"Oil price shock means China is at risk of blowing up"

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The headline above, which comes from an article in the Telegraph by Ambrose Evans-Pritchard, might benefit from a better image. “Blowing up” doesn’t seem the right image to describe an economy at risk of a sudden drop in growth. But something more fitting, like engines going into stall, might have taken too much space.

Aside from that quibble, the article provides further anecdotal evidence that high oil prices are hitting China hard. The country’s export-driven strategy depended on cheap shipping, which has become a thing of the past. We had noted that Hong Kong businesses may shutter 20,000 factories out of 70,000 in the neighboring province Guangdong. Similarly, the article mentions furniture manufacturing returning to the US. A friend who was a senior officer there said there was no reason for the US to send high end furniture building overseas (many of the woods used are domestic in origin) but at Ethan Allen, the analysts wanted it and the CEO was eager to comply.

The second factor is that China has started rolling back domestic subsidies of fuel prices. The government has realized a bit late that its energy inefficiency (amount of energy required to produce one unit of GDP) puts it at a competitive disadvantage, so ending the subsidies is seen as necessary to force businesses to become more efficient energy users. But that adjustment process will be painful.

Update 7/7/08, 2:00 AM: Further confirmation of the Telegraph’s thesis comes from a weekend Reuters story, “Asia’s exporters suffering as global demand weakens” (hat tip Russ Winter):

Deutsche Bank estimates some 20 percent of China’s low-end exporters will go belly-up this year.

From the Telegraph:

The great oil shock of 2008 is bad enough for us. It poses a mortal threat to the whole economic strategy of emerging Asia.

The manufacturing revolution of China and her satellites has been built on cheap transport over the past decade. At a stroke, the trade model looks obsolete….

Asia’s intra-trade model is a Ricardian network where goods are shipped in a criss-cross pattern to exploit comparative advantage. Profit margins are wafer-thin.

Products are sent to China for final assembly, then shipped again to Western markets. The snag is obvious. The cost of a 40ft container from Shanghai to Rotterdam has risen threefold since the price of oil exploded…

Energy subsidies have disguised the damage. China has held down electricity prices, though global coal costs have tripled since early 2007. Loss-making industries are being propped up. This merely delays trouble.

“The true impact of the shock will only be revealed over time, as subsidies are gradually rolled back,” he [Stephen Jen, currency chief at Morgan Stanley] said. Last week, China raised internal rail freight rates by 17pc.

BP ‘s Statistical Review says China’s use of energy per unit of gross domestic product is three times that of the US, five times Japan’s, and eight times Britain’s.

China’s factories “were not built with current energy levels in mind”, said Mr Jen. The outcome will be “non-linear”. My translation: China is at risk of blowing up.

Any low-tech product shipped in bulk – furniture, say, or shoes – is facing the ever-rising tariff of high freight costs. The Asian outsourcing game is over, says CIBC World Markets. “It’s not just about labour costs any more: distance costs money,” says chief economist Jeff Rubin.

Xinhua says that 2,331 shoe factories in Guangdong have shut down this year, half the total.

North Carolina’s furniture industry is coming back from the dead as companies shut plant in China. “We’re getting hit with increases up and down the system. It’s changing the whole equation of where we produce,” said Craftsmaster Furniture.

China is being crunched by the triple effects of commodity costs, 20pc wage inflation, and sagging import demand in the US, Canada, Britain, Spain, Italy, and France.

Critics warn that Beijing has repeated the errors of Tokyo in the 1980s by over-investing in marginal plant. A Communist Party banking system has let rip with cheap credit – steeply negative real interest rates – to buy political time for the regime.

Whether or not this is fair, it is clear that Beijing’s mercantilist policy of holding down the yuan to boost exports share has now hit the buffers.

Foreign reserves have reached $1.8 trillion, playing havoc with the money supply. Declared inflation is just 7.7pc, but that does not begin to capture the scale of repressed prices, from fuel to fertilisers. “There is a lot more bottled-up inflation in this economy than meets they eye,” says Stephen Green, from Standard Chartered.

Inflation merely steals growth from the future. It defers monetary tightening until matters get out of hand, which is where we are now. Vietnam has already blown up at 30pc. India is on the cusp at 11pc, so is Indonesia (11pc), the Philippines (11pc), Thailand (9pc) – leaving aside the double-digit Gulf.

Of course, oil prices may fall again. They plunged to $50 a barrel in early 2007 after the Saudis raised production. The scissor effect of slowing global growth and extra crude later this year from Brazil, Azerbaijan, Africa, and the Gulf of Mexico may chill the super-boom.

The US Commodities Futures Trading Commission is on an “emergency” footing, under orders from the Democrats on Capitol Hill to smash speculators. If it is really true that investment funds have run amok, we will soon find out.

I suspect that the energy markets have fallen prey to their own version of the “shadow banking system” that so astonished regulators when the credit bubble burst.

I also suspect that Hank Paulson and his EU colleagues have a surprise up their sleeve for the late-cycle über-bulls. Those who claim that derivatives (crude futures) cannot drive spot prices have overlooked a key point. The Saudis and others use the IPE Brent Weighted Average of futures contracts as their pricing mechanism. Futures now set the spot price.

But even if oil comes down for a year or two, the mid-term outlook of the International Energy Agency warns that crude markets will be tighter than ever by 2012. Call it Peak Oil, or just Peak Non-Cooperation by the dictatorships that control most of the world’s remaining 5 or 6 trillion barrels (Mankind has used one trillion so far).

Come what may, globalisation has passed its high-water mark. The pendulum will now swing back from China to America. The mercantilists will have to reinvent themselves.

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  1. Anonymous

    You should start reading ‘The Oil Drum’. Then you will stop entertaining such silly fantasies that there are 6 Tb oil left, or that Brazil and the Gulf of Mexico will ride to the rescue. And once you become familiar with the ELP (export land model) these steep increases in the price of oil will no longer surprise you.

  2. Anonymous

    The title should be:

    “Oil price shock means China is at risk of seizing up” like an engine running out of lubricant.

    And yes, globalization was for the largest part driven by ideology, not by any real cost advantages.

    I’m seeing it right now in my corp where, over the past 10 years, pre-series manufacturing (high-tech electronics) has moved around from the US east coast to South Asia then to China, following grand globalizing strategeries edicted by the great deciderers above.

    But the plan is that next stop is going to be … in freakin’ California and not just in California but in the freakin’ Bay Area, a 20 minutes drive away from the design office.

    The realization finally came upon accountants that shipping prototype parts and engineers half across the planet and 10 to 14 time zones was a gross waste of time and money and that wage differentials between here and anywhere else in the world could not compensate those costs at any extant… The funny thing is that it has always been true. Rising oil prices are just a marginal factor in the decision. And the engineers have been screaming that since … well since ever. But no, it wasn’t globalizely correct.

  3. Michael McKinlay

    Comment #1 is right on the money, we are at or very near Peak Oil.

    Comment #2 misses important reasons for off shoring. First the tax credits companies get to do so, second, that these subsidiaries can then wash their profits through low or no tax countries. It is no accident that there are 14,000 corporations whose mailing adddress is an average sized building in the Caymans. Third and fourth, corporations can offshore pollution and worker disability costs.

  4. Doctor Holiday

    Yah may wanna toss this in the mix here:

    Hot Money Headache
    http://online.wsj.com/article/ SB…=googlenews_wsj

    The starting point is the fact that since last October interest rate differentials between dollars and yuan have reversed. The U.S. Federal Reserve aggressively lowered rates just as the Chinese central bank, the People’s Bank of China, was pushing up domestic rates to fight inflation. Currently, rates on the Chinese central bank’s one-year bills are about 170 basis points higher than comparable U.S. Treasuries.

    This has created an arbitrage opportunity that local firms are exploiting on a massive scale, borrowing cheap dollars to substitute for more expensive borrowings in yuan and for local investments. A second factor driving this arbitrage is the wide-spread expectation that the government will either speed up the rise in the yuan’s crawling peg or implement a one-off revaluation.

  5. Anonymous

    This also needs to be kept in perspective IMHO:

    Intervention will not stop dollar’s slide
    By Peter Schiff
    http://www.atimes.com/atimes/Glo…y/ JG02Dj04.html

    In fact, the United States holds just about 1% of the world’s $7.6 trillion of foreign currency reserves, and our total position amounts to just 2.5% of the total daily volume of foreign exchange trading.

  6. Jojo

    China is going to have a lot more troubles with its [very belated] attempt to clean its polluted air in time for the upcoming Olympics!
    July 3, 2008
    China: An Olympic Loss for Industry
    Strict limits on production during the Games will be felt across the Mainland—and by consumers abroad

    Beijing – Hebei Taihang Cement has been on a roll lately. Its three Beijing plants have been running around the clock, churning out thousands of tons of cement needed to build venues such as the “Bird’s Nest” stadium, where opening ceremonies for the Beijing Olympic Games will be held on Aug. 8.

    But the good times may be about to end. The government has ordered Taihang to shut down its Beijing operations for two months starting on July 20, until both the Olympics and the Paralympics (for handicapped athletes), slated to run from Sept. 6-17, are over. Its 400-plus employees will busy themselves with training courses and equipment repairs, and Taihang will see its cement output fall this year by 500,000 tons, or 9% of its annual capacity. If neighboring Hebei Province also orders cutbacks, as many expect, the damage could be even worse for Taihang—its headquarters and another big plant are located there.

    Taihang isn’t alone. In an effort to clear Beijing’s murky skies for the 10,000 athletes and half-million foreign visitors expected for the Olympics, China is ordering broad restrictions on much of the capital’s industry. Another measure will impose strict limits on the number of cars on the roads during the Games. And the industrial shutdown is likely to extend to a broad swath of northern China and other Olympics venues such as the industrial city of Shenyang, where some soccer matches will be played, and the port of Qingdao, home to sailing events.

    While many companies say the extent of the restrictions isn’t yet clear, others have been given explicit instructions to shut down or curtail output. In April the Beijing city government announced it would ban all construction and limit production at large polluting enterprises during the Games. The city also warned it will take further “stringent steps” in the runup to the Olympics if air quality doesn’t improve quickly enough. Hardest hit will be cement, steel, iron ore, and coal-fired power plants in a broad area surrounding Beijing.

    Full article:

  7. eh

    If they believe that the current high price of oil is a bubble (as some do), then the Chinese could use some of their huge pile of reserves to subsidize fuel prices until the bubble pops. Based on their investment record to date (e.g. BX), that might be a better use of the money.

  8. DownSouth

    Ambrose Evans-Prichard said: “I also suspect that Hank Paulson and his EU colleagues have a surprise up their sleeve for the late-cycle [oil] über-bulls.”

    What might that be?

    This statement, along with the one regarding the “world’s remaining 5 or 6 trillion barrels,” leads me to believe that this is a man who doesn’t have a firm grasp on reality.

    Peter Schiff (article in Asia Times linked to by Annonymous at 3:22 AM) seems to have a little bit better connection to the real world. The prospects of rescuing the dollar are not good, and he goes on to enumerate the reasons why.

    So even though Evans-Prichard acknowledges “Beijing’s mercantilist policy of holding down the yuan to boost exports share has now hit the buffers,” he fails to mention that Saudi Arabia has been doing the same thing. Schiff doesn’t delude himself in this way.

    Evans-Prichard’s schadenfreude over oil’s imagined demise blinkers his vision. Emotion trumps good judgment. For while he acknowledges that the implosion of the dollar would certainly devastate China’s economy, he fails to realize that its effect on the dollar-denominated price of oil is all but uncertin. Evans-Prichard seems to be incapable of envisioning a world where those who own oil refuse to exchange it for worthless little pieces of green paper with president’s pictures painted on them.

    And of course the effects of an imploding dollar on the people of the United States seems to be all but lost on him.

    He appears to me to be a man who would cut off his nose to spite his face.

    P.S. Annonymous’ at 3:22AM link to the Asia Times story didn’t work. I’m going to try again, hopefuly with better results….


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