The other day I had the fortune of hearing P.Chidambaram speak at the India Investment Forum in New York. He briefly touched upon oil, and said that the every $10 rise in oil prices curtails the growth rate of India by roughly 0.5%. So I thought it would be relevant to understand the oil debate – the rapidly increasingly oil demand that threatens to overcome constrained supplies - and the role the dollar-yuan peg has played in making the problem worse.
Oil prices have risen sharply in the past couple of years after the US invaded Iraq, after having remained below $20 per barrel for most of the 90’s. In the wake of Hurricane Katrina, oil futures rose close to $70, their highest level ever, on the New York Mercantile Exchange, which on an inflation adjusted basis is still below the $104 peak that oil prices touched during the oil shock of the 1970s. While so far, the impact of high oil prices on global growth has been minor, it looks that $3/gallon oil might have started impacting consumer demand – at least in the US.
Oil demand has risen sharply in the past few years, while supply has remained stable. The current demand for oil is approximately 82 million barrels/day, and the total crude-oil producing capacity does not exceed it by much – just 1.5 million barrels/day, according to the Wall Street Journal. A more normal cushion is of the order of 4% of demand or 4.5 million barrels/day. The International Energy Outlook forecasts demand to rise sharply by 2 million barrels/day over the next decade, while supply will increase by only 1.5 million barrels/day. The supply remains constrained due to low levels of capital expenditures by the oil companies in new exploration and refining over most of the 1990s, when oil prices were in the low $20s. As such, there is not enough of spare capacity left, and demand can easily overwhelm supply if there was a shock to the oil production and refining infrastructure, which can take the form of Hurricane Katrina and Rita hitting the US Gulf Coast, or a political disruption in any of the oil producing nations.
There are three countries whose dynamics impact the demand side of the oil equation – US, China and India. US is the largest consumer of oil in the world– this country that accounts for 4% of the world population consumes 25% of its oil. On the other hand, China and India have been amongst the fastest growing consumers, and have helped push oil demand threatening close to supply.
The US consumes 25% of total worldwide oil, of which more than half is consumed by cars and trucks. US consumers have continued buying gas (petrol)-guzzling SUVs in the past couple of years, even as oil prices have shot up from $1/gallon to $3/gallon. US consumer demand has remained strong due to a sharp increase in wealth brought on by high real-estate prices and good returns from the stock market in the last two years. This has primarily been the result of low-interest rates. If interest rates went up slightly to calm down the real estate market and also make car financing less attractive, consumers would cut down on oil consumption.
But why have the interest rates in the US been so low? The Fed has tightened short-term interest rates from 1% to 3.75% in the last year and half, but the yield on the ten-year bond – the bond yield more relevant to the long-term house mortgages - has refused to move upward. If anything – at 4.24% currently, it is actually lower than when the Fed first raised interest rates in mid 2004.
Bond bulls say that even though US interest are low compared to historical standards, they are higher than what exist in the rest of the world currently. And so bond investors outside are investing in US treasuries to take advantage of their relatively high yields. Add to that the current uncertainty in the Euro area (Germany, the biggest Euro economy, has had a hung election), and that makes US Treasuries even more attractive.
The biggest buyer of US treasuries these days is China, besides Japan and Korea. China enjoys a huge trade surplus with US, and it needs to put this extra money somewhere outside the country, for otherwise it would fuel inflation within. That place is the US. There is no other place to invest. If EU had been growing faster, then some investments might have gone in Euro zone. That, unfortunately, is not the case. So why does China enjoy this huge trade surplus?
That is because of the yuan-dollar peg. Till before this year, yuan was pegged to the dollar at 8.28 yuans per dollar. This year, under pressure from its trading partners like US and Japan, the Chinese government changed the peg to 8.11 yuans per dollar, and also allowed Yuan to float in a very narrow the trading band of approximately 0.3% against the US dollar, which is too small to cause a meaningful revaluation. As such, Chinese goods remain very cheap in US dollars, and so WalMart, Dell and other US companies continue sourcing from China. So, the trade surplus that China enjoys vis-à-vis the US continues to exist and keep on growing.
If Yuan were to float freely, it would appreciate and dollar would depreciate. Chinese exports to the US would slow down, narrowing the US trade deficit that stands at around $55 billion/month. This would mitigate China’s problem of investing its trade surplus, which it currently does in US treasuries. As such, the demand of the US treasury bonds would decline and the US bond yields would inch up.
This would also help curtail Chinese oil demand. A stronger yuan would lower Chinese exports, and lower the growth rate of this export driven economy, curtailing demand in the world's fastest growing economy and car market.
India has contributed its small might in keeping domestic oil demand high. By keeping the lid on retail oil prices, Indian government has not allowed the oil demand to trend down, commensurate with the increase in global oil prices. HPCL, BPCL and other oil companies are incurring significant losses by selling oil to consumers at below the cost at which they purchase globally, and are on budgetary support.
One should remember that the oil price increase this time is different from the 1970's: then it was a supply side shock with a cartel of Middle East countries suddenly raising prices. This time it is demand driven - a demand that is inflated in US, China and India due to distorted macroeconomic policies. While correcting these policies might temper demand and economic growth in China and India in the short run, it would be healthier in the long-run as it would prevent unsustainable economic forces from building up in the global economy.
What Alan Greenspan has aimed to achieve by increasing the interest rates in the last year and half is to have a soft-landing in home and other asset prices in the US, without pushing the world’s largest economy into a recession. High oil prices have the potential to thwart his aim. The global economy has become more energy efficient in the last 30 years, which is the primary reason why oil price rise hasn’t had an impact on growth so far – however, there is a limit to which energy prices can rise without pushing the globe in recession and stagflation.