Fighting soaring oil prices and inflation

By Dan Steinbock (China Daily)
Updated: 2011-03-24 15:02
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As the era of cheap energy is ending, oil prices began climbing faster. They are rising even faster after Western forces launched attacks on Libya. The prices are currently close to $110 a barrel. Oil-rich Libya was producing 1.69 million barrels a day before the unrest, according to the International Energy Agency (IEA). It is now producing 400,000 barrels a day.

Currently, the symptoms of overheating are confined to a few countries such as Brazil and Indonesia. Though Japan's nuclear crisis caused oil prices to fall a few percentage points, there is no doubt about the rising trend. And as the IEA has said, sustained high oil prices could damage world economic recovery. But the disruptive developments in several North African and Middle Eastern countries, which have led to rising oil prices, is intensifying the risk of overheating elsewhere.

The loose monetary policy in the United States, much of Europe, and Japan may temporarily sustain demand and reduce unemployment. But deferring fiscal adjustment and interest rate hikes too long could lead to overheating in emerging markets.

The fluid developments in several North African and Middle Eastern countries since December have created a challenge for the global oil market. In particular, it has made efforts to deal with the oil price hikes a daunting task for rising Asia. After the global financial crisis, the rise of Asia has been accelerating, whereas rich industrial countries in the West have been drifting into a liquidity trap. It is this "two-speed recovery" that makes policy measures difficult.

In many emerging economies, activity remains buoyant, but inflationary pressures are rising and there are increasing signs of overheating, driven in part by strong capital inflows. As investors seek higher returns, "hot money" (short-term portfolio flows) has resulted in imported inflation and potentially dangerous asset bubbles in emerging Asian and Latin American countries, and elsewhere.

Since 2007, China and India have contributed more to worldwide growth than the US, Western Europe, or Japan. The sustained growth of these large economies is predicated on continued energy-intensive industrialization. Overall, emerging economies account for more than 90 percent of the projected increase in world primary energy demand, reflecting faster rates of growth and economic activity, industrial production, population and urbanization.

Rapid and broad increases in energy prices could hamper the sustained growth prospects in emerging Asia and the sluggish recovery in the advanced West. In China, concerns have been mounting over inflationary pressure and potential hikes in oil prices. Advisers to China's central bank expect consumer inflation to rise by 5 percent this year, and the government has made the stabilization of consumer prices a top priority, hoping to hold inflation around 4 percent.

Compared with international response Chinese policymakers have moved fast to try to contain the impact of soaring oil prices and inflation. Most importantly, this has meant fiscal adjustments and monetary tightening. In early February, the People's Bank of China (PBOC) lifted its benchmark one-year deposit and lending rates by 25 basis points to 3 percent and 6.06 percent. Leaning too heavily on interest rates tends to draw in more capital and thus contribute to exchange rate pressures, as evidenced in Brazil (interest rate at 11.25 percent) and Indonesia (6.75 percent).

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Macro-prudential measures (that is, raising reserve or collateral requirements) can discourage credit creation without raising interest rates. The PBOC raised reserve requirements for lenders after mid-February. Last week, it announced that the reserve requirement ratio would be increased by 50 basis points from March 25 - the third time this year.

But such measures can lead to distortions in capital markets and are often resisted by influential interest groups. In some countries, overheating has led to a paced increase in the exchange rate to ease inflationary pressures. Such revaluation of currency, however, affects primarily the prices of traded goods. Moreover, a rapid revaluation of the yuan would prompt commodity providers to raise their invoice prices accordingly.

Coupled with rapid wage increases, a fast revaluation of the yuan would pose a serious challenge to business.

Since all options have trade-offs, Chinese decision-makers have to make their choices in an extremely challenging environment. Adjusting monetary policies will be very difficult in an interdependent global economy, which is coping with US stagnation, Eurozone debt crisis, Japan's triple disaster, and rapidly-changing situations in North Africa and the Middle East.

The Chinese government has paid attention to people who are most vulnerable to rising inflation caused by oil price hikes. In February, for instance, gas price in Beijing rose to 7.45 yuan a liter. The government should provide subsidies to low-income families, taxi drivers, and other sections of society that could be hurt by price adjustments. Energy subsidies cannot be withdrawn quickly because that would reduce social cohesion.

On the other hand, subsidies are unlikely to offset higher oil prices paid by cabbies, and energy subsidies will not be viable in the long-term. In 2010, China's reliance on imported oil climbed from 33 percent to 55 percent. In the coming decades, this dependency will increase further.

In the 19th and 20th centuries, the industrialization and urbanization of the ascendant Western economies - the United States, Western Europe, and Japan - greatly benefited from relatively low energy prices. In contrast, China and India, with their large populations, cannot hope to duplicate an economic model that relies on high consumption of energy.

Coping with soaring oil prices and inflation is a balancing act between short-term relief and long-term sustainability. China seeks to do its share. But so should the advanced economies.

The author is research director of International Business at the India, China and America Institute, an independent think tank in the US, and visiting fellow at Shanghai Institutes for International Studies.