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Food Price Controls: we’re at DEFCON 2
 

July 20, 2011

Over the last 12 months, amid persisting foodstuff inflation, price controls have returned to the public eye. There are now frequent reports that senior government officials are calling for a "controllable range" of prices for food.

In a sense, price controls never went away. The Chinese government has long maintained an active interest in prices by selling its reserves of, for example, grain at auction. This natural level of market-led adjustment is the most frequently used, and preferred, of three options the government has at its disposal.

The second option is to apply various forms of pressure on key participants. This often includes a variety of activities. Telling major traders and producers to avoid further price increases is one; inspections by various local administrative departments (Industry & Commerce, Tax authorities, Customs, etc) is another; special programs of inspection and registration at company facilities and wholesale markets is another. When we hear in the media that the Chinese government is enacting price controls, it usually means that the second option is being exercised.

Third is the nuclear option. As the lead controller of the managed economy, the government reserves the right to cut out the middlemen, and sell directly to customers. This option "nukes" the existing distribution system, taking down large sources of tax revenues and putting a larger number of people out of work.

While we are clearly going nowhere near the nuclear option, the market option is getting a mixed reception by state planners. On the one hand, using the market requires much less political capital and, given that this is a short-term problem, allows room for maneuver later when prices come down. On the other hand, the relationship option is quicker, more decisive and reduces the impact of speculators hording food (the Bête Noire of socialist economies).

Previous governments have not hesitated intervene in the foodstuffs sector when the markets become misaligned with political intent, as premier Zhu Rongji did over a decade ago with grain. According to China Leadership Monitor's archives:

"In the mid-1990s, serious losses started to pile up at the state grain bureaus. In a remnant of the old "dual track" system, grain managers were trading on both public and private accounts and profiting by selling cheap public grain for high market prices. Offended by the double-dealing of local officials, Zhu "reformed" the system by re-instituting the state grain monopoly, and forcing local officials out of the free market."

While it's a stretch to refer to corrupt public / private arbitrage as "the free market", the piece accurately conveys how the seeds of the current crisis were sown (so to speak). After premier Zhu restricted private trading houses, grain was traded through Cofco, which has a mandate to keep a certain percentage of production in reserve to prevent a loss of control over pricing, and companies like New Hope, an animal feed processor.

At the time, China was enjoying bumper harvests of grain. So much so, in fact, that significant spoilage was occurring in the soviet-era silos, prompting the government to boost donations to Pyongyang and embark on a biofuels program. This overabundance masked some flaws in the distribution mechanism: First, it has created an enormous potential bottleneck, which is now inflating the cost of grain distribution; second, loans taken out to finance purchases have become non-performing as the grain rots; third, the inflexibilities of the pricing mechanism have led to downstream companies abnormally over performing or underperforming; and finally, as a corollary of the aforementioned, speculators have entered the market and started stockpiling.

The drought of 2010 was the shock that triggered food price inflation. Not only is grain more expensive, but so to is chicken (it takes 2 kg of grain to produce a deadweight kg of chicken), pork (6:1) and beef (12:1), all of which rise at a greater rate. This amplification knocks-on into the economy, causing median salaries to rise, bumping up the price of most other items too. The drought has also hit China's cotton output, causing export prices for textiles to spike (but that's another story).

How does this play out? Again, contrary to popular perception, the government prefers to use the market mechanism. Indications are that towards the end of this quarter it will ramp up market activities (the government and state-owned entities like Cofco have huge reserves). According to a recent report by the USDA (opens a pdf), China is going to increase imports of corn by 300% with "favorable pricing opportunities for U.S. corn". Much, if not all, of this corn will be used for shoring up reserves.

Indications are that domestic supply constraints are easing. Here in Beijing, we are enjoying the wettest summer in years and, as a frequent traveler to rural parts of Hebei province, I can report that the land is looking much healthier than before. More empirically, the NDRC has reported that mid-season numbers are up by around 2.5% for rice, wheat and corn.

Food pricing inflation isn't going away, however. The government will be have to bring it back from the current 14% to around 6%, to achieve the forecasted 4% CPI by the end of the year. Is this manageable? My instinct tells me we are going to have to see multiple rates rises in order for that to happen, which is not good news for private SMEs.

 

About GCiS China Strategic Research

GCiS (www.GCiS.com.cn) is a China-based market research and advisory firm focused on business to business markets. Since 1997, GCiS has been working with leading multinationals in sectors ranging from technology to industrial markets, medical, chemicals, resources, building and constructions and a few others.

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