Who Pays the Price of Price Control: Consumers and now Shareholders

Stephen Green penned an excellent editorial on inflation in the Asian Wall Street Journal recently. At the end, he argues “The Golden Years are over, at least for the moment. The time for hard choices is here.” I couldn’t agree more. Instead of implementing more effective monetary policies (a combination of hiking interest rates and revaluation of RMB), the government chooses to impose price control and bring China back to the planned economy. As Kornai and others have told us, this is not the way to go and will cause a lot of problem. In the context of an essentially market based economy, things in China may be a bit different from the picture that Kornai paints.

First, the classic problem that price control creates of course is shortage because while the market price of a good increases due to scarcity, the state is telling vendors to continue selling a good at an artificially low price. This of course generates healthy demand for a scarce good that is in short supply at that price. This reminds me of the curry chicken rice I enjoy at my hotel in Beijing. In the past, one order got me many pieces of chicken on the rice. About three months ago, I got three pieces of chicken; perhaps I will only get one piece when I arrive in Beijing next week. The price of chicken, like all meats, is now controlled by the state, so the hotel finds it difficult to locate cheap chicken and may even have to go to the black market to buy chicken at a higher price. The hotel itself is probably under some pressure not to raise the price of curry chicken rice– thus, my barren curry chicken rice. In the oil market, shortage is particularly severe in Guangdong because Hong Kong truck drivers, many of whom have mainland license plates, are driving to China to fill up the tanks at a much cheaper price. There may even be some smuggling of gasoline out of China. In southwestern China, there are tales of people smuggling rice out of China.

This leads to the second problem that partial price control creates losers who need to be compensated. The oil sector exhibits this problem on a large scale. PetroChina and Sinopec have to purchase crude oil at the world market price, refine it, and sell gasoline at an extremely low domestic price. This gap has widened tremendously as crude prices increased dramatically in the past year. First of all, such price differentiation fuels China’s accelerating appetite for gasoline consumption, which market prices would dampen. In fact, the price control and the resulting growing appetite for gasoline are likely creating upward price pressure on international crude prices. I saw a futures trader saying as much on CNBC the other day. Second, it creates huge losses for the domestic refineries, which are operated by PetroChina and Sinopec. The short-term solution of course is subsidies, and billions have begun to flow to these firms. Perhaps that is the medium term solution as well because China currently has a pretty full treasury. However, if the price of one commodity is controlled, creating shortage, consumers would switch to another similar commodity, boosting prices. The government finds it necessary to impose price control on additional commodities and also compensate more money losing firms. China already has to subsidize electricity firms which have to provide power at a low price and the food industry that is selling food at artificially depressed levels. Deficits can increase quickly with the need to subsidize an increasing array of industries.

If you believe in a secular upward trend in oil and commodity consumption, as many do, the supply shortage of oil and perhaps a few other commodities may never improve significantly. Would the government permanently subsidize oil refineries? If so, the profitability of these firms would permanently depend on government subsidies. Granted, China made SOEs do the same thing in the 80s, creating large SOE losses which were ultimately paid by the state banks. Now, however, both oil SOEs and banks are partially listed. For shareholders of these Chinese entities, the future profitability of their investment will depend almost entirely on government bailouts (okay, that has always been the case, but we were hoping for better). Of course, lobbying can ensure a certain level of profits, but it becomes very unpredictable. As a political scientist, I of course welcome this trend! Perhaps more people will now need my opinion about whether the State Council will give subsidies to Sinopec. However, the need for such specialized knowledge does not bode well for small investors’ confidence in these state owned behemoths.

If China is prepared to adjust prices upward, as India is doing, how would it do so without social instability. If we take the price of gasoline, it is clear why China has controlled its price in the Olympic year. Cab drivers tell me that the government does not want to raise the price of cab rides, so they are limiting the price of gasoline (actually, this is mysterious, so what if foreigners pay a few bucks more?!). Obviously, cab drivers, especially in Beijing, already live on a narrow margin (take home pay is between 1000-1500 RMB a month- around 200 USD a month), so higher gasoline price without higher fares would cause a serious hardship. After the Olympics, one can almost certainly expect at least a 10% rise in both gasoline price and cab fares, but even a 25% increase would not bring Chinese gasoline prices close to world level. China should raise the prices of everything upward to the market level and subsidize “needy” groups like the poor and cab drivers. On the food front, the central government is fearful of doing so because they remembered what happened when they hiked food prices too quickly last time (in 1988). Besides, food prices will likely go back down when the global market adjusts itself. On the gasoline front, the problem may well be a prolonged one. The optimal case is that China liberalizes gas prices, subsidize cab drivers, but make private car owners pay the higher gas price, which discourages driving and at the same time pushes the car industries to roll out hybrid and even hydrogen cars. This is the only long-term solution to the current impasse. Of course, politics intervenes, and China will likely muddle along with small rises in gasoline prices and subsidies to refineries. Consumers and now shareholders pay the price of price control.

4 Responses to "Who Pays the Price of Price Control: Consumers and now Shareholders"

  1. akmi   June 5, 2008 at 2:10 pm

    Even without price controls, oil refiners face historically low profit margins as oil prices rose faster than gas and diesel prices.

  2. Anonymous   June 5, 2008 at 3:06 pm

    In some countries where corruption is rampant and have weak institutional structure, price controls and subsidies may seem an easier option than implementing food stamps and cash transfers for the poor. Unfortunately, the rest of the economy benefits more than the poor from these subsidies. Moreover, coping with oil shocks is a short-term challenge while things like safety-net systems for poor, etc can be improved only over a period of time.

  3. Guest   June 5, 2008 at 3:09 pm

    As mentioned above – can China raise prices without causing social instability? and can China deal with the consequences of price rise on inflation and monetary policy, and on export competitiveness (and its impact on the country’s development process)?

  4. Michael Pettis   June 6, 2008 at 8:34 am

    There is another problem with price controls in China, Victor. Excess money causes an increase in demand relative to supply that forces up prices — which is inflation. In China, the rapid rise in food prices absorbed most of this excess demand, which is why inflation in the non-food sector has been low until now — food prices rose so rapidly that they took up more than their share (33%? 40%?) of the increase in demand caused by loose money and so exerted downward pressure on non-food prices which, in an overall inflationary environment, showed up as non-food inflation below average inflation. But once food prices stop rising so quickly, the excess demand will spread elsewhere and we will see non-food inflation catch up with food inflation.Price controls have the opposite effect on other goods. By keeping prices on oil and other goods artificially low, they absorb less than their share of excess demand, and so the excess demand must show up elsewhere and cause higher inflation in other goods. Price controls, besides all the problems that you already mention, might not even have a longer term (measured in weeks or months) impact on overall Chinese inflation.