China's food pain to be New Zealand's gain

Tyndall Monthly Commentary: Food supply problems are likely to slow China's growth rate in the near future but could boost New Zealand's dairy sector and drive our dollar higher.

Tuesday, September 4th 2012, 9:00AM

by Andrew Hunt

Last week, and somewhat against the world's expectations, it was announced that the Chinese Purchasing Managers' Index had fallen below 48, its lowest level for nine months and a level that might be considered as being consistent with a technical recession in China. Moreover, our own weighted estimate of the true underlying industrial production growth has dropped to a 1% year-on-year rate, which implies that production year-to-date has been essentially flat in China's vast industrial sector.

Initially, financial markets responded to this latest run of weak Chinese data by rallying on the belief that the local authorities would now "have to ease" on the back of this weak economic performance. With China, though, potentially having suffered a $60 billion balance of payments deficit in the second quarter as a result of sharply accelerating levels of domestic capital flight, there may now be a binding external sector constraint to domestic policy initiatives; China may not be able to ease without sacrificing its currency at a most inopportune moment in the global political calendar. Hence, the "big easing in China" may still be some way off, despite the weak output data.

Moreover, even if the external accounts were not seen as a constraint by domestic policymakers, the still rapid rate of wage inflation within the economy should be a constraint. According to China's own data, wage inflation is still north of 20%, although this is not currently being reflected in either the CPI or even export prices. We suspect that this dichotomy between the behaviour of wage inflation rates and output prices is largely because companies are being obliged by the weak demand situation to absorb the wage pressures, with an unwelcome impact on profit rates.

To many, it may be surprising to find that China still apparently has a wage inflation problem, given the acute economic weakness that we are observing. In fact, we suspect that the demand for labour resources is indeed quite weak at present but despite this, wages are rising simply because they cannot fall below subsistence levels. It is the rise in the latter that is continuing to drive up wages at present, even against a background of very weak industrial output trends.

According to our analysis, the cause of a sharp rise in (particularly urban) subsistence costs in China over recent years has been a mixture of the effects of the past increases in property prices and - most importantly of all - the continuing food supply issues that have dogged the economy for some time now. China's own population data reveals that, over the last 10 years, China's urban population has expanded at an average rate of 3.7%, implying that the urban population has increased by almost 40% in a remarkably short space of time. We estimate from the available data, though, that the growth in "marketable" food output over the same period has been notably slower, perhaps only expanding at an average rate of 2.7%. This proprietary estimate of agricultural production is based on a weighted average of the food output data, rather than on the authorities' official aggregate data, which is reported rather unhelpfully in nominal terms.

The reasons for the relatively slow rate of agricultural output growth (which is certainly well behind the 15% average growth rate of IP over the last ten years) are likely to centre on the ongoing stagnation in the amount of farm area that is being sown, the various water supply issues, the removal of labour from this traditionally relatively low-productivity sector and the inefficiencies implied in the farm ownership system. Certainly, China's agricultural sector remains ripe for reform but, in the near term, more temporary measures have to be found in order to address the Chinese food crisis.

In the short term, we would suggest that virtually all that can be done to correct China's food output shortfall is either for the country to slow the urbanisation process and/or to begin to import more food and both these seem to be occurring at present. Indeed, we find that, according to press reports and anecdotal evidence, the pace of urbanisation does seem to have slowed of late and, more reliably, China's own trade data reveals that, in nominal USD denominated terms, Chinese food imports officially rose by 31% in the year to July and that they have grown at close to a 40% average annual rate over the last 3-4 years - a seemingly consistent development within our overall story.

This food supply constraint and what it implies for the growth rate of the urban population will have significant implications for the wider economy. Specifically, we estimate based on the reasonable assumption of there being little or no trend improvement in food output growth over the next five years that China will in theory need to limit its urban population growth to around 1% per year over the next five to ten years in order to cool its food shortage problems. This slower rate of urban workforce growth would then seem likely to lead to a lower average rate of industrial production growth (perhaps 10% rather than the 15% rate that was achieved over the previous decade). Moreover, the slower urban population growth should also lead to a slower trend in tertiary sector output growth and therefore to a notably lower sustainable headline trend rate of GDP growth - perhaps a 6-7% average rate rather than the 10% that was achieved over the last 10 years.

Admittedly, on an average basis, 6-7% trend GDP growth over the next 10 years would not seem too bad and indeed still quite optimistic for many of the world's "China plays". We doubt, though, that even this lower rate of average growth could be countenanced initially since, in order that the food output numbers can "catch up" with the urban population (and so remove the food shortages and inflationary pressures that they have caused within a timeframe that would be acceptable to the general population and political system), there could be little or no growth in the urban population or their output.

We would therefore suggest that in the next year or so, China can only hope to reduce its subsistence cost inflation problem if urban population and indeed total output growth slows below the 3-4% speed limit implied by the food production data. This seems to be precisely what is happening, judging by the latest output series and the trends revealed by the country's very weak import data.

More positively, it is apparent from the industrial production series that China is now investing more in its agricultural sector to solve the country's speed limit problem in the longer term. For example, although the overall production data is clearly very weak, fertiliser production is very strong, as are other agricultural inputs. Hence, there is some chance that food output growth may manage to accelerate a little and thereby raise the economy's speed limit a little but, nevertheless, in the near term we suspect that China's overall rate of GDP growth will be limited to 3-4% or even lower so that the price of subsistence problem can be addressed and inflation brought down. Therefore, in the long term, while China may still be able to produce an average rate of GDP growth of around 7%, in the near term, growth may be limited to half that rate - although as to whether this will ever be admitted remains to be seen.

Over the last 12 months, Chinese food imports have risen by around 30% in nominal terms but its imports of coal and other fuels are only up by 5%. Meanwhile, China's imports of iron and steel are either not growing or are in fact declining, with the result that its total imports of primary goods are barely growing despite the sharp rise in food imports. Unfortunately for food-importing China, though, the drought in the US has already resulted in a collapse in US food export growth and we understand that the country may only be weeks away from being obliged to begin slaughtering dairy cattle for want of food supplies. This juxtaposition of the effects of the US drought and China's rising demand for food imports could clearly lead to some further disruption in the global supply of dairy goods and we wonder whether, as a result, New Zealand may be able to gain a terms of trade and perhaps even an export volume windfall as surging Chinese food import demand collides with weak US food export trends. Thailand, Indonesia and the Philippines, which have seen weak agricultural export trends of late, may also be beneficiaries of such an event, as could some African nations. Australia's agriculture sector should also be a beneficiary but, unfortunately, its mineral industries may face tougher times given the import patterns noted above and this could prove more important to the aggregate economy. We therefore wonder if the NZD may be about to gain from a China theme of its own.

Andrew Hunt

International Economist, London

Andrew Hunt International Economist London

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