Low prices, not inflation, are the cause of China's problems

Regular readers will have seen an awful lot in this column over recent months - possibly too much - about how China is threatened by inflation. Yes, rising prices are a danger. But the source of many of the mainland's woes is not inflation. On the contrary, the cause of some of the biggest problems is that prices are too low. Take the drought that is playing havoc with grain crops across much of central China. Sure, the immediate cause of the water shortages are low river levels after the driest spring in decades. But as Monitor argued back at the beginning of April, the underlying reason for China's water problems is not so much a lack of rainfall but rather the grossly inefficient way agriculture and industry use the scarce supplies that there are. With only about 2,000 tonnes of fresh water for each person, China has the most meagre water resources of any big economy. Even Australia has more than 10 times as much per head. Yet thanks to the government's price controls, water tariffs in China are among the lowest of any major economy. Typically users pay just 45 US cents a tonne, less than a quarter what the Japanese pay (see the first chart). Not surprisingly, this artificially low price encourages waste. Half of the country's entire water supply is used to produce the grain crop. Even in a normal year, local rainfall can provide only a fraction of the water needed. The rest is supplied from rivers and groundwater sources via irrigation systems. But with little economic incentive to conserve water, China's irrigation systems are desperately inefficient. According to the Ministry of Agriculture, as much as 20 per cent of the entire water supply is lost each year to leakage from irrigation channels. Raising water tariffs would encourage investment in more efficient irrigation methods and alleviate China's chronic water shortages. But in the meantime the authorities have been forced to release billions of tonnes of water from the Three Gorges Dam. That might come as a relief to the parched downstream farms, but the release threatens to exacerbate another problem caused by artificially low prices. With the head of water in the Three Gorges reservoir already well below the optimum level for powering the project's hydro-electric plants, the planned discharges are sure to reduce even further the amount of electricity the dam can provide to China's grid. That's a problem because the country is already suffering crippling power shortages. Once again the reason is the government's price controls. In China, electricity is artificially cheap. Over the past five years the price of coal, which is used to generate 80 per cent of the country's power, has more than doubled. But over the same time period electricity companies have been allowed to raise their tariffs by only a third. As a result, they are haemorrhaging money, with the coal-burning plants owned by China's five main generating companies losing 10 billion yuan over the first four months of the year. And the more power they generate, the more money they lose. Not surprisingly, that acts as a powerful incentive to run the country's power stations at well below their full capacity. The result is a national electricity shortage, and the rolling power cuts that are affecting companies in many parts of the country. Meanwhile, low electricity prices encourage profligacy among users. For example. according to the chemical company BASF, fitting basic insulation could cut the air-conditioning bills of Chongqing's one million richest households in half. But with electricity prices set artificially low, the annual savings would be too small to justify the initial investment. In a country plagued by power shortages, it's cheaper to waste energy than conserve it. And it's not just the excessively cheap prices of water and electricity that are causing economic problems. The price of money itself is too cheap. With benchmark borrowing costs at just over 6 per cent, and consumer price inflation running at more than 5 per cent, the real interest rate is just 1 per cent for many commercial borrowers (see the second chart). And if you prefer to use producer prices rather than consumer prices, borrowing costs are actually negative in real terms. That's a powerful incentive for companies to borrow and invest, further fuelling inflationary pressures in an economy that is already overheating. Once again the problem is that prices are too low. The government's price controls mean well, but it should be obvious by now that they are doing more harm than good. It's time to do away with them.