China’s first quarter growth report of 11.5% and the market reaction thereto illustrated one market-forced dilemma faced by the world’s policymakers: in the long run, they can have cheap money or cheap commodities, but not both.
China’s statistics are notoriously unreliable. However there’s no reason to suppose they have become suddenly more unreliable; an acceleration in growth from 9-10% in 2005-06 to 11.5% in the first quarter of 2007 is still a substantial acceleration, even if the real figure is from 5-6% to 7.5%. Moreover it’s not surprising that acceleration would have taken place. China repatriated $42 billion from its international Initial Public Offering stock issues in the first quarter; since several of the stock issues in the past year were for Chinese banks, you can be sure that the money has been on-lent, mostly to dodgy state –owned companies, thus increasing China’s rate of growth. When the Industrial and Commercial Bank of China makes a $646 million loan to the state-owned Zhanjiang Port Group there’s very little documentation, and not much expectation that the money will be paid back, as distinct from just feeding the endless thirst for infrastructure in Guangdong province.
The People’s Bank of China has made several feeble gestures towards raising interest rates, but in a country where foreign exchange movements are restricted and most credit is allocated by government fiat the Chinese economy is far from a market system and real restraint is a long way from happening. While excess Chinese liquidity has fed into the international system and inflated the rest of the world, any monetary tightening that affects the Chinese economy will have to come from the West.
Only when real interest rates net of inflation are above 3% in China’s principal markets, the United States, the EU and Japan will Chinese output growth begin to slow, and the breakneck expansion of Chinese consumption be reined in. At that point, of course, it is likely that the bad debt problems in the Chinese banking system, which have failed to manifest themselves for s decade as world liquidity has inexorably grown, will cause a crisis within the domestic Chinese economy that will retard its growth rate and halt its progress to becoming a major international wealthy economy for at least half a decade.
Rapid growth in China has major economic effects, apart from flooding the world with Chinese manufactured exports, because China has 1.3 billion inhabitants, 50% more then the United States, the EU and Japan put together. Consequently a China that had a Western living standard would be a prodigious consumer of natural resources (if you believe in global warming, it would also make the planet more or less uninhabitable south of Spitzbergen – fortunately this column is thoroughly skeptical about global warming!)
This is already happening. Delays at the Australian port of Newcastle are now so bad that the prime minister John Howard has refused to rule out taking over the port. 60 ships were taken out of commission to wait at anchor for three weeks because of port congestion, thus single-handedly causing a world shortage of bulk carriers and driving freight rates up by 30% since the beginning of March, according to the Australian. The price for some classes of bulk carriers are double their level of a year ago. The reason for this is Chinese demand for coal, the principal export through the port. Chinese energy demand is increasing by 13% a year and 78% of China’s power plants run on coal.
It’s kind of gratifying, in a 19th century way, that the emergence of China as a major economy is manifesting itself on the world economy through a world shortage of coal carrying capacity. Lord Palmerston would have understood the problem well; indeed with one of the first degrees in economics (from Edinburgh, taught by Adam Smith’s former colleague Dugald Stewart) he would have anticipated it, which is more than most modern statesmen seem capable of doing. Nevertheless, the result of the problem is the same as it would have been two hundred years ago: an inexorable rise in the prices of commodities and transportation.
Oil, gold, copper and corn, as well as freight rates are all close to their all time highs, and showing no signs of retreating. The fall in commodity prices enjoyed by the world since last May has reversed itself, and those commodities which are not already at record levels are showing every sign of breaking through.
Free market ideologues will proclaim that this is not a problem and that the high prices will call forth new supplies of the commodities concerned, so that prices will drop back down. If demand were rising only moderately, this would undoubtedly be true. For example this week a new survey revealed that Iraq’s petroleum reserves may be double what had been expected, with new prospects in the Sunni-controlled Western desert. This is not only good news for the prospects of long-term tranquility in Iraq (because the Sunnis will now have their own oil reserves and in the long run revenues) it is also excellent news for the world’s oil consumers.
However the snag is that even without the current insurgency in Iraq, and the consequent reluctance of foreign oil companies to devote their technology to the country, those additional reserves could not produce additional oil supplies until 2012 or so. That delay of five years is crucial; since Chinese petrol consumption is increasing even more rapidly than its coal consumption a five year delay in producing new supplies would have seen Chinese consumption double against a supply base that had increased little. World energy demand increasing by 1-2% per annum can be accommodated, provided there are no wars in crucial areas and the world’s consumers work together; world demand increasing by 4-6% per annum is impossible to manage.
In this context, indeed, we need political as well as economic mechanisms. China’s need for energy and other resources is not going away. Telling the Chinese leadership that scarce resources such as oil and coal will be allocated by the free market through the price mechanism will not satisfy them. These people after all are more than a little suspicious of market mechanisms and suspect that the world’s “haves” rig the economic system in their favor and against the “have-nots.”
The natural Chinese reaction to lectures about the benignity of the free markets is to use political influence to lock up their own sources of oil and minerals, notably in countries such as Iran, Venezuela and Sudan whose politicians are naturally antagonistic to the United States. Since those countries don’t have access to competent management or modern technology, China can provide it, without any tiresome lectures about human rights – win-win all round, for the average Third World dictator seeking membership in the Axis of Evil.
This enriches and perpetuate some very unpleasant regimes, which might otherwise collapse of their incompetence, makes western efforts on human rights and democracy even more futile than usual, and endangers U.S. interests since one or other of these dictators will eventually decide it might be fun to engage in some nuclear terrorism.
However this all-out win for the bad guys is completely unnecessary. It is not in fact in China’s interests to depend for its resources entirely on the competence of assorted homicidal fruitcakes. China is rapidly becoming a wealthy country, so has an exponentially increasing stake in the world’s economic system. It’s far better for China to work with suppliers that are part of the global economic and political community, rather than outlaws. Not only is their supply thereby more secure, but by not enriching madmen China can reduce world tensions, increase world prosperity and enrich itself further.
Just as there is an Organization of Petroleum Exporting Countries, which attempts to act as a monopoly seller of oil, so there needs to be an Organization of Petroleum Importing Countries, which confronts sellers with a united front on such matters as human rights and support for terrorists, adjusting purchases between buying countries in order to accommodate the needs of its members’ economies. It may be objected that this is not a free market solution; well, the oil market is not free, and has not been since the West’s feeble capitulation to Saudi-Iranian pressure in 1973. A monopoly buyer/monopoly seller arrangement is far more beneficial than the current system whereby China is motivated to destabilize oil producing countries and subsidize “bad guys” that won’t deal with the West.
In addition, if there was agreement between oil buyers, it might be possible to destroy the link between oil revenues and Third World governments, which has produced such appalling economic performance throughout the Middle East and other oil producing countries, while enriching some of the world’s most unpleasant regimes. Trust funds whereby oil revenues were paid directly to the inhabitants of oil producing countries, ideally as vouchers for education, healthcare and social security, would represent an infinitely better use of oil payments than anything that anything that has so far been tried outside Norway and Alaska.
In the world economy as a whole, the flood of cheap money over the last dozen years has caused uncontrolled economic expansion at a pace much faster than the world’s resource supplies can be expanded. While consumer price inflation has been suppressed for the last decade by the one-time communications revolution of the Internet and mobile telephony that has enabled global supply chains that were previously impossible, this effect will not last for ever. In the 1880s, an equivalent communications revolution produced declining goods prices, as world money supply remained constant, bringing improving living standards for all except debt-ridden commodity producers. Today, with fiat money, its price-reducing effect has been swamped by printing money, so asset price inflation has resulted.
As the period of loose money has extended, its inflationary effect has increased, and is now beginning to swamp the effect of new technology. Rising commodity prices are today producing inflation that is always higher than expected, persistently breaking through central bank targets. It took 14 years and three election cycles for the inflationary impetus of President Lyndon Johnson’s attempt to provide “guns and butter” without raising taxes in 1965 to work its way through to consumer prices sufficiently to make the world’s monetary system cry “No mas” and appoint Paul Volcker Fed Chairman. It is now 12 years since Alan Greenspan began to increase M3 money supply by nearly 10% per annum in 1995. During that period the world has gone on a spending binge that has taken stock markets and house prices to unheard of heights while, unlike the 1880s price deflation, enriching nobody much in the West except speculators.
We seem to be approaching a crisis point, at which rising commodity demand overwhelms the market, producing a price spiral that overwhelms the world economy and bursts the stock market and asset price bubbles. This will produce a painful few years, but it will be good for us. When the world economy rebalances itself, after half a decade or so, Chinese growth will continue at a sustainable pace, while the rest of us will enjoy cheaper housing and higher yields on our investments. Only the speculators who failed to get out in time will lose money. One has limited sympathy.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)