Illustration: Peter C. Espina/GT

There have been widespread reports of heavy flooding in the Pearl River Delta and along the Yangtze River. The floods have affected 26 provinces so far, and with the rainy season still in its early stages and the wet zone remaining in the south, it is likely that more provinces will be affected. The situation seems increasingly comparable to events in 1998, when from mid-June to early September massive flooding affected areas across the Yangtze River, Pearl River, Nen River and Songhua River. Like this year, 1998 was also influenced by a strong El Niño. Therefore, a repeat of the effects of the 1998 rainy season is very possible this summer.

The large-scale flooding should have a significant, but short-lived, impact on the economy.

In the short term (within one quarter), the flooding will have a negative impact on economic activity across most industries, in part due to weaker industrial production and fixed-assets investment. In 1998, industrial production growth fell slightly during the affected months of July and August from quarter two levels, but a larger decline is expected this year as the nature of industrial production is now more complicated (for example, relying on shipping and logistics, which could be heavily affected). Industrial production growth and fixed-assets investment growth is likely to slow more markedly in July and August.

Nevertheless, in the next year, a positive demand from post-flood reconstruction and restocking activity may drive up both production and investment. Several sectors should benefit from the rebuilding, including building materials and equipment, automobiles, furniture, irrigation, transportation infrastructure and fixing and maintenance services.

The flooding should also provide a significant upside risk to current inflation forecast for the third quarter.

Food production and transportation will be highly impacted, leading to a surge in consumer price index (CPI) inflation, particularly in vegetable, fruit, grain and meat prices. According to data from the National Bureau of Statistics (NBS), eight heavily flood-affected provinces account for 44 percent of the country's land area for vegetable production, 37 percent for grain production and 27 percent for fruit production.

The various food prices will be affected in different ways. Vegetable prices are likely to spike higher during the flooding, a major difference now being that back in 1998 the growth rate of vegetable farmland was surging at a double-digit pace. In the last few years, the expansion of land use has been slower.

However, vegetable and fruit supplies are expected to quickly recover once the flood waters recede, as vegetable production cycles are short and major fruit production centers are located outside the current affected areas. Therefore, the surge in vegetable and fruit prices is expected to be brief and mostly concentrated in quarter three.

The impact on grain output could last longer, not only because grains have a longer production cycle but also because flooding may have damaged storage facilities of harvested grains in affected areas. A resurgence in pork price inflation is also expected, which despite hitting 33.6 percent year-on-year in May, had shown signs of peaking as hog production had begun to increase in recent months. According to NBS data, the eight provinces most affected so far produce 40 percent of all meat for the country.

Should a scenario similar to 1998 play out, it is estimated that food prices will have a significant and immediate effect on CPI inflation, with CPI likely to spike above 3 percent year-on-year in the third quarter. While the inflationary impact from vegetable and fruit prices may fade quickly, the impact from the supply of grain and meat (in particular pork) is likely to continue for a few more quarters, with CPI moderating gradually to around 2.5 percent year-on-year.

The producer price index is likely to rise abruptly in September because of this increased demand, as suggested by the 1998 experience, but the impact should be temporary given the overall overcapacity backdrop. Increased demand from China may also put upside pressures on commodity prices.

Fighting the floods and post-flood reconstruction could lead to more fiscal spending. This reinforces predictions of the fiscal deficit widening to 4 percent of GDP this year, above the previously stated consensus of 3.1 percent. It is likely that the People's Bank of China will fully understand the dynamics behind the spike in CPI inflation caused by the floods and monetary policy will not be affected. Expectations of three 50 basis point (bp) reserve requirement ratio cuts and one 25bp benchmark interest rate cut this year remain, as monetary easing will benefit and support post-flood reconstruction, and lower the funding cost for corporations that may have suffered massive capital loss from the floods. M2 growth and credit expansion will also likely rebound in August and remain strong for about one quarter, as banks and producers prepare funds for rebuilding in advance.

The author is chief China economist at Nomura Securities. bizopinion@globaltimes.com.cn