The severe drought in the Yangtze River region is unlikely to lead to a major shortfall in grain supply, but prospects for the autumn harvest remain uncertain.

The drought's impact on China's agricultural prices and inflation, especially through expectations of increased inflation and more speculative activity, warrants close monitoring.

The Yangtze River region, a rice bowl, has experienced its worst drought in 50 years between March and May, which in turn has affected agricultural production and (futures) prices through lower output, higher irrigation costs, as well as higher inflation expectations and more speculative activity, adding to concerns about already-high and persistent inflation.

With the affected regions accounting for close to 30 percent of the nation's annual grain output, the drought has raised concerns about domestic grain supplies.

Based on an assessment by Barclays, the domestic grain supply appears under control. While the output for early-season rice is likely to be reduced, a major shortfall of grain/food supply is unlikely. Also, China is mostly self-sufficient in wheat and rice, the most important crops for the nation's food security. National grain reserves remain ample, and the reserve collection and auction system have been improved.

On the other hand, it is still too early to draw conclusions about full-year output given differing production cycles for grains and differences across the affected regions, as well as the uncertain weather outlook.

This week's rainfall may provide some relief. Moreover, the region is expected to enter the rainy season from mid-June, a period that is often associated with risks of flooding.

The drought has also added to the power shortage concerns given the reduced hydro power generation in the affected regions. However, I believe that while power shortages will likely persist into the summer, the overall impact on industrial production is unlikely to be significant, based on historical experiences.

I also expect the government to respond with the necessary measures to boost power generation and curb demand - strong demand and lack of incentives by producers are the main reasons behind the power shortages. The government recently raised electricity prices for non-residential users in 15 regions, following increases in on-grid power prices in a total of 21 provinces since April.

China's grain production can be categorized by season as summer crops (mainly wheat), early-season rice, and autumn crops (including mid-season rice, late-season rice, and corn). Their importance varies, given that the three harvests account for about 23 percent, 6 percent and 71 percent, respectively, of the country's total annual grain output.

An analysis based on the latest information available indicates that the summer harvest should be secure despite the drought earlier this year in northern China; while the negative impact of the drought in the south on the harvest looks limited. The Ministry of Agriculture this week forecast that the country will reap a bumper summer harvest.

Meanwhile, the southern drought has so far mainly affected early-season rice (crops in the affected regions account for around 2-3 percent of total annual grain output), as seedlings could not be planted in some areas and some paddies could not be irrigated. The mid-season rice planting period in some areas ended in May and hence were also affected.

The prospects for the most important crop of the year, the autumn harvest (70 percent of the total), remain uncertain, given that most crops have yet to be planted and will depend on whether the drought persists.

The recent developments have not altered my inflation forecast of 4.6 percent for full-year 2011. I continue to expect CPI inflation to peak in June-July and moderate to below 5 percent in August, though there are risks of a delay.

But close monitoring of the drought situation and its impact on food prices and inflation expectations is still warranted.

Nationwide, high-frequency data show a broad-based pickup in prices in May, with aquatic products up 6 percent month-on-month, meat up 5 percent and grain 1 percent, suggesting year-on-year CPI inflation will likely rise to 5.4-5.5 percent in May, which could push June's rate up further to about 6 percent.

The author is vice-president and China economist at Barclays Capital Asia Ltd. The opinions expressed here are entirely her own.

(HK Edition 06/09/2011 page2)