More Balderdash!

Yesterday the media reported that China was going to increase oil prices by approximately 18% by reducing subsidies. This news was generally received by the investment community as a positive with regard to reducing the global price of oil. The price of oil dropped substantially on global markets. Presumably, the thinking, what little of it that there was, was that by increasing the price of oil Chinese consumers paid, a reduction in overall demand would be created. As a consequence, the overall supply, relative to this demand would increase, and global prices would drop.

The amazing part about this event is how well it illustrates the level of shallow thinking and the consequent behavioral response. Modern financial theory, increasingly being debunked by real life events, attributes some greater overall knowledge of incorporating all known information into aggregate market response with respect to efficient disclosure of asset valuations. This most recent event, however, is more representative of how poorly markets incorporate and reflect information into asset prices. Consequently, it is one more example of how inefficiently markets reflect appropriate valuation.

Even a superficial follower of the Chinese financial and economic system would know that China is facing a serious inflation problem. At the same time, because of its uneven distribution of economic development, it also has millions of people it needs to keep productively employed. The problem faced by China, and a good part of the rest of the world, is containing inflation while, at the same time, maintaining reasonably strong economic growth. It is difficult to see how the new Chinese policy of increased oil prices would contain inflation.

A more reasonable expectation is that the response to increased oil prices will be to pass the added cost along to the end consumers. The upward wage pressures China was already experiencing is likely to be increased in response to a higher income need among its workers. A later consequence would likely be to see the price of Chinese exports increase. Since much of the rest of the world is hooked on Chinese goods, it would be reasonable to see increased inflationary pressure in those countries importing Chinese goods. The United States and Europe are large importers of Chinese goods. As a consequence, we can expect to see increasing inflationary pressure in these regions arising from this event.

While there has been increasing pressure on China to strengthen its currency vis a vis the US dollar, this event would suggest that one way to try to contain the Chinese inflationary factor would be to keep the US dollar stronger vis a vis China's currency in order to retain purchasing power. At the same time, China has huge US currency reserves, and oil is traded primarily in US dollars on global markets. This means that China stabilizes its purchasing power of oil, reduces political policy pressure to strengthen its currency relative to the US dollar, and preserves a sustainable core rate of economic growth. As usual, this appears to be a masterful, strategically thoughtful Chinese policy move.