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How China's monetary policy drives world commodity prices

05/02/2006Frank Shostak

In order to cool off the strong pace of economic activity, on Thursday April 27, China's central bank raised the one-year lending rate by 0.27% to 5.85%. The Chinese central bank tightening of the interest rate stance has unsettled world commodity markets that for the past five years have been displaying spectacular performance.

For instance, the price of oil rose from US$19.5 per barrel in November 2001 to US$75 per barrel in April this year — an increase of 284.6%. The LME price of copper jumped to $7,147 per tonne in April — an increase of 425% since October 2001.

During that period the price of zinc increased by 346% whilst the price of gold rose to US$653/oz in April from US$257/oz in March 2001-an increase of 154%.

It seems that the stance of China's monetary policy is of crucial importance in driving world commodity prices. The key mechanism behind this is the combination of aggressive monetary expansion and the almost unchanged rate of exchange against the US dollar.

How monetary expansion and the rigid exchange rate drive commodity prices

Based on the huge trade surplus with the United States, which stood at $114 bill in 2005, most analysts have concluded that the current rate of exchange of 8.017 yuan to the US dollar is far too high. However, what matters for the currency rate of exchange is the pace of money expansion relative to real economic growth — not the state of the trade account.

After falling to negative 1.2% in March 2001 the yearly rate of growth of the central bank balance sheet (monetary pumping) relative to real economic activity climbed to 28.2% in September 2005. In February this year the yearly rate of growth of the relative pumping stood at 22.1%.

In contrast, the yearly rate of growth of the Fed's balance sheet in relation to real economic activity fell from 11.6% in September 2001 to 0.9% in March this year.

Since China's monetary expansion relative to real economic activity has been accelerating whilst in the United States relative pumping has been decelerating, it follows that China's yuan has to depreciate against the US dollar. Yet the Chinese central bank kept the yuan unchanged against the US dollar at 8.29 from December 1996 to June 2005.

Now, the massive monetary expansion has given rise to a strong demand for capital goods (in order to expand the infrastructure). This in turn has lifted the demand for raw materials and oil. Under normal conditions if the exchange rate had been allowed to freely fluctuate the monetary pumping would have raised the price of dollars in terms of the yuan, thereby making the employment of various imported raw materials not a profitable proposition. However, once the exchange rate is kept unchanged then things become somewhat different.

The unchanged rate of exchange in fact reinforces the growing demand for raw materials. Keeping the rate of exchange unchanged whilst lowering the internal purchasing power of money through monetary pumping makes dollar-priced goods relatively less expensive for the holders of the yuan.

What allows China's central bank to sell US dollars at a subsidised rate is the massive stock of foreign reserves, which stood at US$875 billion in March this year versus US$169 billion in January 2001.

By directing its demand to dollar-priced commodities China has significantly contributed to their overvaluation versus other goods and services priced in US dollars. (Whilst China cannot print dollars and therefore lift prices of all the goods and services priced in US dollars, it can push prices of some goods relative to other goods).

If China were to appreciate its currency, as most experts advise, this, given loose money policy, will only reinforce demand for commodities from China. The recent hike in China's interest rate is not the prelude for more interest rate increases.

Chinese authorities are unlikely to go "all the way" to cool off the rampant pace of money driven economic activity given the still high unemployment rate. Unofficial estimates suggest that the urban jobless rate could be above the 8% mark, whilst at least 150 million people in rural areas are without work.

In short, for the time being, the loose monetary stance is likely to stay intact. For the time being, the loose monetary policy of China will continue to provide strong support for commodity prices. It is not possible to tell how long can China continue with its loose policy and rigid exchange rate.

Sooner or later the music will stop on its own accord once the stock of foreign reserves begins to dwindle. For instance, an economic slowdown in the United States could have a significant effect on China's stock of reserves on account of a fall in exports.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He maintains weekly data on the AMS for subscribers through Man Financial, Australia. Send him mail and see his outstanding Mises.org Daily Articles Archive. Comment on the blog.


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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.