The Chinese Producer Price Index (PPI) finally recorded a positive growth rate of +0.1% in September 2016 after 52 months of negative growth (see Chart 1). One way to interpret this is to consider the government’s recent efforts to reduce excess capacity in the industrial sector a success. The recovery of PPI has led to the end of price deflation and bought about a return to industrial profits, the signs one would expect in an economic recovery. Before we can follow accredit the Chinese government for this achievement, it is worth digging into the details of this price recovery and determining whether this is sustainable.
The PPI is a price index tracking prices of both final and intermediate industrial goods. Along with the Consumer Price Index (CPI), the PPI is a broad metric used to track price movement in the Chinese economy and feeds into the People’s Bank of China’s (China’s central bank) monetary policy decision. For the past 52 months, the PPI has been declining due to issues of excess capacity in the industrial sector. In simple economic terms, supply exceeded demand and this result was price falling.
In 2009, as a response to the GFC, the Chinese government responded with the world’s largest (in terms percentage of domestic GDP) fiscal stimulus. This led to a huge construction boom of infrastructure, real-estate and industrial capacity. In the steel sector, steel-making capacity nearly doubled from 644MT in 2008 to 1,106MT in 2013. As the Chinese government begins to tighten both fiscal and monetary policy starting in 2011, and real-estate construction peaking in 2013, the Chinese economy is left with industrial capacity far larger than it can naturally digest. Many industrial plants were left idle with a bloated work force managers cannot drastically reduce out of fears of social instability. To continue paying these idle workers, the industrial sector borrowed from the state-owned (or more precisely state-friendly) banking sector. This growth in unproductive debt explains the decline in returns to investments and threatens the financial stability of the banking system.
Breaking down the components of PPI into producer (intermediary) goods and consumer (final) goods; we can see that the recent rise in PPI has been entirely attributed to the rise in the price of intermediary goods. Since 2013, the movement of consumer good prices has been flat. Drilling one level down to observe the subcomponent of producer goods, we can see there has been a broad recovery in all three subcategories (mining and quarry, raw materials and manufacturing). Of these subcategories, the recovery in mining and quarry has been the most pronounced.
From Economics 101, we learnt price increases are usually the result of either: 1) higher demand; 2) reduced supply or; 3) a combination of the two. In this scenario, it is strange that the rise in PPI is occurring in an environment of weakening industrial demand. During the period when PPI has been rising the fastest (from March 2016 until September 2016), fixed asset investment- the demand source for industrial goods- has been falling (from 10.7% to 8.1% in the same timeframe). The divergence between these two series is strange. The only way I can square this circle is that supply must have fallen more than demand to result in higher prices. I use the following simple graph to outline my logic.
The reduction in excess industrial capacity was outlined as the number one goal for the government to accomplish this year. The recovery in industrial prices through controlling the output of the sector and a return to industrial profitability can be pointed to as signs of success. However, I would be cautious to bring out the champagne and celebrate. From a casual observer’s perspective, there is something eerily unnatural about this recovery and the way the government has pursued the reduction in supply.
In a market-economy, the allocation of supply-and-demand would be conducted by the market: the summation of collective decisions by households, corporates and the government. However, in China, this industrial recovery has been entirely engineered by the government going hand over fist in controlling who can produce and at what rate. As a response to the Central Economic Work Conference in late 2015 that identified cutting excess capacity as the core mission for 2016, each province responded with their own plan. If was as if the Emperor has spoken and all the underlings are falling over themselves and competing to demonstrate their loyalty. For example, the provincial sum of reduction in steel capacity exceeds even the upper limited set by the central government (100MT to 150MT over the span of three to five years) and questions the level provincial commitment once the central government nears its target.
Despite the Chinese government’s promise in the Third Plenum of 2013 to allow the market to have a ‘decisive role’ in resource allocation, this recovery has had nothing to do with the market. The government through many layers of bureaucracy are choosing winners-and-losers and often in a murky and arbitrary manner. For example, to control coal production, the government announced a mandatory reduction (from 330 days to 276 days) in working day coal companies can operate regardless of the competitiveness of individual firms. Blanket administrative fiat as such impedes efficiency and upgrading in the sector which is the ultimate goal the government wants to obtain.
To rely on the market will be to allow competition to occur and weaker companies will either be forced out of the market either by bankruptcy or a buy-out by stronger firms. However, in China, bankruptcies and buy-outs are often the fate that falls on to firms who are not in favour of local politicians as opposed to their underlying economic situation.
In conclusion the recent industrial recovery is occurring at the grace of political leaders and is not indicative of improving economic conditions. I wonder how sustainable this ‘recovery’ is given its artificial nature. Throughout the 2000s, the Chinese government has tried multiple times to control growth in the coal and steel industry and has failed each time once political pressure was alleviated and leaders focus their energies on more pressing matters. Throughout 2016, the Chinese economy has been fortunate there has not been any macroeconomic shocks either externally or internally to derail the leaders’ attention. In an increasingly complex world, shocks and instability are an inherent characteristic of the modern economy and are unavoidable. When the next shock inevitably occurs, will the leaders still have the persistence and energy to push through further capacity reduction? If not, the problems of industrial deflation, falling industrial profits and higher levels of bad debt will return, wasting the hard work and achievements that has occurred in 2016.