Summary
China's new administration will introduce its economic reform agenda at the Communist Party's Third Plenary Session on Nov. 9-12, with an emphasis on continuing to adapt market-oriented policies for the regime's political purposes. The government hopes to use some elements of capitalism to increase efficiency and forestall economic stagnation while retaining central control over political institutions and core industries in order to avoid liberalizing too rapidly and inducing a post-Soviet-style shock. Simultaneously, Chinese leaders are attempting to make a credible effort to convince a broad swath of the public that their concerns -- over livelihoods, pollution, health, education and official corruption, among other things -- are being addressed.
One particularly important element of reform is allowing prices on various goods and services to move with fewer restrictions. This could help curb excesses in resource-intensive heavy industry and encourage new growth in high-end manufacturing and underdeveloped services. However, the government has tried and failed to implement price reforms in the past, and its newly redoubled efforts will face considerable complications once again -- especially in the finance and energy sectors. An ongoing dispute between natural gas producers and middlemen in Shaanxi province is indicative of the type of issues China will run into as reforms proceed.
Analysis
China's three-decadelong period of economic reform began with the easing of government controls on prices of agricultural goods after the 1978 Third Plenum, and subsequent price reforms followed throughout the 1990s and 2000s. Nevertheless, the government has been reluctant to remove price controls on several essential, politically sensitive goods. For a long time, China has sought to spur industrial production and shield the public from rising costs by keeping prices artificially low on everything from loans to refined oil products, coal, electricity, water and labor wages.
These policies facilitated rapid economic expansion, but they have also led to overcapacity in many industrial sectors, a voracious appetite for resources and high pollution levels, as well as sharp disparities in income and benefits between workers in the state sector and those elsewhere. Liberalizing prices, among other market-oriented reforms, has become key to addressing these issues.
The Risks of Loosened Controls
Part of the challenge of price reform lies in sequencing. Allowing rates to move more freely in a particular sector will affect downstream players or other sectors that may still be restricted. For example, the party's upcoming reforms are likely to focus heavily on the financial sector, since underpriced capital has contributed to the economy's general imbalances, and financial reforms are fundamental to reforms in other sectors. Still, financial reforms cannot happen all at once.
A key indicator of Beijing's ambition is the pace and extent to which it proves willing to liberalize interest rates. Already this year, the government has moved to replace the officially mandated floor on lending rates with a new floor that will reportedly be determined by what banks charge their most credit-worthy borrowers. But the most important move yet to come will be scrapping the official ceiling on deposit rates, which will force banks to compete for depositors, who would then see greater returns on their savings. This is why authorities have freed up lending rates first, leaving deposit rates under the existing cap in order to ensure that banks do not incur higher deposit costs before being allowed to lower interest rates for borrowers. Thus, they delayed the hit to banks and corporations, on which overall growth depends.
The hard part -- liberalizing deposit rates -- still needs to be done. The eventual loosening of controls on savings rates could cause rapid movements of depositors to larger banks that can afford to pay higher rates, potentially draining smaller banks of capital and causing wider problems. This risk makes setting up a national system of deposit insurance a crucial early step in the financial reform. Such a move would prevent isolated bank problems or failures from metastasizing into a series of bank runs, thus providing a fundamental protection to savers before deposit rates are given more room to fluctuate.
Natural Gas Needs and Complications
In many instances in the past -- especially during the global economic fluctuations of 2008 and 2009 -- Chinese authorities have eased price controls only to reverse their efforts later in the face of unfavorable circumstances. While the new administration in Beijing is again taking on price reform, it will struggle as it implements its policies to handle the disparate impacts of price fluctuations at various points in the production chain. Already this year, the National Development and Reform Commission -- China's chief economic planning body, which controls rates in many industrial sectors -- has eased price restrictions on coal, refined oil products and natural gas. But recent developments in the natural gas sector illustrate the complications that await future attempts at price reform.
In recent years, China has suffered from natural gas shortages during peak seasons due to rapid increases in consumption. Consumption grew from around 34 billion cubic meters in 2003 to 145 bcm in 2012. Domestic natural gas production has not increased at a similar pace, and since 2007 China has relied on imports to make up the difference. This year, the country's domestic natural gas supply is expected to fall short by around 8 bcm to 13.5 bcm -- around twice as high as last year's shortage.
Meanwhile, new Chinese policies are attempting to expedite the diversification of the country's energy mix in order to moderate coal consumption, which further boosts natural gas use. For example, the recently announced Air Pollution Action Plan calls for coal to account for no more than from 65 percent of China's total energy consumption by 2017, down from 67 percent today, requiring an increase in natural gas-fired power production. Chinese experts believe the policy, if implemented effectively, will replace some 83 million metric tons of coal consumption in Beijing, Tianjin, Hebei and Shandong provinces with roughly 50 bcm of natural gas, leading to an estimated 30 percent rise in China's overall demand for natural gas compared to 2012. In the coming years, China expects natural gas consumption to rise from 145 bcm in 2012 to 200-250 bcm.
To address the ongoing natural gas shortages, the central government and state companies are seeking to increase liquefied natural gas imports, and the state-owned China National Offshore Oil Corp., or CNOOC, is building import terminals for this purpose. Recent agreements and ongoing negotiations on long-term supply contracts for piped natural gas from Russia, Central Asia and Myanmar indicate that Beijing's strategy to ease the shortages is well underway. But imports are costly, and price reforms are necessary to make them profitable for energy companies -- as well as to encourage domestic production, especially since boosting production will require the technology and expertise needed to develop unconventional resources. In other words, to promote domestic production and enable state companies to manage the costs of increasing imports, the government will have to let prices rise.
The country's most powerful natural gas producers -- the state-owned PetroChina, which produces about three-quarters of China's natural gas, along with China Petroleum and Chemical Corp. and CNOOC -- have argued that without higher prices, they will not be able to fund the investments necessary to expand supply. In May, state media reported that a PetroChina subsidiary had reduced natural gas shipments to customers in Shanxi, Hebei and Shandong provinces by as much as 25 percent. PetroChina blamed the shortage on power plants shifting too rapidly from coal to natural gas; critics accused PetroChina of deliberately withholding supplies in an attempt to pressure the central government to raise natural gas prices.
Since then, economic planners have moved to increased prices. In July, the National Development and Reform Commission raised the price ceiling for industrial consumers by 15 percent to 1.95 yuan (roughly $0.30) per cubic meter. But while being implemented across the country, the price increase has triggered a conflict with companies that liquefy, store and transport natural gas before selling it downstream. The role of these middlemen has boomed since 2010, but they now face financial troubles as a result of rapid expansion, price increases, lack of coordination with power plants, weakening investment and distance from coastal consumers.
The Shaanxi Dispute
In September, PetroChina's Changqing Oil and Natural Gas Field Co. -- which oversees one of the biggest energy plays in China -- said it would raise its storage rates by 26 percent to the highest level allowed by the central government. It also announced what critics have called a pipeline surcharge hike, which would increase "incremental" prices by another 34 percent. In October, Shaanxi Green Gas and eight other middleman companies in Shaanxi province refused to pay the surcharge, since they are stationed at the origin of natural gas flows and do not rely on the national pipeline grid. In response, PetroChina reduced supplies to the companies, most of which have since been relying on stockpiles. The Shaanxi provincial government and the energy giant are in talks to resolve the issue, with the National Development and Reform Commission likely to be the final arbiter.
Similar hitches may occur in Inner Mongolia, another province where the natural gas price hike has yet to be implemented (Inner Mongolia and Shaanxi have had the lowest prices in the country). With peak demand season and winter shortages nearing in China, the natural gas middlemen will receive little sympathy if they cause cut-offs amid pricing disputes with producers. Some may face bankruptcy or require subsidies or bailouts from Beijing or provincial governments.
However, PetroChina, which is under pressure from the Party's anti-corruption campaign, also faces scrutiny over its monopolistic behavior. In addition to allowing prices to rise, top officials have contemplated breaking up the natural gas production and transmission industries. In the case of the Shaanxi dispute, this kind of structural reform would prevent PetroChina from increasing pipeline fees at will. For now, however, China's energy oligopoly remains intact, and any antitrust campaign would take years to implement, even if it had the party's full approval. And while it may be desirable to restructure some natural gas storage companies, doing so extensively would upset local governments concerned with their own economic and social stability -- and it could, in the short term, hinder China's efforts to increase its internal storage capacity.
The Shaanxi dispute highlights the type of production chain disruptions that Beijing will face as it liberalizes rates. The hope is to encourage production, but the effect will be raising the incremental price for middlemen higher than rates paid by industrial consumers (all while shielding residential consumers from price hikes). The ultimate goal is to link domestic prices to international rates, but this process is occurring more gradually. In essence, the dispute in Shaanxi reflects China's broader challenge of raising prices for critical inputs, managing regionally and financially disproportionate impacts on industry and, eventually, moving toward greater pricing flexibility on the consumer side, where ever-present risks to social stability remain.
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