Price caps on the menu?

In his new memoir Decision Points, George W Bush recalls asking Hu Jintao what kept him awake at night. The Chinese president replied: “Finding 25 million new jobs per year”.

That answer reveals the economic tightrope China’s leadership must traverse. Its primary objective is to ensure social stability. One major facet of this is creating enough jobs to prevent massive unemployment. But another is managing inflation and most particularly the price of food. So if Hu had given Bush a less pithy response, he’d probably have added that thinking about how best to keep cooking oil, pork and vegetables affordable also gave him the occasional sleepless night.

The concern, of course, is that when the prices of such staple items rocket upwards, so too do government sensitivities about that cherished social stability.

Just such a situation is in play at the moment. In last week’s issue we discussed the rapid increase in food inflation (see China Ink). A 62% year-on-year spike in the price of vegetables at the beginning of the month set off alarm bells. As did a survey by the National Bureau of Statistics that found 76% of respondents expecting food prices to accelerate next year.

How does that hit shoppers in the pocket? The China Hush blog looked more closely at the practical implications, by examining what Rmb100 ($15) would buy you today versus a year ago in a few everyday categories. The result: 30 fewer apples, 4.5kg less flour and 90 less eggs.

Where else are Chinese consumers feeling the impact? Rising sugar and flour prices are also being blamed for higher prices at McDonald’s 1,100 outlets, for example, where the cost of a burger just went up by Rmb1 (9%), reports Bloomberg (for more on the US restaurant chain, see page 7).

All this led to speculation that government price controls on staple foodstuffs and key commodities like coal are ahead. WiC has discovered from local media sources that while price controls have not formally been declared nationwide, officials in cities and provinces have been encouraged in recent days to get supermarkets to lower prices.

In last week’s issue (“Winter of discontent”) we signalled the coming problems with rising prices. This week we explore the mechanics of price controls, how they were used in 2008, and what it’s likely to mean for equity markets.

A return to the planned economy?

At first glance, it looks like it. The government appears to be attacking inflation with all the weapons at its disposal. Aside from an interest rate hike (and potentially another one quite soon) a raft of administrative measures have been employed to try to persuade a sceptical public that the price of daily necessities won’t spiral out of control. Government-held reserves of grains, cooking oils and soybeans have been released onto the market to ease supply concerns. Subsidies have been offered to vegetable growers; and toll fees have been waived for trucks carrying fresh agricultural produce.

For those most disadvantaged by rising costs – such as the elderly – food subsidies have been announced. Meanwhile, universities in Beijing have been told they cannot charge students more than Rmb10 per meal.

Moreover in a bid to reverse expectations of shortages, the Ministry of Agriculture has also announced that the total planting area of vegetables this winter will reach 8.3 million hectares, up 0.53 million hectares over the previous year, reports the China Daily.

But what topped the headlines was the State Council’s declaration that “in times of need” it would intervene in setting the price of food and raw materials. So far that hasn’t happened, but newspapers report that local governments have been actively trying to manage food prices by attacking the problem from another direction.

In China supermarkets charge management fees to put products on their shelves. Over the past seven days officials have been persuading them to cut these fees, reports the Beijing Times, and thereby lower the retail price.

Indeed, the newspaper says the capital city has seen staple items reduced markedly in price thanks to the measures. For example, while eggs last week cost Rmb9.6 per kg, this week they were selling at Rmb9 per kg; tomatoes dropped from Rmb6 per kg to Rmb5.5 per kg.

So for the moment, it’s a case of ad hoc measures. But behind this – should prices rise again – lies the very real threat of price controls.

When were price controls last used?

In the days of Chairman Mao they were commonplace. But the more surprising thing is that they have reappeared in more recent times. During 2007 they made a comeback in the city of Lanzhou, and in January 2008 they were used nationwide.

On the last occasion, they were again employed primarily to stem food price inflation. Prior to the global financial crisis, surging international oil prices were making food production and distribution more expensive. Making matters worse was blue-ear pig disease, which hollowed out pork supplies, forcing prices to soar. For eleven months the government employed price controls to contain the inflationary impact.

By the end of 2008, Beijing’s leaders felt comfortable enough to lift the caps. Why? Cases of blue-ear had been contained, and pork output was back to normal. The global recession saw oil prices fall dramatically. And instead of worrying about inflation, the government flipped course to stimulate the economy.

There are echoes of the former inflationary crisis in this current bout. Supplies of vegetables, for example, have been disrupted by unusual weather, such as a once-in-50 years flood in Hainan. The price of oil has been edging higher again, as the world emerges from recession. But there are different factors too, not least the role of government policy itself in contributing to inflationary pressures – thanks to that same stimulus spending, and a colossal increase in state bank loans.

Did the last round work?

“To rely on price controls to control inflation is the same as smashing a thermometer to treat fever,” was the China Economic Weekly’s conclusion on the prior wave of caps. Not an especially positive verdict.

Local media has warned that price controls should be avoided as they create distortions. Take one small example. In Lanzhou the local government grew concerned in mid-2007 when the price of a bowl of beef noodles rose to Rmb3. In spite of the increasing prices for grain and meat, it ordered that no restaurant could charge more than Rmb2.50, or else face fines.

But as China Food News reported, the outcome was not to the public’s liking. That’s because the noodle shops reduced the quantity of beef and noodles in each bowl to retain their profit margin. One bowl no longer felt like a proper meal, states the newspaper.

Other undesired outcomes were reported in Heilongjiang. In 2007, the price of pork was Rmb16.4 per kilogram. For a 100kg pig, farmers were making a Rmb400 profit. But after price controls were introduced pigs began selling for Rmb13 per kilogram, and the profit fell to Rmb100. So farmers began to reduce their output. Because Heilongjiang is one of biggest pork producing provinces, pork supply in other parts of China was hit. In Guangdong, there were even pork shortages – recalling the less glorious days of the command economy when China was poor and queues were the norm.

If price controls are imposed nationwide once again, it’s again likely to lead to unintended consequences. The government could end up “doing bad things in spite of a kind heart,” warns the China Economic Weekly.

And if so, a negative impact on Chinese equities?

Yes, says Steven Sun, HSBC’s China equity strategist. “The 2008 experience suggests that the equity market doesn’t like price controls.”

Crunching the data, Sun discovered that when caps were introduced three years ago, the MSCI China index dropped 14% in the following three months. Should price controls be declared once again, he forecasts the Shanghai A-share market dropping to 2,800.

But price controls have not been formally declared and his colleague, economist Qu Hongbin, feels confident that the range of measures already being employed should do the trick, and bring inflation under control. “The risk of explosive inflation is remote given that growth is set to slow to a sub-trend rate, credit growth has already decelerated significantly, and there is a record-high level of state grain reserves. Moreover, we believe Beijing has the experience and more than enough policy tools to combat inflation,” concludes Qu.

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