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The Chinese government announced June 19 that it will raise the price ceiling on a number of energy products by 5 percent to 25 percent. However tentatively, the Chinese are thus beginning to accept the challenge of running the gauntlet between unemployment and inflation.

Yesterday China announced that it would raise diesel & gasoline prices by 1000 yuan/ton, equivalent to around $0.48/gallon. With current prices around $2.70/gallon, this amounts to an increase of +18%. In addition China is expected to raise jet-fuel prices by 1,500 yuan/ton, or +25% today. On July 1, China will also increase electricity prices by an average 0.025 yuan/kilowatt-hour, or +4.7%.

While several other Asian nations have already reduced fuel subsidies, we had expected China to hold off until after the Olympics, so this news comes as a surprise. Before today’s news, we had forecasted China’s demand growth to be 4.7% in 2008, or an addition of 350,000 barrels/day. Based on our analysis of Indonesia’s response to its price increases, we believe that the annualized impact on demand could be 50-80,000 barrels/day, or 15-20% of China’s expected growth. As a result, China’s annual oil demand growth is now expected to be lower at circa 4%.

As a result of this earlier than expected increase in pricing (and the expectations of a further hike after the Olympics) and increases in Malaysia, India, Indonesia and Taiwan, we forecast non-OECD demand to slow from 2Q08 to year end. Coupled with an acceleration of the decline in OECD consumption we continue to believe demand is highly likely to be negative by 4Q08.

Analysis

The Chinese government announced at 10 p.m. local time (9 a.m. CDT) that beginning in two hours it will raise the price ceiling on a number of energy products by 5 percent to 20 percent. Runaway Chinese energy demand has both skewed international commodity markets and presented China with an increasingly distorted energy market as the government, refiners and retailers attempt to pass the buck to someone else.

A 25 percent increase is not a major step, and the increases only incompletely impact gasoline, diesel, jet fuel and electricity. The Chinese already have indicated that there will be several exceptions — public transport fares, for example, will not be adjusted — and any partial price increase that allows for large loopholes will only have a limited impact. And so far the changes seem to impact only the price caps in place — actual subsides, for example to the rural poor, have not been mentioned.

This effort is halfhearted by design. The Chinese system runs on cheap capital, the idea being that if firms have constant access to below market-rate loans, then they can maximize employment and keep disgruntled citizens from going on long marches. It is a system that purchases social stability, but at the cost of a mountain of nonperforming loans. Eventually that mountain has to be dealt with, and past economic crises in Japan and Indonesia — states that use a similar system — are proof positive that the Chinese are proving cannier than the Japanese and Indonesians, however, and are attempting to reform their system piecemeal and break their addiction to cheap capital. One of the first steps in doing this is introducing the concept of rates of return on capital to Chinese businesses, thereby getting firms to recognize that a high debt-to-income ratio is something not to be celebrated. In the early — and even middle — stages of this process this means firms ought to begin to understand that loans should not be used for funding everything. Firms thus begin to think about profit, and shift from being loss-making enterprises that employ gobs of people to leaner firms that operate at a thin profit. In theory, as the transition occurs, newer, financially healthy firms are born to absorb any excess labor.

Jacking up energy prices will be enough to push most of these partially reformed firms back into the red, and risk making them formally bankrupt (again). Unless, that is, the government feels forced to roll back what advances it has made and make cheap credit available en masse once more.
But China is in a double bind. The very capital system that gave rise to its financial problems has generated a second problem: inflation. When everyone has access to unlimited cheap money, they can bid up the price of anything of which there is a less-than-infinite supply: land, buildings and oil. A primary factor behind oil at $130 a barrel has been the lack of Chinese price sensitivity — they can just take out (another) loan to pay the import bill.

We have now reached the point where the Chinese face dire pressure whatever they do, whether that involves leaving the system as is and watching inflation overcome their financial reform efforts, vastly accelerating efforts to curtail inefficient capital use by gutting loans and risking massive unemployment as firms close by the thousands, or freeing energy prices and facing public wrath as inflation injects social instability (and perhaps have higher prices push those same vulnerable firms over the edge anyway). Beijing thus faces a choice between death by unemployment or death by inflation. The two deaths are intimately related; their cause is the same: ridiculously cheap credit.

With today’s increased price caps the Chinese government is attempting to feel out which option will generate less opposition: cracking down on the loan system or raising energy prices. The one (very) bright spot in all this is that the Chinese have chosen to do this before the Olympics, an event that all Chinese see as their day in the sun. Beijing must be sufficiently confident in the system’s stability to take this risk — and after all, it is a very small step laden with exceptions. (After all, fuel riots outside Olympic stadiums would not exactly promote the vision of strength and unity Beijing is aiming for.) That said, there is no doubt the government is fully aware of how few options it really has. However tentatively, the Chinese are beginning to bite the bullet.

Now we wait to see if the bullet bites back.

This entry was posted on Friday, June 20th, 2008 at 6:55 pm and is filed under General, Other. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.