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People’s Republic of China: 2011 Spillover Report—Selected Issues

Author(s):
International Monetary Fund
Published Date:
July 2011
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VIII. CHINA SPILLOVERS: GLOBAL COMMODITY MARKETS1

China’s role in global commodity markets is increasing rapidly. Potentially the most important spillover over the medium term could come from a rebalancing of economic growth toward private consumption. This could reduce China’s demand growth for some raw materials used in processing and investment (e.g., base metals), although historical experience suggests that total energy consumption will still rise by similar rates to GDP growth. Short-run shocks to real activity in China have an increasingly large commodity price effect; for example, a 3 percent shock to industrial production growth (1 standard deviation, or nearly 1 percent of GDP) causes crude oil and copper prices to rise by 6 percent. This would have widespread global terms of trade effects.

1. Role. China is a large consumer of a broad range of primary commodities. Its market shares have increased sharply since 2000, reflecting rapid economic growth but also the economic structure, notably rapid growth of exports and large-scale fixed asset investment. China has come to play a dominant role in base metals markets and, to a somewhat lesser extent, agricultural raw material markets. In contrast, China has not yet assumed a large role in global food and energy markets, although its share of world imports is rising.

Figure 1.China’s Share of Global Commodity Trade

(net imports as a percent of world imports)

2. Rebalancing. Realignments in the structure of China’s economy over the medium term (e.g., a lower contribution to growth from fixed asset investment and exports of tradables) may change the nature of China’s participation in world commodity markets. In particular, while relatively high economic growth rates should lead to ongoing increases in commodity consumption, China may experience a decline in “commodity intensity”, which—as Figure 2 shows—for China is particularly high given its income level.

Figure 2.Intensity of Base Metals Consumption

(Kilograms per capita)

3. Quantitative effect. How big is China’s effect in global commodity markets? The main near-term policy spillover from China to global commodity markets is from measures that affect the level of real activity or the accumulation of physical inventory. To analyze the effects of shocks to the growth rate of real activity on some important global commodities—namely, crude oil, copper, and other base metals such as aluminum—global supply-demand models are estimated:

  • Specification. A vector autoregression (VAR) with 5 variables is estimated using monthly data from January 2000 through October 2010: the primary production of the commodity; advanced economy industrial production; Chinese industrial production; the real renminbi-U.S. dollar exchange rate; and the real commodity price. A recursive identification scheme is used, based on Killian (2009) with the variables ordered as above.

  • Results. Real activity shocks have large and statistically significant effects on global commodity prices. The attached figure shows the variation decomposition of commodity prices arising from Chinese demand. In particular, a one standard deviation shock to the trend monthly growth rate of China’s industrial production (about 2¾ percent, or nearly 1 percent of GDP) leads to:

    • Crude oil. A rise in crude oil prices of about 6 percent (equivalent to about US$6.50/ bbl at current prices) after six months. This effect has a persistent effect on the level of oil prices, largely because of a weak supply response.

    • Copper. A rise in copper prices of about 6 percent after six months, with the effect largely persisting due again to a weak supply response.

    • Other base metal prices rise by less and, in some cases (e.g., zinc), there is no statistically significant effect of a price effect. There is no significant effect on aluminum prices, reflecting a relatively large supply response. In contrast to other base metals, China has significant bauxite deposits and aluminum refining capacity that can respond quickly to increased demand.

  • Reserves. It is difficult to identify demand shocks caused by changes in state reserve holdings, for lack of data. At a global level, precautionary demand shocks are modeled as unexpected changes in prices and are shown to have large and persistent price effects.

Commodity Price Variance Decomposition: China and U.S. Demand

Note: 4-quarter variance decomposition to 1 standard deviation shock in industrial output

4. Global terms of trade effects. Material shocks to real activity growth in China have significant global terms of trade effects. Using the global supply-demand model estimated above, the first-round trade balance impacts are presented by country and region of higher prices for crude oil and 5 base metals following a China demand shock (Table 1). Iron ore is also included owing to its importance as a factor of production (limited data availability and the prevalence of long-term contract pricing before 2010 preclude an empirical estimate of the 12-month impact on prices; the change in prices is set to the average of the other 5 base metals, which equates to 1 percentage point increase for a 1 percentage point demand growth shock). The 12-month change in prices is applied to full year imports and exports.

Table 1.First-Round Trade Balance Effects of Oil and Metal Demand Shocks in the U.S. and China

(change in trade balance, percent of GDP) 1/

Unit

demand shock
Standard deviation

demand shock
U.S.ChinaU.S.China
Middle East4.00.73.21.6
Africa1.40.21.20.6
Latin America0.40.10.30.2
United States-0.20.0-0.2-0.1
Euro Area-0.30.0-0.2-0.1
Emerging Europe-0.3-0.1-0.2-0.1
Japan-0.3-0.1-0.2-0.1
Emerging Asia-0.4-0.1-0.3-0.2
China-0.4-0.1-0.3-0.2

Commodity price changes estimated from the 12-month cumulative impulse response of crude oil and base metals prices to an industrial production growth shock. Change in baseline 2011 trade balance as a percent of 2009 GDP. Import and export weights are average trade shares from 2005-08.

Commodity price changes estimated from the 12-month cumulative impulse response of crude oil and base metals prices to an industrial production growth shock. Change in baseline 2011 trade balance as a percent of 2009 GDP. Import and export weights are average trade shares from 2005-08.

  • Overall. Many commodity exporting emerging economies experience a positive terms of trade effect as the value of exports increase. Their trade balances improve, while those of advanced markets and other commodity importers deteriorate slightly.

  • Middle East. The largest effect is seen in the Middle East where oil exporters see a 3.3 percent improvement in trade balances as a percent of GDP.

  • Other commodity exporting regions. Africa, the Commonwealth of Independent States, and Latin America also experience improved trade balances.

  • Commodity importers. This increase is offset globally by small deteriorations in the trade balances of advanced economies, emerging Asia (including China), and emerging Europe.

  • Summary. China’s impact on commodity markets, while significant, remains smaller than that of the U.S. This reflects a smaller share of world consumption for some commodities, such as for crude oil. More broadly, this is the result of the dynamics of real activity growth shocks in the U.S., which tend to be more persistent domestically and have larger effects on the rest of the world than shocks that originate in China.

5. China’s increasing role. Recursive estimations show that, in general, the impact of China on global commodity prices has been steadily increasing over the last 5 years and that estimates based on historical samples may be underestimating China’s current impact (Figure 3). The spike in the estimated impulse responses during the final quarter of 2008 is caused by the significant declines in commodity prices during the post-Lehman Brothers bankruptcy period. Recursive estimations that include separate dummy variables for October, November, and December 2008 smoothed out the evolution of the impulse responses, but the results were qualitatively and quantitatively similar.

Figure 3.Recursively Estimated 4-quarter Commodity Price Impulse Reponses to a China Demand Shock

(cumulative log change)1/

Citation: 2011, 193; 10.5089/9781462342570.002.A009

1/ Dates along the horizontal axis refer to the end date of the sample period. All sample periods begin January 2000. Zinc is not shown.

6. Commodity price decomposition. How important has Chinese demand been for commodity price developments during the last 10 years? To some extent, this is shown by the variance decompositions above. An alternative perspective is to assess the contribution of each of the variables to commodity price changes for each quarter, based on the model estimates (Figure 4).

Figure 4.Crude Oil Prices

Note: Precautionary demand, which is the residual, includes some part of China’s effect.

  • One notable result is the important role played by precautionary demand (or commodity “price shocks” as defined in the VAR). In particular, during early 2009 the recovery in commodity prices was largely driven by precautionary demand. This is likely to be a “China effect” that is not captured by the demand shock because the State Reserve Bureau reportedly began stockpiling commodities in advance of the fiscal stimulus that was implemented later that year and into 2010. During the early stages of the price recovery, explicitly identified China demand shocks provided a positive but small contribution to price changes.

  • A second notable result is the contribution of U.S. interest rates to price changes. Some caution should be exercised with respect to the interest rate contributions as they are based on changes in the real Federal Funds rate. During this period, U.S. inflation was unusually volatile, in part reflecting the pass-through of international commodity prices and, as interest rates approached their zero lower bound, much of the effect can be ascribed to changing inflation.

  • Perhaps the most striking result is the relative size of the effect of changes in the value of the U.S. dollar on commodity prices. Dollar appreciation exacerbated the demand-driven price downturn in 2008 and contributed to the price rebound in 2009. The effects of recent depreciation—occurring through the second half of 2010, during which the U.S. Federal Reserve announced a second round of quantitative easing (QE2) of monetary policy—have been significant. Although the lagged effects of a stronger dollar in the midst of the Euro Area problems was still weighing on commodity prices during Q3, the final three months of 2010 saw dollar depreciation contributing significantly to commodity price changes. The extent to which QE2 contributed to the loss of value of the dollar is still subject to debate and there remains insufficient evidence to claim that QE2 affected commodity prices significantly.

Prepared by Shaun Roache (RES). Based on a forthcoming working paper.

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