In the last few days this space has written about the Goldman Sachs prediction of a “super spike” in oil prices to $105 a barrel, as well as half a dozen pieces about China, like this, this and this. The reason is that China is the cause of the unanticipated incremental demand for oil in 2004 and 2005 that has rattled world markets. We wrote about that a few months ago, and noted China’s 40% increase in oil imports in 2004 at that time. The increases continue this year.

The international market in petroleum products is one of the most researched and analyzed areas of economic importance by consumers and producers, academics, econometric model builders, bankers and others around the globe. Thus it seemed strange that so many people, including OPEC itself, appeared surprised by demand levels and prices. Surprise could mean one of several things — either something fundamental had changed in China’s growth trajectory, or the country was in the midst of a bubble economy, with all the excesses in demand that bubbles bring.

We see a lot of evidence for the bubble explanation: (1) extreme speculation and price appreciation in real estate; (2) unsound banking practices at corrupt banks; (3) unsustainable increases in M2 and commercial and mortgage loans; (4) no serious government action to slow the economy’s breakneck speed through monetary, fiscal, credit or industrial policies. We also noted the parallels to Japan in the late 80′s, and observed that Barton Biggs, who correctly called the Japanese crash at least three years before it happened, had issued similar warnings about China in 2003. Finally, we observe that the dollar during the last 18 months got cheaper and cheaper, supercharging demand and fattening profit margins for many export businesses, since the yuan is pegged to the dollar.

The bubble appears about to burst.

You can see from the chart above that the long slide in the dollar versus the euro has recently reversed. That upward trend in the value of the dollar will continue as the US continues to raise interest rates to ward off inflation (Goldman and Merrill Lynch recently raised their year-end Fed funds rate estimates to 4% and 3.5% from the current 2.75%).

Rising US interest rates and the rising dollar have a number of effects, including slowing economic growth in the US, and in economies pegged to the dollar. China gets hit from a couple of angles, as the relative price of its exports increase in areas like the euro-zone and demand from the US slows, among other things. Because of the way that China manages its foreign exchange policy, the slowdown in demand would also likely result in a slowdown in the expansion of M2 in China.

Speculative bubbles do quite well when credit is easy and getting easier. They run into big trouble when money tightens, which appears to be the emergent trend over the remainder of 2005.

For these reasons, among others, we don’t think it is a good time to buy an apartment in Shanghai or to make bets on oil at $105 a barrel.

This entry was posted on Sunday, April 3rd, 2005 at 1:53 pm and is filed under business, General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.