Global Insight Perspective | |
Significance | The NDRC has announced sharp increases to fuel prices, matched with a more modest one to industrial power prices, as part of efforts to encourage producers to maintain output levels. |
Implications | This move should be viewed as a price adjustment rather than a policy shift, as the agency has still shown a tepid commitment to real steps towards a more market-based pricing mechanism for retail energy prices. |
Outlook | For a variety of reasons, the impact of these energy price increases is likely to have a muted impact on consumer prices in China, with a larger and more direct one on heavy industrial producers. |
What Has Changed?
Late Thursday night, the National Development and Reform Commission (NDRC), the former state planning agency that still sets prices for key commodities, surprised the attentive world with large increases to fuel prices. Prices for diesel will rise by 18%, with a 16% increase to gasoline (petrol) prices. For the aviation sector, the NDRC also raised the price of jet fuel coming out of the refinery by 25%. Electricity tariffs will be raised by 5% for industrial consumers, with no change to residential tariff rates.
However, these prices are far from a shift towards more market-based pricing mechanisms for energy. The NDRC added the following caveats to its announcement about fuel and power price increases:
- These increases would not affect grain farmers, fisheries or forestry enterprises, with this to be achieved by the payment of a subsidy.
- For urban public transport and rural shipping by roadways, subsidies would be used to prevent transport costs from increasing.
- As of July, a modest subsidy would be paid to urban residents receiving public assistance, as well as to most rural villages.
- Fares for taxis and public transport would not increase, with a subsidy to be paid to compensate firms and drivers for the fuel price increase.
- Prices for liquefied natural gas (LNG), natural gas, and rail shipping charges would not increase, with subsidies to be distributed to suppliers of these goods and services as compensation.
In order to protect power producers from further increases to the cost of thermal coal, the NDRC has also "temporarily intervened" in the coal market to cap prices at the level seen yesterday.
These fuel price increases will not take effect in Sichuan, Gansu and Shaanxi in order to avoid any further cost burden to relief efforts associated with recent earthquakes.
The Context
Media reports note the closure of diesel and oil-fired power plants in some areas of southern China, shortages of diesel for those working in earthquake relief efforts, long queues at filling stations, and idle agricultural machinery because of fuel shortages.
As early as a week ago, senior officials continued to talk about the benefits that China's energy pricing policies had brought in terms of economic stability. This stability has, however, come at the price of increasingly tight domestic markets for fuel and power as a result of retail price controls that force producers to almost fully absorb cost increases resulting from the jump in global prices this year.
This would lead one to believe that the Chinese government has judged that the possible risks resulting from these price controls for national energy markets were larger than those associated with a large fuel price increase. The Chinese government has, in principle, long acknowledged the potential negative consequences of its fuel pricing policies, but has been waiting for international market prices to come down to allow it to make progress in resource pricing reform. International market prices have, however, continued to move in the opposite direction, and central government policymakers have been forced to move on energy prices before fuel and power shortages become a drag on the economy. Notably, with this pricing adjustment the NDRC does not plan to relinquish its authority to set energy prices and let markets decide. In the long run, this might be beneficial to economic stability, but this is a step in the direction of market reforms that the agency does not appear prepared to take yet.
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Fuel Prices and the Inflation Question
Consumer Prices
The NDRC has ordered a series of subsidies to blunt the impact of this increase to energy prices on consumers and households. That said, the weight assigned to fuel prices in the market basket that makes up China's consumer price index (CPI) is relatively small. Fuel prices show up in the categories of "transport and communications" and that of "residential", which represent 10% and 13% of the CPI basket, respectively. The last time China raised fuel prices in November 2007, the index for "transport and communication" rose from -1.7 at the end of October, to -1.4% at the end of November, with the overall negative figure reflective of falling vehicle prices and cuts in public transport fees. The "residential" price index rose from 4.8% year-on-year (y/y) at the end of October to 6.0% y/y at the end of November 2007. Overall, non-food price inflation rose from 1.1% to 1.4% y/y during the two-month period.
This latest fuel price increase is almost double the 10% increase in November 2007. One might expect the impact on various measures of consumer price inflation to thus be about twice the magnitude as the last one. However, this is unlikely to be the case given the extent to which the NDRC has attempted to lessen the consumer impact of price increases by excluding prices for LNG, natural gas, and residential electricity. The increase to the "transport and communications" index could be slightly larger given the rapid growth in private car ownership, but again here the NDRC has been clear that it will use supply-side subsidies to help ensure that taxis and other modes of public transport do not raise their fares. All in all, the impact of these price increases on China's CPI could be slightly larger than that seen in November 2007. Yesterday's measures are designed to encourage refiners to produce more, and with price increases matched by subsidies, a balance designed specifically to insulate consumer and households from price increases.
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Producer Prices
Urban consumer price inflation is typically assumed to be the great worry of China's central government, as it fears rising prices could trigger protests, as were seen just recently in India following lesser price increases. However, this concern is not limited to urban areas, as policymakers have also been watching the impact of rising producer prices on the agricultural sector. Producer prices in rural China still lag the overall rate of increase to consumer food prices, yet the gap between the lines in the table is somewhat deceiving, as significant mark-ups take place on the way from the fields to supermarket shelves. According to many, the extent of cost increases faced by farmers, including fuel costs, has more than wiped out the margin of increase for prices they receive for their output in many segments of the agricultural economy. This is the reason behind NDRC's decision to issue new fuel subsidies to farmers.
Consumer price inflation in China has largely been a food story in recent years, though policymakers worry that rising producer prices could eventually find their way into the consumer economy, raise wage expectations, and further drive up producer costs and create an inflationary spiral. So far, high levels of productive capacity in most consumer segments have dampened non-food consumer price pressures, though with an 8.2% overall y/y rate of growth to producer prices at the end of May, these worries will not disappear with these energy price increases.
When energy prices were raised in November 2007, China's overall producer price index (PPI) rose from 3.21% y/y at the end of October to 4.55% y/y at the end of November. This increase was driven by rising costs to the heavy industrial sector, where the corresponding PPI increased from 3.8% y/y to 6.03% y/y at the end of November 2007. For heavy industrial producers with a larger proportion of fixed costs, these fuel increases will hit them more like a tax, and in the coming months a trend similar to that seen at the end of 2007 may reappear.
Outlook and Implications
Based on the impact of the November 2007 fuel price increases, not to mention the efforts on the part of the NDRC to stem the flow of producer price inflation to consumer markets, by year-end the impact of these latest fuel price increases on China's CPI could be limited. This will depend in part on the interaction between producer prices and consumer markets, and to date the former has not had much of an impact on the latter. This announcement by the NDRC is a bold move given the inflationary environment in China, and one that could reflect a greater degree of comfort on the part of policymakers with the notion that many food and commodity prices may have peaked on a global scale and that price signals indicate a course towards falling rates of price increases through the second half of the year as the United States wallows in recession and global growth slows. This latest move would appear to more thoroughly torpedo the notion that the Chinese government was not going to allow either the stock market to fall too far or to make any large policy changes prior to the Olympic Games in August 2008 in the interest of social stability. It is true that this move represents a price adjustment and not a substantive policy change. However, given the politically sensitive nature of consumer prices in China, with respect to the short-term interest in social stability the difference between this kind of price increase and a policy-induced price increase is one without distinction.
Finally, crude oil prices fell by around US$4 per barrel shortly after the announcement of this price adjustment. Chinese officials respond reflexively and with displeasure to suggestions that demand from China is driving up world oil prices. Although those within the NDRC are likely to suppress any glee over the impact that they had on oil prices from public view for fear of appearing self-contradictory, this is perhaps one of the clearest illustrations as any in recent months that news from China moves energy markets. Some have noted in comments to the media, including officials from the International Energy Agency (IEA), that in a high-growth economy such as China's, demand is relatively inelastic, where as these price increases are targeted at the supply side of the energy equation. If refiners in China boost purchases in order to increase levels of domestic supply of fuel, particularly diesel, this glee will be short-lived.