China's Growing Appetites

June 1, 2004 Topic: Economics Regions: Asia Tags: BusinessIndustryIraq War

China's Growing Appetites

Mini Teaser: Oh, East is East and West is West, and never the twain shall meet--unless they need to secure access to strategic natural resources.

by Author(s): David Hale

During 2003 China and Japan competed for the right to develop an oil pipeline in Russia for their respective markets. The Chinese formed an alliance with YUKOS while the Japanese focused on the government pipeline monopoly, Transneft. YUKOS agreed to sell China 300,000 bpd starting in 2006, an amount triple the level of China's oil imports from Russia in 2003 and six times higher than in 2002. When the Chinese chose YUKOS as a partner, it was regarded as Russia's most successful and transparent oil company. Since then, YUKOS's star has fallen with the decision of Vladimir Putin to arrest its CEO Mikhail Khodorkovsky, for meddling in politics. The Russian government has subsequently announced that it will support the construction of an oil pipeline following the proposed Japanese route but with a branch extending to Daqing, China's largest oilfield. The new pipeline will stretch over 4,000 kilometers and run close to the border of the autonomous region of inner Mongolia, where the branch to Daqing will peel off. Russia will be able to satisfy the new demand for oil only by developing deposits in eastern Siberia closer to the Chinese border. Although China perceives that Russia stole land from it during the 19th century, it has not yet begun to demand the return of lost territory. Indeed, the greater risk to Russia's territorial security could ultimately prove to be American and European trade policy. Beijing currently plans to pay for its commodity imports by exporting a growing volume of manufactured goods. If the United States and Europe attempt to curb China's exports, Beijing will have no way to pay for its rapidly growing imports of oil and other raw materials. In such a scenario, China could decide that the most attractive way of securing adequate energy supplies would be to reclaim lost territory in the Russian Far East with large oil reserves. Russia could thus become the casualty of protectionist trade policies in North America and Europe.

While Russia has been ambiguous about its relationship with China, Kazakhstan has given China a warm welcome. The Chinese National Petroleum Company has invested $700 million in oil development. China is about to spend $3 billion on a new pipeline from Atasu to China's Xinjiang Autonomous Region. The three section trunkline of over 3,000 kilometers will ultimately be able to deliver 20 million tons of Caspian Sea crude to western China. As Kazakhstan currently exports 70 percent of its oil via pipelines passing through Russia, it is anxious to develop new markets.

Other regions that could be vulnerable to Chinese territorial claims are the Senkaku Islands (the Chinese call them the Daiyous) and the Spratly Islands in the South China Sea. It is widely perceived that both sets of islands could provide access to large oil reserves. In the 1970s Deng Xiaoping declined to pursue territorial claims in China's neighborhood. He said that conflicts over the islands should be "left for the next generation." In November 2002 asean and China concluded a treaty that called on all claimants to avoid actions that might heighten tensions in the flashpoint region. This was further reinforced last winter by a non-aggression pact with ASEAN. But in recent months, Beijing has once again begun to speak out about its claims. It has criticized Vietnam for attempting to give oil drilling rights to foreign companies and promoting tourism on the Spratly Islands, and it recently allowed a group of Chinese nationalists to land on the Senkaku Islands and plant a flag. The Chinese were promptly arrested by the Japanese police and then sent home to a hero's welcome. The new regime of Hu Jintao has been constantly stressing to other Asian countries that China's emergence as a great power will not threaten them, but China's concern about securing adequate oil supplies could encourage Beijing to become more assertive again over territorial claims in regions which adjoin large oil supplies. As with Russia, the ultimate determinant of how far China will go in pursuing its claims may depend upon western trade policy. If the United States and Europe make it difficult for China to pay for oil imports with exports of manufactured goods, China could decide to pursue a more aggressive foreign policy to obtain oil from disputed territories.

A second potential development is China's likely emergence as a more important player in financing the development of natural resources. The Chinese regard ownership as an important element of control. In the United States, for example, they purchased cutting rights over large tracts of timberland nearly 25 years ago. The big Chinese oil companies are now investing in oil development projects in Indonesia, Latin America, Africa and Australia. China's steel industry has made large investments in Australia's iron ore mines and is planning to develop a joint venture to produce steel in Brazil. The Chinese bought a Zambian copper mine during the late 1990s. The government of Papua New Guinea has invited Chinese firms to bid for a major nickel development project and to acquire a large shareholding in a pipeline that it wants to construct in Australia.

In the past, the largest corporate players in the development of global commodity production have been companies from the United States and the Commonwealth, especially Canada, Australia and South Africa. These companies are currently holding negotiations with China about both investing in new Chinese projects as well as forming joint ventures with Chinese firms to develop mines in other countries. Rio Tinto has several joint ventures with China in Australia. BHP recently announced plans for a 25-year iron ore supply contract to China which will include large Chinese investments in its mines. Four Chinese steel companies will own 40 percent of the mines. As a result of China's obsession with the issue of control, the odds are high that China will emerge as an important partner, if not full owner, of many new natural resource projects.

Chinese firms could also emerge as competitors with American and European firms. Saudi Arabia, for example, recently allowed Chinese firms to invest in its new natural gas industry while excluding American firms from the project. The Saudis were attracted to China because it could be a huge market and there were no tensions over issues such as Israel and terrorism. China also supplied intermediate range ballistic missiles to Saudi Arabia several years ago and collaborated in a Saudi-financed project to develop nuclear power in Pakistan. If the U.S. relationship with the Saudis continues to deteriorate, China could emerge as a more important player in providing them security. President Hu Jintao recently conducted a tour of Algeria, Egypt and Gabon to discuss plans to purchase more petroleum from each country and to expand Chinese investment. In July 2003 the China National Petroleum Corporation spent $350 million acquiring several oil refineries in Algeria. China also just announced plans to purchase 2.5 million tons of LNG per annum from Iran starting in 2008. This project is worth $20 billion and is the largest LNG contract in the world.

Third, China's huge demand for raw materials could produce a sustained improvement in the terms of trade with the developing countries. Since World War II, the developing countries have often suffered from declining commodity prices, especially during periods of recession in the U.S. economy. There were major developing-country debt crises during the early 1980s because of a severely restrictive U.S. monetary policy that depressed commodity prices. Russia defaulted on its debt during 1998 because of a large drop in the oil price that crippled tax revenues. In the future it is possible that Chinese monetary policy might play a more critical role than American monetary policy in determining commodity prices. What remains to be seen is whether China will be more sensitive to its global monetary role than the Americans were in the past.

Fourth, China will emerge as an important factor in the conduct of monetary policy by the g-7 countries. During the past year, China's boom has produced a 25 percent increase in America's crude-materials price index. In the past such large increases in commodity prices might have provoked the Federal Reserve to raise interest rates. But the Fed has not tightened in part because China's exports of manufactured goods are helping to restrain America's consumer price index. Wal-Mart, for example, is now purchasing $14 billion of goods from Chinese companies and $26 billion from American, Japanese and Korean companies using China as an export base. The import of low-priced goods from China is limiting the ability of American firms to raise prices despite rising raw material costs. But at some point, rising commodity prices could cause higher inflation and force central banks to raise interest rates. In the past, the G-7 central banks focused primarily on their own business cycles and the American economy. In the future, they will have to take account of how fluctuations in the Chinese economy are affecting global commodity prices.

During much of China's history, it was difficult for western countries to pay for their imports of silk and porcelain because China did not want western products. (The British introduced opium in order to reduce their trade deficit with China.) In the modern era there are no such constraints on China's trade. In contrast to the era before the industrial revolution, China has an immense appetite for both manufactured goods and commodities from the rest of the world, and it plans to expand exports of manufactured goods in order to pay for these imports. The great risk to this equilibrium is trade policy in the industrial countries. Some countries want to impose trade barriers on Chinese imports. The U.S. Treasury is calling upon China to revalue the country's currency in order to reduce its export competitiveness. China has joined the World Trade Organization (WTO) in order to demonstrate its willingness to open its own markets, but WTO entry does not guarantee that markets will always remain open for China's exports: the United States and Europe have reserved the right to declare trade emergencies and unilaterally constrain Chinese exports of textiles as well as other products.

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