The continued climb of the oil price towards $100 a barrel is grabbing attention both because of its symbolic importance and because of fears that it will worsen America’s economic predicament. The slowing economy of the world’s biggest oil consumer will be hurt further by rising energy costs, but also by the fact that those rising costs will deter the Federal Reserve, America’s central bank, from cutting interest rates as fast as it would like, because of the risk of inflation. Yet the most important effects of $100 oil, both for the world and for America itself, may in fact be felt not in Washington but in Beijing and Delhi.
China is expected to overtake America as the world’s biggest user of energy in two or three years’ time. Demand for energy in China and India is widely predicted to double during the next two decades. But that prediction depends on the strange assumption that energy demand will not be substantially influenced by rising prices. If that were so, it would be the first large market in which huge price rises had no real impact on consumers’ decisions about whether and what to buy. This will certainly prove to be wrong. Prices do matter, they do influence behaviour. Yet in China especially, they may matter in unexpected ways.
The rise in the oil price adds to China’s import bill, for the country imports almost all the oil it uses. That is of no immediate importance, however, for China has a huge trade surplus, with a current-account surplus now an unprecedented 10% of GDP. The real short-term importance of costlier oil lies in its effect on inflation. After a long period of stable or falling consumer prices, China is now worrying about the revival of inflation, with the consumer price index up more than 6% in the past year. In the past, China has used subsidies and price controls to prevent consumers from being hit by higher fuel costs, but that is expensive for the government budget and contradicts another policy, namely the goal to improve energy efficiency and reduce air pollution drastically.
Inflation is dangerous politically to the Communist Party government; it was high inflation that started off the protests in 1989 that led to the Tiananmen Square massacre in Beijing. The best way to control inflation would be to let the currency be revalued by the markets rather than keeping it cheap and tied to the dollar. That would reduce import prices and would make it possible for the central bank to use its monetary policy to control the money supply and inflation rather than, as in recent years, subjugating monetary policy to currency policy. Until now, export industries have lobbied successfully to prevent a rapid currency revaluation. But $100 oil is shifting the balance of the argument away from boosting exports and towards using the currency to control inflation. This looks very likely to force a revaluation at some point during the next year.
Such a revaluation, which is likely to be of 20% or even more, will start to bring about a big change in China’s economy. It will be reminiscent of Japan in the 1970s, when a currency revaluation in 1970-72 followed by the 1973 oil shock forced Japanese industry to move upmarket, to enter more sophisticated, higher value sectors such as semiconductors, cars and robots.
That move upmarket will help China to start to solve its environmental problems, too. Air pollution and the emission of greenhouse gases has got worse during the past five years at a much faster rate than was expected because heavy industry, such as steel, chemicals and shipbuilding, has expanded more rapidly thanks to the cheap currency and cheap capital. That will now change, if the currency is revalued in response to the pressure of inflation.
The other way in which China is likely to respond will also be echoed by India, the other big emerging market that is expected to industrialise and to increase its demand for energy during the next two decades. Both will respond by diversifying their sources of energy in order to reduce dependence on oil but also to help reduce pollution and the country’s contribution to global warming. Both countries are resisting measures to reduce emission of greenhouse gases; but both know that international pressure to do so is going to become increasingly irksome. Some reports say that China has already overtaken America as the world’s biggest greenhouse gas producer.
The easy way to diversify away from oil is to increase still further the use of coal. Coal already accounts for 70% of China’s power production and 56% of India’s. But using more coal will increase pollution, risking domestic protests as well as international pressure. So both countries are likely also to step up their investments in alternatives: liquefied natural gas, which requires new ports and pipelines; renewable sources such as wind and solar (India is already a world leader in wind power); but above all nuclear power.
In neither country are there serious environmental concerns about nuclear energy. On current plans, the International Energy Agency forecasts 6.5% annual growth in nuclear power output in China during the next 20 years and 8.3% annual growth in India. But $100 oil is likely to mean that the investment in nuclear power will be even greater than that. A bonanza lies ahead for the European, American and Japanese firms that dominate nuclear-power technology. But there will also be a big government-led effort to make Chinese firms competitive in that industry. If it succeeds, it would represent a big move upmarket for China and its technology.