China's Rebounding Producer Prices a Window to Cut Capacity

(Bloomberg) -- The tailwind from surging factory prices is strengthening corporate profits and supporting growth, opening a window for China to deepen cuts in excess industrial capacity without inflicting too much damage on the broader economy.

The catch: that window may not stay open for long.

That's because factory prices -- forecast to have increased 7.7 percent in February from a year earlier -- may soon moderate as the effect of low comparisons a year earlier begins to fade. Economists forecast producer price inflation will dial back to a 2.8 percent pace by the fourth quarter.

So while some local authorities may be inclined to fire up the smokestacks to cash in on higher prices now, the better bet may be to mothball excess facilities in things like steel and coal sooner rather than later, while those price gains can cushion the impact of cut backs.

As part of the Communist Party's objectives for the year, Premier Li Keqiang said the nation will cut 150 million metric tons of coal capacity and 50 million tons from steel output. With a potential collision with U.S. President Donald Trump over trade lurking, such reductions may also help blunt any accusations that China is dumping cheap steel on global markets.

"It's a golden opportunity for them to do this because growth for now is not a concern," said Raymond Yeung, chief greater China economist at Australia & New Zealand Banking Group Ltd. in Hong Kong. "They need to prove that the whole reform process is making progress."

So far, reflation has been a virtuous circle for China. Capacity cuts last year helped fuel a rise in global commodities, which combined with rising home values and an avalanche of credit to turn producer prices positive in September for the first time since 2012.

The swing away from deflation boosted company revenues and margins and lowered real borrowing costs. That is making corporate debts -- at 156 percent of gross domestic product last year -- easier to service.

Indeed, given China's status as the factory to the world, some analysts point to the nation's price rebound as the key to the global reflation trade.

Read more: The hidden side to the Trump reflation trade

Yet challenges loom. Companies in industries from steel to cement shaped by years of over-investment aimed at supporting top-line economic growth now have renewed motive to use such capacity. Profits on steelmaking offer “huge economic incentives” to restart idled plants, boosting production at a time when stockpiles are already close to three-year highs, Citigroup Inc. analysts including Tracy Liao wrote in a recent note.

China, the world's biggest coal producer, won't reintroduce widespread output restrictions on the fuel this year as long as prices stay in a range considered acceptable to regulators.

“The supply and demand relationship in the coal market has seen an apparent improvement,” the National Development and Reform Commission said Tuesday. “There is no need to roll out large-scale coal production control measures in 2017.”

Read more: China to Avoid Coal Mine Limits If Prices Remain ‘Reasonable'

Policy makers also show few signs of wanting to curb the most significant overcapacity problem of all -- credit -- said George Magnus, an associate at Oxford University's China Centre and a Bloomberg View columnist. Aggregate financing, the broadest measure of new credit, surged to a record 3.74 trillion yuan in January, the equivalent of Swedish or Polish annual economic output.

"I can't see that cutting coal and steel production by limited amounts, even if realizable, makes much of a difference," said Magnus, formerly a senior independent economic adviser at UBS Group AG.

And while there's at least lip service being paid to cutting capacity in old growth engines, a concurrent push into new industries risks spurring overproduction elsewhere.

Read more: China's 2025 plan risks fanning trade tensions, EU Chamber warns

In short, the Communist Party has its work cut out for it turning capacity-reduction targets into meaningful action.

"The risk of the recovery is it takes pressure off of policy makers," said David Loevinger, a former China specialist at the U.S. Treasury and now an analyst at fund manager TCW Group Inc. in Los Angeles. "People will ask: ‘Why fix what ain't broke?'"

--With assistance from Martin Ritchie

To contact Bloomberg News staff for this story: Kevin Hamlin in Beijing at khamlin@bloomberg.net.

To contact the editors responsible for this story: Malcolm Scott at mscott23@bloomberg.net, Jeff Black

With assistance from Kevin Hamlin