longer guaranteed.

Anyone who tells you otherwise is either being disingenuous or is ill-informed.

The next 12-18 month are going to be very challenging.

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