Don't fear China inflation after fuel price rise

BEIJING (Reuters) - China's surprise increase in fuel prices will not undermine the country's fight against inflation. On the contrary, it reflects confidence that overall price pressures can be contained.

The unpleasant news for motorists on Thursday that their bill at the pumps was going up overnight by as much as 18 percent prompted consternation and anger about the rising cost of living in China.

Economists, however, took the announcement with far greater sangfroid.

Higher resource prices will undoubtedly feed into inflation, but in a nation where consumers spend little on fuel products, the impact will be relatively small. Most economists expect that an extra percentage point, or even less, will be added to consumer inflation over the rest of the year.

Food prices, the dominant source of inflationary pressure in China over the past year, have dipped over the past two months, allowing headline inflation to slow to 7.7 percent in May from 8.5 percent in April.

"That is a significant decline and that also gave them a window of opportunity to make the price hike," said Qing Wang, Morgan Stanley's chief China economist.

There are, however, clear risks in the sudden policy change.

Though consumer inflation has retreated somewhat, it is still within striking distance of 12-year highs.

And while shoppers have seen prices come down, offices and factories have faced a steady increase in the cost of inputs. Producer price inflation reached 8.2 percent in May, the highest in nearly four years.

The heftier bill for fuel and power will add to these pipeline pressures, Zhao Qingming, chief economist at China Construction Bank, said.

But while manufacturers may find their margins squeezed, the pass-through to consumers will be muted.

"I think now is a good time for this. It won't have a big impact on consumer prices," Zhao said.

Refined oil has a weight of just around 0.5 percent in the consumer price index, Goldman Sachs says. Food accounts for a third of the CPI basket.

ADJUSTMENTS

And motorists burdened by the jump in fuel costs will simply spend less on restaurant meals, karaoke outings, jewelry or what have you. So while relative prices fluctuate, headline inflation will not be nearly so volatile.

"When oil prices are high, consumers have to cut expenditures on other items, so demand for other products will be lower," said Gene Ma, chief economist for China Economic Monitor, a Beijing consultancy.

Ma calculated that consumer inflation was pushed up by about 0.3 percentage points when China last raised regulated fuel prices last year.

Even if the impact is twice as large this time, given the steeper increase in fuel prices, it would still be less than an extra percentage point of inflation, he said.

Traders, hearing of China's fuel price rise on Thursday, bet that the country's demand for oil would drop, reckoning that companies would use fuel and power more sparingly. International crude prices fell by nearly $5 a barrel.

Supporting the view, Ha Jiming, chief economist at China International Capital Corp, said Chinese growth would be trimmed by 0.2 percentage point this year, as energy-dependent companies bear the weight of the costs.

This, however, is a debatable proposition in a country where pumps have run dry when refiners, faced with guaranteed losses in selling fuel far below the level of global crude prices, cut back on production.

The pricing change could actually produce a more efficient allocation of what consumers and businesses will increasingly appreciate as scarce resources.

"While high prices could cut some demand, alleviated shortages could also be positive to growth," Ting Lu, Merrill Lynch economist in Hong Kong, said in a research note.

INFLATIONARY EXPECTATIONS

Equally unpredictable and ultimately more worrying for Beijing is how Chinese will react to the shock -- for that is what the price increases amount to.

Chinese officials have repeatedly said fuel and power rates served social and economic stability, even while stating a commitment to bring them in line with global markets at some nebulous point down the road.

Certainly, few analysts or ordinary Chinese thought Beijing would deviate from the status quo before it hosts the Olympics in August. Authorities are acutely aware that inflation was a key factor behind the 1989 demonstrations in Tiananmen Square.

Underlining the sensitivities, the government pledged to subsidize vulnerable groups such as farmers, fishermen and taxi drivers. And it exempted residents from the electricity tariff increase, targeting just industrial and commercial users.

"People are more able to tolerate price rises today than they were in 1989," Liu Xubuo, a dissident writer, said. "There won't be chaos."

Containing inflationary expectations, never mind street protests, may be the biggest challenge for Beijing in the months ahead. But China would not have acted so decisively on the fuel and power price increases if it thought inflationary expectations were uncontrollable.

"This obviously shows that their concerns about inflation have diminished considerably in the last few weeks," said Mark Williams, China economist at Capital Economics in London, said.

(Reporting by Simon Rabinovitch and Eadie Chen; Additional reporting by Benjamin Kang Lim in Beijing and Daniel Bases in New York, Editing by Chizu Nomiyama and Neil Fullick)