Mainland plays waiting game on oil subsidies

PUBLISHED : Tuesday, 10 June, 2008, 12:00am
UPDATED : Tuesday, 10 June, 2008, 12:00am

Steady hand needed to defuse issue

Beijing's strategy of using public funds to pay for higher oil prices to protect consumers has become a ticking bomb that economists say will require steady hands to defuse.

Oil hit a record US$139.12 a barrel on Friday on the back of a weak US dollar and mounting tensions between Israel and Iran, putting prices at about double what they were a year ago. During that same period, the mainland raised petrol prices only 9 per cent as it tried to curb the economic effects of higher energy prices.

The mainland applies price controls on many commodities from food to fuel to protect its citizens from market-driven price rises. But inflation still hit 8.5 per cent last month.

'Despite the price controls the government has in place, overall prices are going up. They can't keep up with the game,' said Sean Darby, a strategist at Nomura Securities.

And the pace of the game is likely to pick up, as more analysts predict oil at US$150 per barrel this summer, while Goldman Sachs says the US$200 mark could be reached within two years.

Economist agree that at some point domestic energy prices must be raised, and then the central bank will have to deal with a much larger inflation problem. Will the government wait until after the Olympic Games, or will a summer energy shortage force it to make a move before then?

'The longer the government waits, the higher eventually the energy prices will have to be adjusted, and the larger the impact may be on downstream industries,' Goldman Sachs analyst Hong Liang wrote in a recent report.

Economists say the mainland has enough money to keep paying the subsidies, which last year cost Beijing about US$27 billion, or 0.8 per cent of gross domestic product. Morgan Stanley predicts implicit subsidies could reach about US$100 billion, or 2.2 per cent of GDP this year.

'There are three conditions for such a move - inflation should be stabilised at a low level, the government needs to wait and be convinced that no social unrest would be caused by the price rises given the experiences of other countries and, lastly, because it can't bear the pressure of a fuel shortage,' said Ha Jiming, the chief economist at China International Capital Corp.

Regulated cheap prices encourage growth in fuel demand from consumers including industrial users that produce goods for export to more affluent countries.

However, the subsidies do not cover the gap for companies such as oil refiners and power producers that must provide energy to consumers at controlled prices while paying higher market prices for raw materials such as coal and crude oil.

'Such persistent and rising financial losses, if unmitigated soon, would likely lead to serious electricity shortages in the coming peak summer season,' Ms Liang wrote.

'Rising global oil prices, elevated domestic inflation pressures, and looming energy shortages clearly call for a more market-based approach to monetary tightening, particularly a faster yuan appreciation.'

Allowing the yuan to increase in value against the US dollar, in which most global commodities are priced, would effectively lower commodity prices for Chinese consumers. While this may appear a gentler tactic compared with cutting subsidies, limiting the value of the yuan is a political issue in China and could hurt exports as they would become more expensive to buy in other currencies.

'[The government has] the fiscal ability to ride this out this year. Deregulating prices is politically a huge obstacle,' said Arthur Kroeber, a director of consultancy Dragonomics. 'I don't think [it] will let the yuan appreciate more quickly because [it is ] worried about the effects of a strong currency on exports.'

The coal industry that creates urban smog and has environmentalists everywhere admonishing China is actually a nice cushion against higher oil prices and may allow the mainland to stick to its market control strategy longer than other nations.

'Relative to other major economies, China is much less import-reliant for its energy needs. China's coal economy means it has more ability to withstand high oil prices,' said Mr Kroeber, who estimates the mainland imports only about 15 per cent of net primary energy needs, compared with more than 40 per cent in the US and 90 per cent in Japan.