25/04/2008

China’s Policy Conundrum

It is not just British consumers that are feeling the pinch from rising food and energy prices. They are also causing consternation, even food riots, in many emerging market countries. In this Spotlight we focus on China as a prime example of the ‘growing pains’ being experienced in many rapidly expanding economies.

Inflation is rearing its ugly head in many forms in China. Overall, consumer price inflation rose by 8.3% over the year to March, close to the highest levels for over a decade. Food price inflation has been running at 25% over the same period! Whilst China is able to subsidise some domestic prices, for example offsetting some of the higher costs of energy from reaching the end consumer, the authorities have been understandably concerned about this surge in inflation. They have reacted by raising interest rates, by allowing the exchange rate to rise, and by incorporating other forms of monetary tightening such as increasing reserve requirements for banks.

Will such policies be successful? It is important to look at both cyclical and structural drivers of these trends. China’s secular urbanisation and industrialisation have caused a massive draw on global resources, such as copper and iron ore. In the early part of this century, China became a net importer of oil. More recently, agricultural prices have enjoyed a rally. There are several links between rising agricultural and oil prices. Transport, machinery and artificial fertiliser costs are some examples, while increasing demand for bio-fuels has caused a substitution of land previously dedicated to growing food crops towards alternative crops to provide ethanol. China is actually still self-sufficient in grains, and effective subsidies have kept grain price inflation lower than overall food inflation. However, the recent snowstorms and pig diseases caused big disruption to Chinese food production; hence prices for pork and dairy produce have been running at problematic levels. Lastly, China’s own urbanisation also causes displacement of previous farming land towards industrial or urban usage. These drivers are inextricably interlinked.

The extraordinary demand strains that China places on global commodities are coupled with supply side problems. Oil is harder to come by, requiring more complex measures to extract from deeper waters and smaller oil fields. Similar pictures can be painted regarding the difficulties in ramping up iron ore and copper extraction. Supply-side constraints can also be seen to cause problems with agriculture in many of the major global food exporters, as a mixture of changing weather patterns, droughts and floods have made good crop yields increasingly unreliable.

Undeniably China is growing fast: in 2007, the economy grew by 11.4% pa, and in 2008 it is expected to grow by around 10% pa. Growing at double digits for years in succession is no mean feat, and the authorities have done an impressive job of balancing growth and inflation in recent years. Nevertheless, the government faces some complex and difficult issues in coming months. How best to slow the economy via either the exchange rate or the banking sector, affecting exporters or domestic firms? How best to balance the needs of the rural and urban households, for example when higher food prices benefit some but not all the rural poor? How best to compensate companies whose profit margins have come under increasing pressure as regulations do not allow significantly higher prices to offset higher raw material costs? The more the pressures on commodity prices are structural, rather than cyclical, the more the authorities will be forced to consider more drastic action to ensure social stability and continued economic expansion.

Jason M. Hepner, CFA, Investment Director, Global Strategy, Standard Life Investments