China needs structural economic reforms to prevent future meltdown

The cash crunch faced by property developer China Evergrande Group in recent weeks has drawn comparison to the 2008 financial crisis, when seemingly minor turbulence in real-estate finance blew up into an economy-destroying hurricane. There's an even better candidate for a 2008-style emergency in China right now, though: The energy crunch that's sent coal prices soaring over $200 a metric ton and cut power to industry and homes across the country. The vast state-owned power generators that keep China supplied with electricity - the parents of listed subsidiaries China Shenhua Energy Co, Huadian Power International Corp, Huaneng Power International Inc, Datang International Power Generation Co and China Power International Development Ltd - are in a similar position as US mortgage giants Fannie Mae and Freddie Mac. Like Fannie and Freddie, they're partially state-owned entities whose job is to use private finance to fund public-policy goals - in the US case, mass homeownership; in the Chinese case, cheap power.

Such entities depend on an implicit guarantee that they'll always be bailed out by the government if things get too tight. The questioning of such a backstop after Lehman Brothers Holdings Inc was allowed to fail in September 2008 is one key reason why the world tipped into financial crisis. Right now, it's the precise nature of China's promise to its power companies that's up for debate.

The long prelude to the current situation can be seen as a test of that support. With coal providing about two-thirds of China's electricity, generators are caught between the regulated prices at which they sell power and the market-determined cost of their fuel. That became a problem earlier this year after domestic coal prices started to escape the 520 yuan ($81) a ton to 570 yuan a ton band that Beijing targets. Profits at some generators fell 70 per cent from a year earlier in the first half.

One way to avoid the rising price of coal is to buy less, and depend on the reserves built up when it was cheaper. That appears to be what's been happening this year, with end-users' inventories of soot slumping in July to less than a quarter of their level a year earlier, even as they held steady at mines and ports - an indicator that it was power and industrial end-users who were eating through their stockyards.

That's a risky strategy. If there's one thing that will cause the price of a commodity to spike, it's low inventories. By running down their stocks, generators have been counting on the government to release its own reserves, and perhaps loosen restrictions on mining and imports, to flood the market and avert the sort of spike in coal prices that has unfolded in recent weeks.

"The second half of this year is expected to be subject to certain market risks," Huaneng warned in August. "Overcapacity production is officially criminalized, forcing mines producers to strictly comply with approved capacity amount, limiting potential increase of production."

It's telling that, barring a few minor reserve releases, the government has held firm for so long. Decarbonization and a crackdown on under-regulated industries are central planks of President Xi Jinping's policy platform. Officials have shown great reluctance to abandon those objectives just because generators are failing to manage their supply and demand.

Still, something has to give. With coal prices spiking in recent weeks and the troubles of Evergrande highlighting Beijing's unwillingness to endlessly backstop loss-making businesses, generators have been left no option but to switch off altogether rather than sell power at deep losses. That's the immediate reason for the sorts of power cuts seen in China over the past month, spreading from factories to households as well.

It looks like the government has blinked first. Miners, after months of being ordered to stick closely to capacity limits, are now being ordered to produce as much as they can, people familiar with the matter told Bloomberg News. That should help to take the wind out of surging thermal coal prices and prevent the current crisis from extending into the winter, when sufficient energy supply can be a life-or-death matter.

There is, to be sure, an attempt to make this retreat look like a withdrawal. The latest advice from Beijing's economic planners last week focuses on protecting individuals but continuing the crackdown on industry, especially when it's most energy-intensive and polluting. Allowing generators to raise prices to end-users, as is happening in Guangdong province, will also help create a more commercial power market. Electricity consumption controls have even been loosened in a way that would permit potentially unlimited volumes of cheaper renewable power into the market.

The risk, as with the rapidly fading fears over Evergrande, is that Beijing has simply deferred a pressing problem again. If China doesn't reform a system that refuses to face up to its internal contradictions, the problems of an economy fed by credit and carbon will only fester and grow. (Bloomberg)