China’s economy in danger as consumption weakens and raw materials soar

China’s economy, which is in desperate need of recovery after the epidemic, faces a new round of risks as prices of commodities have been rising in recent days, but poor consumer spending performance has led to constraints on manufacturers’ production capacity.

Chinese official media reported Tuesday that China’s State Council held a meeting to point out that the rapid rise in commodity prices in the short term has made production and operation difficult for companies, and asked for help in coping with the price hike in raw materials. This is the third consecutive executive meeting of the State Council to focus on the issue of rising commodity prices.

A number of recently released economic data confirm the trend of economic weakness. Data released by China’s National Bureau of Statistics showed that the official manufacturing purchasing index (PMI) fell to 51 in May, down 0.1 percentage points from the previous month and less than expected; the price index rose to a high in recent years, with the purchase price index of major raw materials and the factory price index rising sharply from a year earlier.

Almost simultaneously released Caixin PMI also showed that the manufacturing purchase price index rose to the highest point since January 2017 in May. Surveyed companies all reflected that rising raw material costs have increased manufacturing costs and remain cautious about hiring more workers.

However, household spending remains weak and producers are having difficulty passing on the pressure of rising raw materials, which has led to a decline in producer margins, dampening future production by companies and threatening the prospects for economic growth.

Jiandao Shi (Derek Scissors), an economic and trade expert at the U.S. think tank Enterprise Institute, told the Voice of America, “China’s recovery should be carried by the retail and service sectors. If they don’t have the ability to sustain the current growth rate, industry and eventually real estate will be affected by commodity prices and growth will slow.”

Rising commodity prices

Commodities such as copper and iron ore have been on the rise so far this year, rising by more than 20 percent. Economic experts believe this is due in large part to the fact that supply and demand have not yet returned to balance following the global pandemic.

Alicia Garcia Herrero, chief economist for Asia Pacific at the French foreign trade bank, told the Voice of America: “Global commodity prices are rising due to pent-up demand. This is particularly true for China and construction-related commodities, such as iron ore and copper. The stimulus from last year is still in place and still driven by infrastructure.”

Demand is recovering faster in industrialized countries than on the supply side as vaccinations for new crowns improve and countries around the world gradually ease restrictions against the outbreak. Many major commodity exporters are emerging markets and developing countries hit by the epidemic, and their production remains below pre-epidemic levels, causing commodity prices to rise because of supply shortages.

Financial speculation is also behind the rise in commodities. Due to expansionary monetary policies, there is ample liquidity globally, leading to large inflows of funds into commodity futures markets.

Francoise Huang, senior economist for Asia Pacific at French credit insurer Yuliyany, said the impact on China’s economy depends on whether the rise in commodity prices will be passed on to downstream prices, and that final consumer demand is not yet strong.

She told the Voice of America, “The latest price data suggest limited price transmission, with raw material price increases far outpacing inflation for intermediate and consumer goods. This means that margins for manufacturers in downstream industries are under pressure.”

In recent weeks, Chinese policymakers have mostly expressed concern about rising commodity prices, calling for stricter management of supply and demand and a crackdown on speculation. That has led to a pullback in some metals prices, but such a correction may not last long given improving global demand.

China’s central bank also abruptly announced on Monday an increase in the reserve requirement ratio for foreign exchange deposits at financial institutions to 7% from the current 5%, which will limit sales by commercial lenders in response to successive sharp rallies in the yuan.

A stronger yuan will, to some extent, offset the impact of higher commodity price quotient. But this policy adjustment shows that regulators are equally concerned that a stronger yuan will make Chinese goods more expensive in foreign markets and hinder the recovery of China’s manufacturing sector.

However, the analysis points out that China’s central bank is unlikely to withdraw economic stimulus measures in order to smooth commodity prices due to the poor performance of consumer spending. Because higher consumer prices can directly affect the cost of living and cause social instability, Chinese officials are more focused on consumer inflation than producer costs.

In China, the typical situation is that commodity inflation does not reach consumer goods,” said Shi Jiandao. Commodity inflation is not the reason for government deleveraging.”

Huang Liyang similarly argues, “Given that the recovery is not yet fully broad-based, the recent rise in commodity prices is likely to be negative for the Chinese economy on net in the short term, and liquidity is likely to remain ample in the months ahead.”

Economic Aftermath

The rapid rise in raw materials has triggered a series of knock-on effects. China is the world’s largest consumer of copper and other commodities, and the country’s economic demand affects global commodity prices while being affected by the rise.

Some Chinese companies began stockpiling, while others faced shortages of raw materials, and the supply chain was significantly impacted, causing damage to the normal order of economic operations.

There are also reports that some Chinese producers have chosen to temporarily shut down or slow down production while waiting for prices to stabilize. But that strategy could backfire if global demand continues to rise and supply becomes increasingly scarce.

Manufacturers are staying more cautious about recruiting new workers as costs rise. in May, the official PMI index of employees fell 0.7 percentage points from a year earlier to 48.9, below the Rongxu cut-off, suggesting companies are laying off more workers than they are hiring.

Wang Tao, chief economist at UBS Securities in China, recently predicted in a report that commodity prices will fall in the coming months but may rebound in September-October during the next peak construction demand season, with the producer price index remaining high in the second half of the year, while the transmission of consumer prices remains relatively limited.

Gary Hufbauer, a trade expert at the Peterson Institute for International Economics, told the Voice of America that China’s economy could grow 0.3% less in 2021, dragged down by high commodity prices.

Meanwhile, ballooning debt, restrictions on real estate financing and a pullback in demand for Chinese consumer goods as foreign productivity recovers will weigh on China’s economy in the second half of the year.

Julian Evans-Pritchard, a senior China economic analyst at Capitol Macro, recently wrote in a report, “Now that the economy has surpassed its pre-viral trend, we see a weaker pace of growth this year.”