China Industrial Sector: Divided Profit Growth under Supply Shock
By Suyang Zhou - Research Analyst, Kamen Parushev - Research Analyst and Alex Cull - Marketing Manager
Recently analysts are debating on whether the Chinese economy is entering a ‘new boom cycle’. Better-than-expected GDP in H1 2017 seems to be sufficient evidence for the optimists, however, a set of key macro data weakened in July and August. Surprisingly, producer prices and industrial profits rallied consistently even when the economy was trending down. Such a contrast may reflect a supply shock amid supply-side reform, in which supply shrinks more than demand, leading to faster reflation but slowing economy (quasi-stagflation). Looking into industrial breakdown, profit growth is divided between upstream and downstream industries. Supply constraints in upstream industries lifted their product prices and profits, which turned into soaring costs of downstream sectors.
How to interpret the recent rally of producer prices? We believe supply depletion in some industrial sectors is an important driver to such reflation. While tractions from demand side are not so strong given the weakening investment growth. In other words, this price cycle is quite different from three cycles in the past two decades, which were all driven by booming demand at first.
In year end 2015, Chinese authorities introduced supply-side reform, in which capacity depletion was prioritized. The steel sector alone downsized production by 65 million tonnes last year. Thanks to government intervention, PPI started to bottom out since early 2016, which is the reasoning behind the recent price rally.
Nevertheless, looking into key macro data in July and August, indicators from demand side (e.g. retail sales, FAI, export) and supply side (e.g. industrial production) were all trending down, moving to the opposite of soaring PPI and industrial profits.
This difference implies that the supply shock could be a major reason for producer price rally, which also propped up industrial profit growth. The effect of price is so strong that the whole economy exhibits faster reflation with slower growth (quasi-stagflation).
In summary, increase in industrial profits was partially attributed to price recovery amid supply shocks in upstream sectors (primarily raw material mining). According to the National Bureau of Statistics (NBS), price reflation effect contributed RMB127.3 billion (31.2%) to incremental profits on year-over-year basis.
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