CHINA TAKES AWAY THE COMMODITY PUNCH BOWL / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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NOVEMBER 26, 2010.

China Takes Away the Commodity Punch Bowl .

By LIAM DENNING

If commodities bulls have a religious mantra, it is "China giveth." The risk is it now taketh away.


China is struggling to tame an inflationary dragon. Prices, especially for food, are rising strongly, and expectations for future price increases have surged.


Beijing blames U.S. quantitative easing, or QE, for pushing up the price of the commodities that China consumes voraciously. But QE is only part of the story. Chinese money supply surged by the equivalent of 40% of GDP last year, according to Lombard Street Research. This year, it has expanded by $115 billion a month, says Citigroup, far higher than QE's monthly budget of $75 billion.


Beijing's efforts to curb inflation to date have centered on raising banks' reserve requirements, with some now at a record 19%, and adopting some price controls.


These have done little to curb rampant bank lending, though, which likely will significantly exceed the 7.5 trillion yuan ($1.129 trillion) target set last year. Price controls, blunt instruments that distort supply, carry a whiff of panic.


If Beijing's response is slow, that raises the danger of greater tightening down the road to tame more rampant inflation, including interest-rate increases.


Economist Phil Verleger sees a parallel with the U.S. when Paul Volcker was running the Federal Reserve and ratcheting up interest rates to squeeze inflation. The oil price fell 32% in real terms between 1979 and 1983, the period of his first tenure, as the U.S. suffered two recessions.


Back then, U.S. demand dominated oil markets. Now, traders focus on China. And it needn't take a recession there to savage oil and metals prices.


Chinese oil-demand growth in any given year equates to roughly 60% of its real economic growth rate. The International Energy Agency projects Chinese GDP to expand 7.9% a year on average. But say an anti-inflationary crunch cuts that to 5%. The implication would be for China to burn one million barrels of oil a day less in 2015 than the IEA forecasts, reducing global expected demand growth by 19%.


Beijing might yet engineer a soft landing. But it would be curious indeed to bet on higher commodities prices in anticipation of the Fed overdoing QE while simultaneously having faith in the fine touch of China's central bankers.


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