One of my frequent reads in the econoblogosphere is Brad Setser’s Follow the Money. In a recent post, Setser covered the topic of a June 13 Wall Street Journal article that posits transportation costs from China would affect trade with the US. This in turn was based on a May 27 analyst report from CIBC World Markets provocatively titled “Will Soaring Transportation Costs Reverse Globalization?” Salon’s How the World Works caught this even earlier back in 2006, and updated the post on June 6. I duly covered the topic myself a week ago in in my June 9 Shanghai Star Business Journal column, reprinted below.

But first, Setser raised an interesting question: Why did the WSJ article focus on transportation costs from China when the RMB appreciation has also been significant in 2008?

I would answer this in two ways from a purely practical approach. (I’m going to focus on the US since it is the largest export market for China.)

• China-based firms usually price in US dollars, not RMB, so for much of the appreciation of the past several months, possibly even for all of 2008, suppliers may be locked into existing contracts and pricing schemes, or under frequent pressure from US customers to keep prices steady. This makes the RMB’s rapid appreciation of the past five months less important.
• Transportation costs, on the other hand, are usually set at the time of shipment by a third party (most orders from China may be quoted ex-Factory or FOB to a China port, but rarely priced ‘all-in’ to a foreign port). Therefore, transportation costs for the buyers have been increasing more quickly in the last few months.

As well, there’s probably an economic argument to be made about elasticity of transporation versus a change in price due to exchange rates, but I’ll leave that one alone for now. Instead, here is my article from the June 9 Business Journal:

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China’s Coming Oil Shock

The recent sudden increases in the global price for oil threaten to choke off China’s export economy, further clouding the outlook for what should have been the country’s Olympic year in the sun. June 6 saw the biggest one day price gain ever, exceeding even the period during the two oil shocks in 1973 and 1979, an increase of more than ten dollars in one day. As prices for crude oil continue to climb, closing at an all-time high of US$138 per barrel June 6, China is now facing rising transportation costs that could derail its economic development.

The recent run-up in oil prices was not the first shock China has dealt with in 2008, but the effects of snowstorms, civil unrest and the Sichuan earthquake, already making 2008 one of the most unpredictable in China’s modern development, may be eclipsed by the consequences of a sustained high oil price on China’s economy.

China is not alone: Since the record oil price spike, foreign leaders have been calling on OPEC to increase production. While many analysts believe that the high price is a distortion, possibly due to over-speculation, even a short-term stay at these record prices will cause economic pain for both developed and developing countries. The leaders’ calls echo President Bush who, in March, criticized OPEC for not answering his call to raise output.

At that time, OPEC appeared to be rebuffing Bush for mismanagement of the US economy and US dollar. At present, other global leaders are starting to express worry. Seeking to draw attention to the issue before the upcoming July G8 meeting in Japan, Australia’s Prime Minister Kevin Rudd recently said “We need a clear statement from the world’s major economies to the OPEC producers to lift their production quota now.”

China is caught between a rock and a hard place. It is an export economy relying on its weak currency to fuel exports, while its fuel is made more expensive because of the weak currency. Some analysts say the oil price is set to rise further. Morgan Stanley predicted US$150 oil by July 4, while in May Goldman Sachs forecast US$200 oil within two years before a cutback in demand would cause a return to rational pricing. If this happens, China will be hit with a double body-blow.

First, while China’s currency exchange rate has been set against an unspecified basket of currencies since 2005, when the US dollar peg at 8.28 yuan per dollar was ended, it is still weighted heavily in dollar terms, meaning that as the US dollar depreciates against other major currencies, so does the yuan albeit at a slower pace. With prices for crude set in US dollars, the cost China is paying per barrel steadily increases. This could add further pressure to revalue the yuan at a faster pace.

Second, and this is the real kicker for an export-driven economy such as China’s, transportation costs are going off the charts. Specifically, ocean freight, all those millions of containers being sent from China to the US and Europe, are now significantly more expensive. A May 27 report by CIBC World Markets forecast some major transportation cost increases: If, as Morgan Stanley predicted, oil reaches US$150 per barrel, shipping a container from Shanghai to the eastern US will increase from about US$8,000 today to US$10,000. If the US$200 target from Goldman Sachs is realized, the shipping costs of that same container will rise to US$15,000.

How big of an impact would that have? According to PIERS Global Intelligence Solutions, China shipped the equivalent of 4.65 million 40 foot containers to the US in 2007. This means that, if all those containers were sent to the east coast with oil at US$200 a barrel, the increase from today’s prices in overall shipping costs would top US$32 billion. Suddenly, cheap clothes and knick-knacks for Wal-Mart aren’t so cheap anymore, and the US supply chain would start to shift back to nearby countries such as Mexico.

Of course, China may be expected to produce higher-value exports to negate the effect of transportation costs or to place more emphasis on domestic market consumption rather than on exporting - both of which appear to be happening already - but if the oil prices increase too much too soon, manufacturers could not retool quickly enough. The effect on exporters would be compounded if the high oil price also drives the US further into recession, reducing aggregate demand.

China, the world’s second largest user of oil after the US, can act to alleviate the oil price shock for itself and the global economy by reducing the gasoline subsidy to China’s transportation system as India and Malaysia have recently done. China has some of the cheapest gas in the world among non-petroleum exporting countries, even cheaper than the US currently. This promotes inefficient vehicles and transportation choices. Reducing the subsidy will not only make Chinese industry and transportation more efficient, it will help China meet its own environmental goals and improve quality of life for everyone.

Categories: Drivers of the Drivers, Globalization, Primary Growth Drivers, Trade