China’s Energy Woes

June 30, 2008 • Commentary
This article appeared in the Far Eastern Economic Review on June 30, 2008.

The process of creative destruction, Joseph Schumpeter wrote, is “the essential fact about capitalism.” The old is destroyed by the new and improved. But it is an essential fact that the Chinese leadership is unwilling to accept. Thus for 30 years, with great success, China has harnessed capitalism without embracing it.

But as the economy grows and diversifies, the capacity for success with the old formula is becoming more doubtful. There are too many interests to balance; too many signals to manage. Yet the leadership’s response to rising energy prices — the most pressing economic issue of our time — suggests that it has no intention of changing course anytime soon.

China has long provided fuel subsidies, which have been blamed for encouraging wasteful consumption, propping up inefficient industries, degrading the environment, and forcing energy consumers in other countries to pay higher prices. But record oil and coal prices, driven in no small part by economic growth in China, have made it that much more expensive to subsidize gasoline, diesel, and electricity consumption.

Add to that the growing acceptance around the world that taxing carbon emissions is the proper response to inefficient production processes and suddenly the cost of those Chinese subsidies, in direct financial terms, could double. It would seem that now is the perfect time for the government to announce the cessation of subsidies, price caps, and other interventions in energy markets, altogether.

If energy prices and output were determined by supply and demand, progress could be achieved on a whole host of important Chinese policy objectives, from greater energy efficiency and environmental restoration to eliminating economic deadwood and reducing trade imbalances. But instead on June 20 the government announced retail price hikes (subsidy reductions) for diesel, gasoline, jet fuel and electricity, and it re‐​established price caps on thermal coal, which had already been freed from government control. To prevent coal producers from chasing higher prices abroad, and to hedge against the increased likelihood of coal shortages, the government is expected to ban coal exports (which are already limited) in the near future.

The subsidy reductions are a step in the right direction, but the government is still setting prices without any capacity to accurately project supply and demand. Its overarching goal, of course, is not efficiency or economic rationalization or greater trade balance, but social harmony, which in this context means directing benefits to those interests that are most restive and burdening the relatively quiescent with the costs.

The coal price caps, in conjunction with electricity tariff hikes, are a bid to allow energy companies — in which millions of agitated Chinese hold equity — the opportunity to finally squeeze out profits and to avoid electricity shortages during the peak summer months. Retail prices had been capped in a bid to contain inflation.

But energy price inflation would be more efficiently addressed if the government allowed the market to determine the value of the Chinese Yuan. Most bets are that the Yuan would appreciate considerably, reducing prices in China for imported oil and coal. That policy move alone might encourage more consumption of energy, but not necessarily, if the subsidies and price caps were abandoned too.

More than ever, the Chinese economy needs market signals to allocate costly resources. The government has played a central role in that respect, but as to be expected, it has not allocated efficiently. Unproductive, unworthy state‐​owned enterprises have squandered resources, while more efficient factories and industries have gone wanting for optimal supplies.

Market‐​determined energy prices would lead to greater energy use by the factories and industries that can justify their energy consumption — businesses that can cover those costs and make profits — and less consumption by inefficient businesses. Companies that cannot stay afloat without subsidized energy should be allowed to go under. If they can’t manage with today’s energy prices, they will always be a drag on the economy. And the sooner they exit the market, the sooner the efficient producers will strengthen.

Of course higher energy prices and a stronger currency would likely reduce foreign demand for Chinese exports, and would encourage Chinese consumption of imports. Achieving greater trade balance and shifting the focus of the Chinese economy away from exports and toward greater consumption has been a stated goal of the leadership.

The United States and Europe share that goal for China. Earlier this month, U.S. Treasury Secretary Henry Paulson, who has been measured and rational in his assessment of the causes of the problems afflicting the bilateral relationship, urged China to abandon its energy market interventions, which he considers a structural impediment to greater trade balance. Mr. Paulson’s approach is distinct from that of the U.S. Congress, which is less inclined to think long‐​term and structural and more willing to countervail the perceived effects of Chinese energy and trade policies through sanctions.

The Chinese government’s decision to continue to play a central role in energy markets will continue to be a source of international friction. It certainly strengthens the hand of those who will act if China doesn’t.

In its continuing bid to avoid Schumpeter’s prediction, the Chinese leadership should sacrifice its interventionist energy policy.

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