As you read the mainstream media, you will find that more and more attention are paid to the fundamentals of China’s economy. Recently, reports of Chinese ghost cities made its way to the newspapers and TV news reports. Attention are brought into the inflation problem that China is facing, and the efforts by the authorities to clamp down on the property bubble that are brought about by real estate speculation. Then we hear reports on the MSM of characters like Jim Chanos, who famously made the claim that China is Dubai times 1000. So, it is fair to say the mainstream is catching on the scepticism of China’s economic ‘miracle’.

While it is true that the mountains of bad debts, excesses, bubbles, corruption and price inflation in the Chinese economy are unsustainable in the long run, it is another matter to predict when this unsustainable trend will result in an almighty crash. As Professor Chovanec put it astutely, China’s bubble is “extremely persistent,” though he is careful to qualify that that it is by no means sustainable.

So, a week ago, when we saw this news article about electricity shortages, we wondered whether a hard landing for China is near? As that BBC article reported,

Offices and shopping malls in the Chinese city of Shanghai will be urged to close their doors on the hottest days of the year this summer.

The power rationing is necessary due to the country’s shortage of electricity.

The electricity grid serving China’s financial hub does not have the capacity to meet peak demand the authorities say.

China has been coping with power shortages since March, because of coal supply problems and a drought.

If you are curious about the answer to this question, our friend, Paul Adkins, from AZ-China had completed an in-depth study of the situation in China this summer, as the country runs out of electricity. (You can order this report by contacting them on their web site. And note that we do NOT receive any commissions for any sales of their report.) We have read the report and can only provide you with our interpretation of the most important facts…

This is not the first time China is suffering from power shortage. The last it happened was “especially in 2004, but also in 2006 and 2008.” Today, the primary reason for the electricity shortage is the high price of coal. Coal is the main input cost of producing electricity in China. Unfortunately for the power generator, the price of electricity in China is capped by government decree.

The result?

As AZ-China’s study reported,

High coal prices and relatively lower electricity price increases have combined to deteriorate the fiscal situation of power producers, making power plants lose motivation to increase capacity utilization.

Now, the current ‘shortage’ of electricity is not due to a real physical shortage. The power generators, in fact, have excess spare capacity. As the study continued,

The utilization of thermal generators has not reached the historical maximum point.

Utilization hours of thermal power equipment was 5,031 hours in 2010, 16% lower than 5,991 hours in 2004, indicating the [Independent Power Producers] IPPs can improve utilization. On a theoretical basis at least, they can fill the power supply gap; it should only be a matter of time before the National Development and Reform Commission releases policies for stimulating increased power generation.

And here is a very interesting dynamic that is happening in China. As Paul Adkins wrote in his blog article,

The electricity generation companies have been baulking at paying the high price, and running only on contract coal, which they purchase for a much lower cost.That?s on the surface, but there?s more to it. The power generation companies certainly buy coal at a lower price than the spot market. But here?s the rub. They are re-selling their coal back into the spot market. they take as much coal as the contracts allow, then sell ?surplus? coal. In some cases, their reported profits have come more from reselling than from power generation.

So, the power generator ran out of coal, but it becomes the Government’s problem.

Now, you may wonder, in an authoritarian country, why don’t the government order the power producers to produce more and solve the problem at a stroke?

Well, here is the power of incentive at work. As Paul wrote in his blog article,

Because the key people in every layer of management are measured by the Communist Party?s Organisation Department, using profit growth as the key measure. Careers are at stake, but they are built not by doing what is best for the country in some altruistic way, but through turning in a report card that shows you made money during your tenure in that job.

Once you understand the situation, you will be able to understand that the present electricity shortage is due to economic policy screw up, not due to an actual physical shortage.

Hence, the quickest remedy the government can make to alleviate the situation is to raise the price of electricity. But wouldn’t this result in rising price inflation? The short answer we can give you from reading AZ-China’s report,

A moderate power price rise won?t be a great influence on CPI.

That’s the good news. The bad news is that this is a temporary fix for 2011. The problem is in 1 to 2 years time,

… as the failure to keep investing in thermal power generation creates an ever-larger gap with demand.

That’s when the real physical shortage will occur.

So, if someone’s going to short China today on the basis of the present electricity shortage, we wish them good luck!