The Chinese Domino Has Fallen... Or Has It? And Why No Power, May Really Mean No (Inflationary) Problem
Earlier today SocGen came out with a report that is a must read for everyone who has an even passing fancy in global monetary policy, as the currently rampant inflation in China, and the approaches ushered to deal with it, threatens to derail the global "recovery" (although not sure in what: printing of credit money - yes; economy - no) which according to Morgan Stanley is "too young to fail." To be sure, SocGen discusses the first of three dominoes that will or already have, fallen, as part of the increasingly popular domino theory of Chinese inflation. SocGen explains: "Quite simply, the domino theory of 2011 is that when China comes under the influence of inflation, the surrounding countries, those with the most immediate trade ties, would also fall to inflation. It will only be a matter of time till those economies with the greatest trade ties; indeed the entire world has succumbed to the great inflation cascade emanating from China." And the first domino, which SocGen claims to already have fallen is the following: "The first domino is China creating autonomous structural inflation: China’s domestic inflation accelerated at an unprecedented pace at the end of 2010 and policy makers remain well behind the curve. As China engineers its economy to a more domestically focused one, its demand curve is shifting outwards and the global supply curve has been inelastic in response. That domino has already fallen and is the focus of this paper." And while we respect SocGen's opinion on China, most recently referenced to debunk a BCG report on imminent US-Chinese worker wage parity, in this case we wonder if SocGen has simply gotten on the boat of conventional wisdom a little too fast. What we mean is that "structural" inflation may not be all that "structural"especially if one considers a flip to a traditional Stalin saying: "no man - no problem".... in this case "no electricity - no inflation." Bernstein's Michael Parker explains...
As Bernstein's Michael W. Parker and Alex Leung report in Blame it on the Rain, "As constant media reports are pointing out, China is going to be "short 30GW" of power this summer and power cuts may be as severe as they have been "at any time since 2004". The threat to China's manufacturing heartland is clear." This is in the context of recent speculation that due to record drought, Chinese power production may suffer. And while the authors argue whether or not there truly is a drought induced electricity shortage, they look at something different: whether or not not hiking electricity prices, and the power shortages that would result, are not the natural best way to cool the economy: not monetary policy, not price controls: electricty.
Notwithstanding discussion of China being "30GW short" of power and the comparisons to power shortages in 2004, the current power shortage problem can't really be explained in terms of GWs. Broadly speaking, power shortages are a function of one of two things: lack of power stations or a lack of money to buy the fuel to run the power stations. In 2004, the problem was a lack of power stations (and, to a lesser extent, transmission capacity). Today, the problem is a lack of money....when thermal utilization for the year is north of 66%, there is almost guaranteed to be no spare capacity at 3pm on a Tuesday in August. No spare capacity means the lights go out, as happened in 2004. Today, there are plenty of power stations in China so more power stations will not solve the problem as the problem is not a lack of gigawatts. It's the price of coal.
Coal prices are set by the market and are currently high. Electricity prices are set by the NDRC and have hardly increased with the run-up in coal prices since 2009. Accordingly, most coal-fired power stations are losing money if they are sourcing coal from the spot market. The economically rational decision is therefore not to generate electricity. But this creates power shortages...
Simply put, power price increases are inflationary and the Chinese government is currently focused on lowering inflation. Accordingly, a nationwide power price increase to alleviate the problem is not likely. Letting the current stand-off run its course – in the worst case scenario, allowing electricity shortages and the high price of fuel substitutes to force factories to shut down - would slow the economy. And that's the key point in our view: increasing electricity prices is inflationary while holding prices steady would achieve the NDRC's current economic goals. If those are the options, why would the NDRC increase tariffs right now?
And, unlike 2004, a little power shortage may be just what the Chinese economy needs right now. The threat of an economic slowdown in China simply isn't what it used to be. As Fan Jianping, chief economist at the State Information Center (an NDRC think-tank) commented this week in reference to slowing economic growth: "It should be a good thing. In the short term, a slowing economy provides favorable conditions for a price drop… in the long run, it helps restructure the economy."
Perhaps China knows all too well, that while the entire world is focused on its "structural" inflationary problem which is already taken for granted, as most look at Chinese inflation from the lens of its place of origination, the US, it actually holds the key to its own salvation, and that is simply to turn the power off (or run out as the case may be). No power - no running machines - no output - no wage growth - no product and service scarcity - no inflation. (with the added bonus that there is no way for people to communicate by thefacebook and plot the overthrow of the government). And there goes the entire problem: and not in a delayed fashion through money velocity and credit availability, but literally overnight. Like flipping a switch.
Incidentally, there was not one mention of the word electricity in the SocGen report. Which may ultimately very well end up being right, although that would likely be one of the first times when conventional wisdom actually ended up being correct.
Anyway, for those who wish to read why, in SocGen's opinion, the Domino has fallen, read below.