The secret of Korea's success, nuclear energy?

Of course, there are many secrets for Korea's economic miracle, a few where they did a lot better than Taiwan.

Lee Yuan-tseh, nobel prize winner, cannot compromise ideology and pseudoscience to what he knows, so he finally spoke out in favour of Nuclear Plant #4, albeit a few years late he was.

What are the issues about nuclear energy?

• It is cleaner, emits less CO2 than fossil fuel
• It can last millions of years for human being, fossil fuel last for a thousand at most, some said a couple hundred or less
• It is safe, given proper management practice
• We still have the opportunity to replace nuclear power with more natural energy sources such as solar, wind, tidal, vegetable oil, ethanol, etc. Though the only candidate that can generate enough energy to replace fossil fuel cleanly are probably solar, and nuclear fusion.
• For more see here
  

What has Korea done that is different, see charts below.
Total Fuel Percentage by Nuclear Power

Percentage Electricity Generated by Nuclear Power

Now see where China is at the chart, think about the soaring demand and price recently. China should have built a lot more nuclear power plants in the 1980s and 1990s. I have no idea why such a crucial and strategic issue has been overlooked all these years. Someone need to be held responsible. Perhaps that person is Li Peng, who let his educational background (hydroelectric power) biased a more rational debate and decision making process.

Related: An excellent account of Chernobyl aftermath by Elena Filatova. Equipped with a Geiger counter, she travelled through the ghost towns near Chernobyl, in Ukraine and Bylorussia, giving you lessons on alpha, beta and gamma radiation. Meanwhile, tons of pitctures on the area today, and the 'frozen' pictures inside the Soviet era apartments of 1986. Some said it is an exxaggerated (or frauded) account, but the phtotos are still amazing and I found her narrative (whether she travelled there in tour group or motorbike does not really matter) credible.

Categories:

• biz
• science
• taiwan
• korea

How the Ukraine Russia (RosUkrEnergo) gas deal work

The new Ukraine-Russia gas deal will involve a new company RosUkrEnergo, (background here and here) which will

• import gas from Russia at $230, from Turkmenstan and Kazakhstan at $x (prce for Turkmenistan is set at $65, probably higher for Kazakhstan), annual volumes are 17 and 40 bn cm respectively
  
• own the interests to the pipeline in Ukraine, i.e. earning $1.6/tcm/100km for the 130bn cm gas passing its border
• sell gas to Ukraine at $95 at current price structure, but adjustable as its cost/revenue position changes

I think the formula works roughly at below (where I assumed that x=70, and made some assumption about the length of the gas pipe. The numbers might be slightly different in the deal)

_________________ Russia __Asia _______Total
Volume (bn cm)_______ 17 ____ 40 ________ 57
Price/tcm___________ 230 ___ 70
Total cost ($M)______ 3910 _ 2800 ________ 6710
Avg Price ($/tcm) ______________________ 118

________________ Ukr pipe ___ Rus pipe __ Total
Volume (bn cm)______ -130 ________ 40
Distance (km)________ 800 ________ 500
Price ($/100km/tcm) __ 1.6 _______ 1.6
Total cost ($M) _____ -1664 _______ 320 ____ 5366
Avg Price ($/tcm)________________________ 94

This is a reasonale deal, satisfying the interests of both sides. More importantly, now RosUkrEnergo secures control of Ukraine's pipelines and hence supply to the EU.

Ukraine, now paying a higher price for gas, has more incentive to change its wasteful habit. It will help to curb demand and hence ease some pressure on energy price in the world. As a sidenote, if China would deregulate its price control on oil and gas, we should also see a decrease in demand and hence price in world market.

Categories:

• energy
• world
• business

Ukraine gas price, industry unit convention, and the core issues

In a nutshell

• Ukraine got dirt cheap gas from Russia
• Russia wanted to raise price, and the asking price is reasonable
• Ukraine controls the pipeline from Russia to EU, Russia is obligated by contract to deliver gas to EU's door, so it is hijacked by Ukraine now (illegally)
• Russia could sue Ukraine, but its negotiation position could only improve if it has alternative to fulfill its contact obligation to EU
• Most western media are sympathetic and biased toward the Ukrainian view. All I got were incomplete or biased info. As a result, it took me a while to figure this out. Below is how I got this.
  

---

I keyed in "Ukraine Russia gas price" dispute, I got 2890 entries (NYT, BBC, CNN)

• "The dispute centers on Gazprom's politically influenced pricing system. Ukraine, through a deal arranged under former President Leonid D. Kuchma, has been paying $50 for 1,000 cubic meters of gas, reflecting Russia's practice of providing discounted energy to former Soviet nations still in the Kremlin's orbit...Gazprom, has proposed charging $220 to $230 for 1,000 cubic meters, in line with prices in Europe. Mr. Putin has offered a $3.6 billion loan to Ukraine to help cover the costs, a gesture variously seen as pragmatic or patronizing." - NYT
  

• "Ukraine, which currently pays $50 per 1,000 cubic metre, has said it is prepared to phase in world prices gradually and can only raise its payment to about $80 for now." - BBC

Yes, I know there is a dispute on prices. $50 per 1000m³ is too low, $230 per 1000m³ may be too high. But what is the fair market price? None of the report tells us what the market price is.

I googled a bit, I was left frustrated. All I got is the market price in MMBTU

• The most recent price Dec average traded on NYMEX and Henry Hub is $13.418/MMBtu, Nov/05 average was $11.649 (oilenergy.com)
• A chart here show similar price

This does not tell me whether Russia has offered Ukraine a fair deal, unless I figure out how many cubic meter a MMBtu is equivalent to. I need convert a non-metric energy unit to its (equivalent) metric volume unit.

1. 1 MMBtu = 1.054615 Gigajoules
2. 1 GJ=26.8 m³

So $13.4/MMBtu is $13.4x(1000/26.8/1.053615)=$474 per 1000 cubic meters.

Because it is difficult to transport gas, the price could vary by as much as 10-25% for different location. For simplicity I would assume Ukraine should get 20% discount (suggestion welcome) due to its proximity so the "fair market price" should be $379.

Ukraine also insists that it should get a 15% cut for passing the gas through its border to other countries that Russia export to. If we assume for every cubic meter Ukraine buys there is one cubic meter Ukraine helps transport via its pipelines, the fair price should then be $322.

Russia's asking price is $220-230 per 1000 cubic meter. From this calculation it seems to be a very reasonable deal.

Update (Jan2): according to BBC, GAZPROM'S 2006 TARIFFS PER 1,000 CUBIC METRES OF GAS

• Ukraine: US$230
• Belarus: US$47
• Armenia and Georgia: US$110
• Lithuania, Latvia, Estonia: US$120-125 (NYT)
• Moldova: US$160 (NYT)
  
• Romania: US$280
• Average EU charge: US$240; US$255 according to timesonline (this number is dubious, I expect EU price to be higher than Romania's, due to distance and affordability. According to Oil & Gas Journal, "in the 1970s, the United States had established an embargo on certain supplies to the Soviet Union after the Soviet invasion of Afghanistan. However, several European countries anxious to receive gas supplies from the USSR agreed to supply pipes and compressor stations to complete the needed pipeline infrastructure. Those European contractors - mostly from West Germany, Italy, and France - were to be compensated by supplies of Soviet ga.")
  

I suppose the discrepancy of the Romania/EU price and the NYMEX/Henry Hub prices is probably because the price lock-in signed a couple years ago. With the building of undersea piplelines to supply Germany, and a new pipeline connecting to China, Russia will have more customers and will be able to command a higher price. More background info see here.

Update Jan 3 : Russia re-opened supply to Ukraine, because by contract it has the responsibility to deliver gas up to the former USSR border (point B in the map below, source). EU would sue Russia, not Ukraine, if it does not get its gas. So Ukraine succeeded in hijacking the gas pipes in its border. Ukraine's position is strong, until Russia can use the Poland/Belarus branch to bypass Ukraine. Meanwhile, Russia can sue Ukraine for stealing the gas, but that still leaves Russia in an awkward situation.

The map below is from NYT, if ther is indeed an artery running from A to B. Russia has a way to bypass Ukraine to Slovakia. Romania and Moldova would still be cut off, but EU would be reconnected in a couple weeks through some reconfiguration of the pipes.


When one reads this piece from Times and this from NYT. The NYT essay looks like the worst WSJ editorial and full of biased views. One has to wonder, perhaps Oxbridge are still much better institutes than Harvard-Yale?

Update Jan 4: Ukraine gets a good deal at $95/tcm effectively ($230 - cost of transport at $1.6/100km/1tcm).

• It is significantly lower than any other country except Belarus. This shows how much clout Ukraine has due to its geographic location.
  
• This also sort of dispel the myth of Russia bullying Ukraine (because a reasonable deal was reached).
  
• The deal will be valid 5 year, after that Russia will have alternative route and new contracts from Russia will only guarantee to its own border.

Update : Details of the deal

• "Ukraine will pay 230 usd per 1,000 cu m over five years, while the transit price for Russia gas through Ukraine to European customers will rise to 1.6 usd per 1,000 cu m per 100 km of pipeline from the existing 1.09 usd...[Ukraine said it] will end up paying 95 usd per 1,000 cu m for a combination of 'Russian and Asian gas' "
• A simple calculation: for every cubic meter Ukraine consume, it delivers 14 cubic meter to EU, if one assumes the pipe artery is 700 km long. ((230-95)/1.6/7). However, the actually situation may be complicated because $95 effective price includes "Asian" gas from Turkmenstan/etc.
  

Categories:

• energy
• world
• business
• pol

Map: world energy supply and demand

This is a very clear map showing the world energy supply and demand, (source: Rice University report)

• Demand: the light up area satellite photo is used
• Supply: the proven reserve of gas (and oil, which are highly correlated)
  

Categories:

• map
• world
• energy

Siberia pipeline odyssey

Putin signed an accord with Japan on the Siberian pipeline

• It will reach Skovorodino by summer of 2008 (Phase 1). That would allow China to build a branch to connect Skovorodino to Daqing (blue line).
• Russia also agrees (tentatively) to connect Skovorodino to Nakhodka afterward, that would satisfy Japan's need. But "No date has been set for the second stage, and Putin gave no timetable or other specifics."

China had negotiated and reached a deal with Yukos to build a pipe line from since 1992, from Angorsk via Chita to Daqing (yellow line). Unfortunately when Yukos was nationalized the deal was terminated. Japan has then seized the opportunity and tried to shut China out and the current pipeline was proposed (with a detour to north of Lake Baikal due to environmental concern - Baikal is the deepest lake (1637m or 5369 feet!) in the world and perhaps also the cleanest large lake remains on earth, the shaded areas are natural reserves oir national parks. It is also for environmental reason that the terminus was changed from Vladivostok/Perevoznaya Bay to Nakhodka).

Here is another myth that I scratch my head very hard:

• I can understand why Japan can be concerned about the pipeline passing through China, even though the route is shorter and the cost cheaper, because the Koizumi regime's general hostility and distrust on China. However, why does Japan try so hard to shut China out? The "reason" Japan provided is China will "siphon" away the oil at upper stream (they learned a lot from Saddam, it seems). But don't the Russian make the decision of which branch it open the taps to? Don't price and market determine who gets the goods? It should be noted that China does not try to shut Japan out, it just wanted a branch to deliver the hydrocarbon to Daqing.

Putin is not Chen Shui Bian or Annette Lu, he knows the more customers he has the better price he can command. He wants to be able to sell his oil to everybody, not just China, also to Korea and US via Nakhodka.

Had the Angarsk-Daqing line been completed, there would have been much less pressure on world oil demand because China could shift its sourcing to the extra capacity Russia has. Maybe we could all have been able to enjoy cheaper gas. Japan's bullying has hurt the world's oil importers including itself, as it has paid a lot more to import oil at a higher price today.

Update SEP/2006: Dili blog

Categories:

• geo
• biz
• pol
• russia

Commodity demand and the China factor

A recent presentation of the Macquarie Bank contains very interesting data charts on world commodity demand and some discussions about the impact of the China factor.
The first chart shows that the trend in metal prices finally decouple from that of OECD lead indicator in recent years. The explanation is pretty simple, as over 2 billions people joined the world labor, and hence consumer market, the indicator needs to include the urbanization of these 2 billion people.

The second chart shows that after the steel consumption (per capita) peaked in 1973, for about 25 years the growth in GDP/capita did not drive growth in steel consumption. It was only by late 1990s, that the correlation was observed again.

The third chart shows the same information for Copper and Nickel (but the axis were curiously switched). The stagnation in per capita consumption was less persistent than that for steel. One possible reason is that technology innovation (recycling and substitute materials) for steel may have played a more important role than for copper/nickel.

The fourth chart is the most interesting. There is a GDP/cap correlation line, showing China is about 1/3 below the line in terms of per capita consumption of copper.

1. There is still room to grow for China's consumption, especially as its GDP/cap grows
2. Even more room for India and other developing countries (unlabelled dots)
3. Much more interesting observation is that for Taiwan and South Korea (and Finland, Sweden, Belgium). I believe that is due to the electronic and computer related industries, which consume a lot of copper
4. An immediate corollary for this observation is that Taiwan and S Korea are not the end consumers for copper. The consumers scatter in various parts of the world, in their export destinations (mainly the OECD). I can even bet that Japan in the 1960s stands high above the line.
5. Now come back to look at China, the "world factory". It is now quite straightforward to conclude that a lot of "China's consumption" is not consumed by China, instead, it is "re-exported" as finished goods to the rest of the world. Therefore, some of China's "apparent consumption" growth are indeed relocation of processing and assembling factories from existing processors such as Korea and Taiwan, and that the end consumer are still the same people in OECD countries -- i.e., a zero-sum transfer to China.
6. Therefore, to predict the future we need to separate China's consumption into 2 portions, domestic consumption and export consumption, because the two have very different starting bases and growth trends. Projecting the per capita growth for China is a very different task compared with that for Japan's or France's, as some may have reached the saturation levels.

A per capita study on a per country basis could be misleading in today's globalized world, especial when we analyze exporters. It is important to carefully distinguish secondary industry consumption (processing and exporting) from ultimate consumption (end consumer), in order to make an accurate projection.

The fifth chart is Macquarie's projection for 2001-2010. It shows China's consumption (red) as a portion of the world, for copper, aluminum, nickel and zinc. Macquarie projected China's consumption in 2001-2010 to be from 1/3 (Nickel) to 2/3 (Zinc) that of the world! Based on our discussion above, I believe this is definitely an over-estimate. The more likely number could perhaps be between 1/3-1/2 of the world. I am also curious about their projection of steel consumption, because a lot of the steel was indeed consumed domestically (construction and builfding) and such unsegmented trend analysis may be more accurate..

Now 1/3-1/2 is still a very high number. That is because this includes end-consumption of the OECD countries and many other which import from China. One way to verify this is to trace the historical per capita consumption of OECD countries, they most likely have decreased significantly as production was shifted to China. In particular, the US consumption may begin to decrease in mid 1990s and that for EU beginning of this century.

A much more reliable benchmark for per capita consumption of a commocidty is oil. Since the re-export for oil (and derivative products such as plastics) may distort the big picture less dramatically (except for Singapore and the Netherlands, they would be the odd one out above the correlation line). China consumes about 1/4 of the oil in the world, commensurate to its population share. (slightly higher than its population share due to its high energy consumption industries, compared with that of, e.g. California or Bangalore)

To conclude,

• Is China part of the cause for recent surge in commodity demand and price? Yes, one of the main factors.
• Is this reflected by the trade figures? Not really, the amount processed to be exported as finished goods needs to be taken into account. They are not consumed by China.
• Would China's consumption grow at the current speed for long? No. Because most of the 'transfer from Korea/Taiwan' will be completed soon and then it is about the true growth of China.
• Would China continue to have a low productivity/energy ratio (measured by GDP/fuels burned)? Yes. Because China's industries are mainly manufacturing indsutries. In fact, it will continue to be lower than that of India.
• Is China consuming all the commodities (as the Macqarie projection predicts) of the world? No. Raw metals flow into China only because the first step of manufacturing occurs in China. China's role in commodities is no different from that of Holland and Singapore in oil refinery.

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Update: My hypothesis on copper "consumption" of Taiwan, Korea and Japan is confirmed. See this chart by a BHP Billiton Report.

• Japan's line flattens below the BHP trend line since 1993 (the rightmost 10 red points). But I would actually push 6-7 dots further left and trace the decline back to 1986/87. Strong indicator that the consumption shifted into indirect, i.e. via imported parts/finished goods, mostly from China. The vertical descent between 2000-04 (rightmost 4 dots) could represent another wave of migration of factory.
• The slope for Korea (green dots) is higher than that for Japan, and that for Taiwan (blue dots) higher than Korea's. A strong evidence that slope is inversely correlated to the size of the economy. i.e. export (of copper related products) as a % of GDP is highest for Taiwan, then Korea, then Japan when they are at the same GDP/cap level
• One can view Korea and Taiwan's numbers as the sum of two numbers, the export portion, and the true domestic consumption which is comparable to that of America or Japan
• China's (per capita consumption) line, will have a slope smaller than Japan's, because its population base is larger.
• In fact, Henandez of BHP Billiton raised the same question I raised in the upper corner of his chart, "High apparent consumption for export oriented manufacturing economies?" I feel good. :)

The Myth of the strategic location of the Taiwan Strait

I read from many reputable reports that the Taiwan strait is a strategic sea route for oil (and other commodities) from middle east to Japan (presumably via Malacca Strait / Singapore). e.g.

• "Tokyo must have concluded that a potential cross-Strait war would interrupt Japan's energy supply routes from the Middle East" - Yale Global
• "Japan sees a key sea route, the Taiwan Strait, in danger." - Der Spiegel

I was confused. So I did a small exercise with maps, Curzon style.

• The red route is the shortest path between Singapore and Yokohama. It passes the Luzon Strait (Babuyan Channel and Bashi Channel), not the Taiwan Strait
• The yellow route passes through Taiwan Strait, is obviously a detour from Japan to anywhere, except maybe Haiphong
• For transportation of other materials from SE Asia, e.g. Brunei, the Black route shows that Taiwan Strait is even further away from the ideal route
• Even if Taiwan Strait is more convenient, the availability of the alternative via Luzon Strait deems it "optional" instead of "essential"

Indeed Taiwan Strait is of strategic important to China, as it connects Guangzhou/HK to Shanghai and beyond. It may also serve as a short cut between Korea (Pusan) and Vietnam (Haiphong). If anyone should be worried, it should be the Koreans and Vietnamese.

Update: US PACOM map agrees with me.

Now, why is Japan so interested in a sea route which is really very marginal to its needs?

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Apppendix

A note about Great Circle (geodesic) path:

Since the earth is a sphere and the map is a projection onto a plane (with area distortion), my straight line approach is only an approximation.

To be more precise one needs to use the "great circle" to find the shortest path on a spherical surface. The graph on the right shows the great circle for (see great cicle tool here)

• Singapore -Tokyo (via Luzon Strait): 3324 miles
• Singapore - Makung (Penghu) - Tokyo: 3352 miles (should be longer because the GC path has to cut into Hsinchu, which tanker cannot sail into)
• Singapore - Kinmen - Tokyo: 3383 miles

So the path via Taiwan strait is 1-2% longer than that via Luzon Strait, not a sizable difference, but Luzon Strait is more "strategic".

The last chart is using azimuthal projection from Singpaore, so that every striaght line from the center represents the shortest (great circle) distance, (but lines not passing the centers are not). We can again see the shortest path is closer to the NW tip of Luzon.

How to reform China's oil industry (iii) - oligarchs and deregulation

As discussed before, China has serious structural problem in its oil price, and SDRC is responsible for this mess. The problem lies not only in its price control, but also in the oligopoly. Furthermore, the coupling of oil extraction, refinery and retail value chain is nullifying any effort to improve efficiency.

Chinese media are also looking at this problem, and reaching similar conclusions. Here are the key points listed in an excellent essay by Chinese economist Sheng Hong (盛洪) about a month ago:

• Sheng argued that gasoline price in China is not too low, it is the lack of competition (and hence low efficiency) that caused the problem. He compared the pre-tax gasoline price for a few countries, in RMB/Liter on August 1st, 2005 (for grade RON 93=PON 89) - I am not sure how Sheng accounted for VAT, but that is only a small percentage compared to fuel duty and does not affect his conclusions (probably also compensated by lower labor/rent cost in China as well)
• USA: 4.49 (5.33 incl tax)
• Germany: 4.39 (12.58)
• France: 4.09 (11.9)
• UK: 4.13 (12.7)
• China: 4.26 (4.26)
• The current price cap does not work, as it does not reflect the true economics in the industry. For imported crude, the oligarch are probably adversely affected by the price control. For domestic crudes, they are making obscene profit, because the overall price has rised but cost (of extraction to refinery to retail) does not change. It is all very muddled and impossible for SDRC to determine a fair market price
• The cost for domstically produced crude: the state only charges charge RMB30/ton of mining loyalty fee (the US charges about 1/6 crude price as loysalty for mining, which is US$73 per ton, assuming crude price is $60/barrel. 1 ton=7.3 barrel). So the oligarchs are actually making obscene profit at mining, hence there is no incentive to improve efficiency. (note: the cost of exploration and mining is supposed to be higher for China, due to management expertise, technology and to a lesser degree, geological factors
• Current price control is only at the retail level. The oligarchs are free to set wholesale prices. By setting a high wholesale price, or delaying/refusing supply to independent retail stations. Independent Retail Gas Stations are crushed
• Sheng also pointed out a fatal mistake by SDRC in 1999 (#38 document), where smaller refineries were shut down in the name of "improving scale and efficiency". This essentially eliminated competition for the oligarchs. Sheng also blamed "#38" for failing to require the oligarchs in providing "Universal Service Obligation", (and "uninterrupted service") which is a common obligation for oligarchs (e.g. in telecom industry), essentially giving up any check and balance for these oligarchs

However, SDRC is still resisting, citing various lame excuses, such as various complications (lack of competition and fear of smuggling) created by themselves in earlier years. There are a few problems to be solved, and SDRC need to untangle the complications it created ASAP

• Some Chinese media tend to include road tax into the cost of operating a car, but that is nonsense, because a fixed car tax will not discourage oil usage, instead, it is more likely to encourage wasting
• Yes, lifting price cap alone does not solve the problem. Because there is no real competition. The oligarchs will continue (and be encouraged) to operate under sub-optimal efficiency. Competition is needed to ensure a fair price
• As long as the value chain (from extraction to refining to retail) is integrated, it is hard even for the oligarchs themselves to improve efficiency, because there is no accoutability for the sub-divisions inside the oligarchs. Therefore, lifting price control can help to discourage waste, but will not help to improve efficiency
• One probable reason that CNPC, Sinopec and CNOOC have been so eager in securing crude (instead of) refinery assets is they could ask for state subsidy in terms of cheap capital and the profit is less affectedd by domestic price control. This obviously does not align with China's interests (or Chinese people's), as acquisition might be overpriced, and the more urgent needs for refinery investment are not met

To address the aforementioned problems, China needs to form a clear objective for its energy policy. Among the key objectives are, (1) encourage efficiency use of oil (vs other energy sources), and (2) improve efficiency of the oil industry (by competition). This can be achieved by deregulating the oil industry and removing price control at the same time:

• Deregulate oil industry by decoupling the oil exploration/extration, refinery, retail value chain
• In transition period, the price control can be impose at the crude oil level (using international market price - not to be large than a few %), instead of at retail gasoline level. This is easy to implement, e.g., by introducing an independent company to arbitrage via importing/exporting
• Once the crude price is secured, one can rely on competition to ensure the wholesale and retail prices are "fair". To do this, one needs to make sure there is sufficient compeition at the refinery and retail levels.
• To ensure competition at retail level, crude producers and refineries are not allowed to own retail. (Spin off baby-CNPCs, baby-Sinopecs per province, and encourage cross-province competition) This would then help to improve efficiency at the retail level and ensure fair market price through competition. The retailers should be allowed to also import gasoline from world market, though in reality it might not be practiced if there is suffcient cometition at the refinery level
• Even though crude producers and importers may still own refineries (some synergy), independent refineries can compete effectively because curde price is connected with the oil market (and they should be allowed to purchase at world market to ensure this)
• Now it will be hard for the oil oligarchs to muddle the price matters, as crude price becomes very transparent
• Further decoupling oil refinery and gasoline retail can be considered. Even if the companies may still be linked, for synergy reasons. But they should have independent financial and accountability. This would help to ensure a fair market price for gasoline wholesale
• Finally, introduce more competition into each sector. (This will be a slow process)
• Lift price control, meanwhile introduce mechanism to ensure pricing interface with international market. e.g. create an independent import/export company to ensure the domestic and international crude prices do not diverge.
• (As suggested by Sheng) Impose loyalty fee (based on % crude extracted) for mining, and introduce more oil producers, so that the loyalty fee (the percentage) will be determined based on auction. One bonus of this loyalty is that the crude collected can be used to build up China's strategic oil reserve.

SDRC talk about oil prices

SDRC's Deputy Minister Zhang Guobao said, "China has been contemplating on fuel tax", but he then added "we have been waiting for the right opportunity when oil price is lower". He said China is not going to build up strategic reserve while oil price is at this level. He also admitted that there is a 30% difference between the price cap and world market price (Diesel in China is RMB1500-2000/ton cheaper)

Mr Zhang, there were plenty of such opportunities, i.e any single date from 1991-2004, and you and your predecessors messed up. You failed your job as a the "state planner". China became an oil importer in 1993, importing 1M tons. in 2004 crude oil import was 117M tons. Oil tax was first proposed in 1994 and approved by People's Congress in 1997.

But I was not being fair to Zhang. The problem is, in theory one will never be able to tell when the oil price is low. Perhaps SDRC should, instead of waiting for some subjective "low", set an objective (internal) measure, e.g. when oil price is at 52 week low, implement the tariff; or set a simple number of say, $40/barrel.

More importantly, it should first lift the price control and subsidy. Mr Zhang listed a variety of sectors which oppose the lifting of price control, from taxi, to farmer's machines, to the army vehicles. He was even concerned that taxi drviers will lose business if taxi price is raised. I will tell him what, more people will take the bus or subway, yes, traffic on taxi will decrease. Some of the taxi drivers will have to find another job, because lower oil consumption means cheaper oil, and hence more job opportunity from other industries (which are less affected by oil cost than the taxi industry). Why am I so confident there will be a net increase of job? Because the market is more efficient without having to pay for the "oil-subsidy-tax". What Zhang forgot to mention is that it is the average Chinese people (who take the bus or bikes) are subsidizing the taxi passengers and car drivers, when their tax is diverted into oil subsidy.

The bottom line is, some people in China are still not fully convinced that market will take care of itself. They tend to over-estimate their ability to "Plan", and forget their job is to "Reform", even though the name has been changed from NDPC (National Development and Planning Commission) into SDRC (State Development and Reform Commision). I would not blame SDRC for missing the opportunity to build up oil reserve, or to implement oil tax. We do not expect them to be George Soros. Even Soros makes mistakes. But I would blame them for pretending to be Soros, and for not learning from this lesson that they do not possess the ability to "plan". By subsidizing energy spending, SDRC has encouraged inefficiency, and severely damaged China's competitiveness in developing energy saving techonologies. One example is SDRC's favorite child, the auto industry. It is no surprise that hybrid car technology was developed in Japan, but never in US or China.

Katrina, New Orleans, Hans Brinker, Metastable state, Speculation, Oil price, RMB, and others

How are these connected? Ans: through the concept of "metastability" and "equilibrium point". Look at the diagram to the right,

• The ball in the diagram on the left is in a stable state. Whichever side you push the ball, it is going to go back to the point as shown, its equilibirum state
• The ball in the middle is at a meta-stable state. Move it a little, it roll to one of the sides
• The ball in the right is in neutral equilibirum. Move it and it stays wherever it is put at.

Now to Katrina. The water in the Mississippi around New Orleans is above sea-level (that is why it would continue to flow into the sea) and 80% of the city of New Orleans is below sea-level, and therefore, further below the Mississippi water level. NO is in a metastable position and Katrina is the finger that moved the ball. That is why the flood never recede in New Orleans. The water in Mississippi is like the ball in the middle figure of the 1st diagram. Look also at the 2nd diagram (source LSU, click for details) to the right where the yellow areas are portion of the city below sea level, and green areas above sea level but below river level. The 3rd diagram here is a cross-section diagram showing how dangerous the situation has always been. We are familiar with the legend of Hans Brinker who plugged his thumb into the dike to save Holland but not many (including myself) knew that New Orleans is a Holland in the US.

The Yellow River (Huang He) in China, through thousands of years of flooding and dam-reinforcing, has its riverbed a few meters above the cities around it. In 1931 the flood killed millions of people. But water eventually receded because the ground is still above sea-level and there is somewhere for it to flow to.

New Orlean is different. The only solution is to reinforce the dikes, then pump out all the water. In future, we still need our hero Hans Brinker on guard. Even more so if one believes in the theory of global warming and polar ice melting. Because sea level can only be rising in such scenarios.

Now what does this have to do with speculators and oil price? In my previous post, I suspected the current oil price has surpassed what demand and supply should dictate. If that is the case, $70 would represent a metastable price (1st diagram, middle figure) while the left figure is probably somewhere between $70/barrel and the $20-30 price a few years ago. No one really knows where the equilibrium point (right figure) is, and in reality price never really settles at the equibrium, as trading activities will move it around and the equilibrium itself shifts as demand and supply change every second. When speculators are moving in a direction following the "natural law" toward the equilibrium, no one can really stop them. (e.g. Asian Financial Crisis, Oil price from 2000-2004). But once they sail beyond where equilibrium is, it is like New Orleans' altitude situation. You can defend it in short term. Sooner or later it is going to move back toward its point of equilibriums. Like the release of a pendulum, it always overshoots. Speculators want to maximize their profit and will always push to the other extreme. But sooner or later it will move back. (See RMB in 1998 vs today). The Hans Brinkers of the world are admirable, but like the Asian central bankers in 1997, their effort will be futile (螳臂挡车). Same for speculators who ignore the fundamentals.

This applies to the RMB exchange rate regime as well. Before July 21, RMB was tied to USD, and at some point has been driven way passed the equilibrium point. One can argue RMB is still undervalued today, but at least it is not going to drift away further with the new mechanism in place. The objective should be to bring it closer to where it belong, slowly. The huge dike of capital control should insulate the flood, but its job would be easier if the differentials in water level is not too drastic.

Oil price will peak after it cross the $70 mark, and US has full control on oil price now

Click this link to look at the chart at EIA. Notice the pikes since 2004

• 67) OPEC delegates agree to lower the cartelÂ’s output ceiling by 1 million barrels per day, to 23.5 million barrels per day, effective April 2004.
• 68) OPEC agrees to raise its crude oil production target by 500,000 barrels (2% of current OPEC production) by August 1—in an effort to moderate high crude oil prices. Price onlfellened slightly but quickly shoot up (compare the quantitative adjustment of 68 with 67)
• 69) Hurricane Ivan causes lasting damage to the energy infrastructure in the Gulf of Mexico and interrupts oil and natural gas supplies to the United States. U.S. Secretary of Energy Spencer Abraham agrees to release 1.7 million barrels of oil in the form of a loan from the Strategic Petroleum Reserve. Price corrected briefly and shoot back right afterward

The above is for what happened from 2004 till Mar/2005. More recently (number labels added by me),

• 70) Aug/1/2005: King Fahd died, although Saudi has been effectively ruled byt he heir for about 10 years already, oil price continued to hike with this excuse
• 71) Aug/27/2005: Hurricane Katrina send oil price to $69, do we expect oil price to correct when production resumes in Gulf of Mexico?

You can see every single time when there is an event favorable for oil price to rise, it rises. Even if that temporal event has ceded, the price does not correct to its original value, as it should have (because it is unlikely the demand/supply scenario changed that much during a couple weeks). However, when there is an event indicating the other way, oil price did not adjust to the same scale. What am I getting at?

1. There is a fundamental trend of continuous rise in demand, no question about it, China and India, 2.3 bn people consuming oil. However, this rate of increase is not new in 2004. We had it coming since 1998, or may I say 1978?
2. The pikes seems to be pushing beyond a normal upward trendline (which can be plotted using x-day average), So it is very likely that someone is trying to manipulate the market (on top of reason 1 above), the speculators, the hedge funds

These are no news to any of us. After all, speculators are riding the general market expectation, and very often, helping market close in to the "equilibrium price". However, when we study the one-sided adjustments above, it is hard not to believe that oil price has already passed the "equilibrium point". Dong Tao of CSFB seems to agree. He said that "hedge fund are responsible for today's high oil price". (Via 东亚经济评论 East Asia Economic Review, in Chinese)

In CSFB, Tao has first hand contact with hedge fund managers, and commodity traders. His logics are: crude oil futures dictate spot price, and he knows that 20-30% of the future contracts are hedge fund bets, which are all highly leveraged bets. When leverages and stakes are so high, the underlying motivation is no longer driven by economic fundamentals (or the "expectation" of these fundamentals). Irrational bets are common. He quoted some examples ("educated rumors", I suppose):

• some hedge fund managers have been buying information from Mossad agents (Israel's secret agent, they are 100 times better than CIA) for first haninformationns in the Middle East
• some even tried to meddle with Venezuela politics (Tao did not say how, maybe sponsoring both sides so that the fight continues? or bribing the ministers?)

The implication: this is a metastable position and that it could collapse when the one-side bets are no longer sustainable (like LTCM in 1998) e.g., if there is a sudden increase in supply (e.g. Venezuela, Iraq stabilizing, Iran compromising, or US selling "strategic reserve") or a sudden drop in demand (a looming recession), triggering stop-loss order circles. Dong thinks it is now very risky to bet on oil price to rise further, and trouble is waiting the speculators.

Update: One more important point to add. Higher price will lead to higher supply, and eventually lead to the correction in supply (deep water drilling and oil sands) and demand (alternative energy). The price of silver in 1979-1981 is a good lesson.

Now, US announced it may use its strategic reserve. Government should not intervene on market activities. But since Katrina affects US, it gives a perfect reason.

"Obviously, the Strategic Petroleum Reserve is there for emergency situations, and that would include natural disasters," [White House Spokesman] McClellan said. "But it's just too early to know at this point."

It seems Bush administration is finally trying to act. Because the price hike is threatening the economy and more importantly, the financial risk for invention is very low now. What is better than invention while making huge profit at the same time (selling the "strategic reserve" high and buying low later)?

In the next few days, if the threat of dumping reserve will not stave off speculators, there may be real dumping of the reserve. If the Bush government does it right, it should dump more the amount it needs to. i.e. pushing oil price back to under $50 or even $45 per barrel, to tricking a chain reaction of stop-loss orders by hedge funds. Then it should buy back the reserve slowly again.

However, the obstacles are the oil interest group lobbyist, and the family business of Bush himself. So, oil price would peak but it might not retreat as it should. It is all up to the Republican government. Unlike a few months ago, when no one is very sure whether the equilibrium point has been passed. The question is, do they want to win the next election? Bush himself does not care. But there are other side of the market force, as mentioned (4 paragraphs) above, or some of the dark arts of hedge fund might turn into a scandal. Collapse of one single hedge fund will suffice to trigger the stop-loss circle due to its high leveraging.

---

Updates:

Econbrowser has a great analysis , looking much deeper into the supply and demand of oil than I did here.

• "The Energy Information Administration also reported that global oil consumption fell 0.1 mbd in the first quarter of 2005 compared with the fourth quarter of 2004... Taken at face value, the difference between global production and global consumption growth would imply either a build-up of inventories or less inventory drawdown during the first quarter of this year, though it could also reflect inaccuracies in either or both of the underlying statistics."

Let's set aside any urge to relate to a conspiracy theory about hedge fund with refinery prompted by the rumors Dong Tao heard, the fact is demand in 2005 did not increase over that of 2004, and supply did not decease. So what has happened to the price?

China's oil price (ii) - and transition of SOE

As predicted in my earlier post, China anti-market pricing policy is running into crisis. Gas stations in Guangdong refuse to sell and Sinopec/CNPC are not supplying the retail stations. Long lines make fueling wait into hour-long ordeal, or sold out when you reach the pump. Even People's Daily is admitting it now. WSJ also run a good report on "China's Fuel Shortages Add to Pressure to End Central Planning".

A few thoughts

1. The phenomenon in Guangdong showed that the oil oligarchs, although state owned, are rebelling by hoarding the gasoline. This is good evidence to rebuff China bashers in the CNOOC/Unocal incidence. Yes, the GM is indirectly appointed by the government, but P&L is definitely becoming a higher priority. This will likely set precedence as one of the crucial baby steps for the SOEs (state owned enterprises) to break free from state control.
2. Chinese gov't will eventually have to give in to market force, by liberating gas price soon. Can't think of other option
3. Well, there is a bad solution to the current mess. It could work in short term, provided oil price moves down in the international market. Not a good option. Anyway, this is the bad solution: subsidize the oil companies on a per-liter-sold base (sort of a negative sales tax). This is bad because it is easy to circumvent. And when it comes to finding loopholes against unsound policies, Chinese are genetically adapted and practically trained. e.g. a) parallel export /smuggling oil out of China (HK trucks have always been filling as much as they could before return to the border - now the risk is for regions outside HK and in a more organized scale); b) oil oligarchs can fraud higher sales # for more rebate from government; to name but a few. I am sure they are more creative than me
4. The better and easiest option is, of cource, to let RMB appreciate a bit more (thanks Brad for reminding me the obvious). There are pros and cons, the oil price has risen by a percentage much larger than any feasible RMB appreciation could counter, but by feeding all numbers into a formula, there must be a solution as to what is the best percentage RMB should appreciate vs subsidy needed. (Even if one includes the macro-GDP growth target in the calculation) Still this doesn't solve the artificial price issue.

updates: FT said Oil in many Asian countries are subsidized, it noted "China, the second biggest oil user after the US, is one of the offenders. Retail prices of most fuels are controlled and the domestic refined oil price has risen only 15 per cent this year, against 30 per cent for crude oil." Well, yes, China's oil price is not following international market price. But one has to note that price at the pump should always rise slower than crude. Because the cost include that of refining, additives (basically the difference between PON 87 and 93, or RON 90-95), and operating (transportation, rent, labor). That is true also in the US, although it maybe 20% instead of 15%.

and China Daily is bolder than People's Daily, saying, "it is time for pricing reform!"

see follow-up here.

CNOOC winners and losers: US is the loser in this deal

Only one winner emerged from this deal is Chevron. No one else. Everybody else lost, including every US citizen who does not own a Chevron stock.

Losers (in order - and even Chevron may turn out to be a loser):

1. Unocal Shareholder: no more explanation needed
2. Unocal employees: some jobs are going to be eliminated
3. US as a country, its people, and "free market": The Economist said, "By sabotaging a Chinese bid, America has damaged its own interests...The anti-China hysteria in Washington, DC, the cowardly silence of the pro-China business lobby and the blatant disregard for fair play and open markets is deeply disturbing. A second-rank oil firm such as Unocal is not worth such a sacrifice of principles. Blocking CNOOC has not meaningfully increased America's energy security. But it may have damaged American business interests, in China and elsewhere. How could America now credibly complain about, say, French attempts to prevent PepsiCo taking over Danone? Beijing will no doubt use this incident to deflect American pressure to pursue reform in other areas. American politicians, so fond of seizing the moral high ground, have ceded it to, of all people, the Chinese."
4. USD as a currency: Brad Sester said "Yesterday, it became 100% clear that the dollar is not freely convertible into [equity of] US companies." US gets what it wants, a devaluation in USD, and it is not just in terms of value. I suppose "The Economist" might call it a "degradation of USD". Without the exchange devaluation it so desperately seeks, it sabotaged its own currency hegemony status.
5. You can even argue Chevron may turn out to be the loser, if oil price drops. As it is not a zero sum game between Chevron and Unocal in this case - Chevron is going to get $500M sure money if CNOOC won!

China is getting smarter and smarter, as it made the shrewd (non-)response after CNOOC's announcement. The Foreign Ministry obviously learned from the mistake of making a stupid "demand on US Congress"

• plus - won international sympathy, can use this to better its trade negotiation position with US
• Plus - wisely maintained a low profile after CNOOC quitted: WSJ Aug 5 said "China Restricts News of CNOOC Bid -- China is heavily restricting domestic news coverage of CNOOC Ltd.'s failed bid to buy American oil company Unocal Corp., a move apparently aimed at muffling criticism of the U.S. before next month's summit meeting between Chinese President Hu Jintao and President Bush..."
• minus - PBC will still be limited in its option to invest with its USD stash
• plus - further diversifying on EUR might not be a bad thing

Other corporations in China (e.g. Haier, Yunnan Tobacco, SAIC, Wanxiang) :

• plus - smoother deal for acquiring "non-strategic" asset, thanks to sympathy CNOOC won for them
• minus - expect opposition from China paranoia (see below) for future deal, if it is marginally 'strategic'

CNOOC

• minus - wasted some time and resource of this deal (but shared 50% of the blame for its inexperience in dealing with non-executive directors, and how to manage a public company -- plus = now learned)
• plus - Unocal was viewed as over-priced by the market, as reflected by its share value gain after its called off the bidding
• plus - gain some experiences, and wide sympathy
• plus - Chevron might yield higher share to CNOOC in the Australian deal

WSJ Editorial Aug/3 pp A10: China Paranoia

• "The Red-scare protectionists on Capitol Hill won a victory of sorts yesterday when the Chinese-owned oil company, CNOOC Ltd., withdrew its offer to purchase Unocal for $18.4 billion. But at whose expense? We suspect the big losers are not so much the Chinese but rather Unocal shareholders, who will have to take a lower price for their shares.
  Cnooc's offer was about $1 billion higher than what American-owned Chevron Corp. has put on the table. Had it not been for six weeks of congressional jaw-boning against the Cnooc offer, there's a strong likelihood a bidding war with Chevron might have prompted Cnooc to raise the price further.
  This awkward affair follows on the Bush Administration's misguided demands that China revalue the yuan and the tariff measures directed at Chinese imports introduced in both Houses of Congress. So we now have a fissure in U.S.-China relations at a time when $250 billion a year in two-way trade flows are unambiguously enriching both nations.
  The mystery is why the Washington celebration over Cnooc's stand- down. To be sure, China is a nation with inexcusably suppressed political freedom and way too much state intrusion in the economy. We too were troubled that Cnooc is quasi-state owned. But it is a good thing for Americans if the Chinese use their increasing economic clout and the dollars they accumulate from trade to bid up the value of U.S. assets.
  And since there is one global price for oil, whether Unocal's resources are owned by a Chinese or American firm has no bearing on the price Americans pay for gas. China, like the U.S., is a major importer of oil; Cnooc would have had every incentive to pump oil to keep it on the market.
  A zero-sum neurosis has taken hold on Capitol Hill that the Chinese, with their double-digit rates of economic growth, are creating too much wealth and that all this wealth is coming at America's expense. The real lesson of China's economic miracle of the past decade is that capitalism works. The lesson of the failed Cnooc deal with Unocal is that there are still too many mercantilists in Washington."

FEER/IIE: No Reason to Block the Deal

• http://www.iie.com/publications/opeds/oped.cfm?ResearchID=535

Price Control for Oil in China

HK Standard has a good coverage on the price control for oil in China. As China is making its transition through gradualism ("stone by stone"), it is about time to stop subsidizing oil users. Same for energy (electricity), water, etc.

Without the force of the market, waste or inappropriate allocation of resources are inevitable consequences. I heard that 30%-70% of the water were not accounted for (stolen or wasted) in many Chinese cities. An inefficient and unstable energy supply (and price mismatch between diesel and electricity) also has led to redundant investment in diesel generators for some factories since mid-1990s.

Gasoline prices in China have been about the same level as in US, but become lower recently as they have not kept up with the international market trend. Here is a snapshot for comparison:

• The gasoline prices are RMB4.14-4.62/liter in a middle tier city like Chongqing on Jul23 (after the RMB revaluation), for RON 90-97 (Research Octane Number, corresponding to Pump Octane Number PON 87-93 in US); Using conversion factors of 1Gallon=3.785L and 1USD=8.11RMB, the gasoline prices translate into USD1.93-2.16/Gallon
• According to eia.doe.gov, average price in US is US$2.289/Gallon on July 25th
• If we factor in the un-tradable cost in operating a retail gas station, we could say the prices are pretty much the same in these two countries
• The lack of competition should mean higher retail price and less efficient operation, which might have annihilate any cost gap in labor and rent costs
• This means China, being a country of much less access to oil fields domestically and internationally and one that car travel is not a survival essential as in US, is as generous as US in oil tax/etc. It surely has one of the lowest price for oil for a net importer.

China may have its reason to maintain a stable price for energy. But reportedly one of the reason is for fear of hurting the auto industry (see also a previous post on a related topic). The problem of putting too much priority on the auto industry is, e.g., R&D in fuel economy will not received the right proportion of attention, hence China's auto industry may not be as competitive in markets outside US/OPEC, including China itself when local gasoline prices move up eventually.

There are some alternatives in which one can smooth out short term price fluctuation while keeping prices in pace with the market. For instance, one can use the 30-day (or other length of time, the shorter the better) average to set the price, which is possible if China maintains an inventory equivalent to more than 30 day oil consumption. (In fact, that is what China is doing today, without the inventory stock) China's recent effort in building inventory in Zhejiang will pave the way for such reform. However, this is still a distortion of market behaviors.

McKinsey's Q&A on China

An excerpt on McKinsey's view on China
For full article see http://www.mckinseyquarterly.com/

What executives are asking about China
The head of McKinsey’s office in China answers the senior executive’s most pressing questions about doing business there.
Gordon R. Orr
The McKinsey Quarterly, 2004 Special Edition : China today

The stability of the banking system, the protection of intellectual property, and adherence to trade commitments are just a few of the long-term issues facing China. They are also the foremost problems in the minds of senior managers of multinational corporations that are already there, contemplating expansion, or considering whether to jump in for the first time; international investors worry about them as well. The following questions and answers, based on McKinsey's experience working with China's government and with Chinese and foreign companies doing business in the country, offer a view of how the country is handling these and other long-term concerns.

What is the condition of China's financial system?
Our view is that most banks are performing much better today than they were a few years ago, although they are carrying massive amounts of bad debt from the days when their primary role was to help maintain employment by supporting state enterprises. Today banks have improved their operating systems and skills, and they have a much stronger risk-management culture.
Indeed, banks are on a strong upward trajectory, and many are quite profitable: in 2003, two of the largest—Industrial and Commercial Bank of China and China Construction Bank—earned operating profits of more than $7 billion and $2.5 billion, respectively. The government-regulated interest-rate spread between deposits and loans gives these banks an enormous margin, one of the largest in the banking world, and they are using it to write off bad debt. Regulators understand the importance of this interest-rate spread, which will remain in place for several years. The potential spread has actually increased this year as banks, for the first time, have been allowed to charge higher rates to riskier customers.
In addition, banks are making money on most of their new commercial loans, though favorable market conditions have helped a great deal—you generally don't see many defaults in an economy growing at 9 percent a year. It remains to be seen whether the improvements in commercial risk management will be robust enough to cope with a weaker economy.
For the big state banks, capital injections to clean up balance sheets before shares are sold to the public also promote the write-off process. Smaller banks are receiving infusions of capital and capabilities from Western investors. Overall, we believe that the chances of a banking crisis are receding.
The real challenge most banks face is the need to prepare for a drastic shift in their sources of profit. Today virtually all profits come from deposit taking and commercial lending. In ten years, retail credit, fee-based activities, and lending to small and midsize enterprises will probably account for about half.
But most Chinese banks have few of the skills needed to compete in these new business areas. They generally lack retail risk-management skills, so the small amount of retail lending undertaken today is generally unprofitable. Some banks are improving their capabilities rapidly and benefiting from foreign capital—Citibank and HSBC, for example, are investing billions of dollars in Chinese financial institutions. But the majority of local banks must do much more to capture the growth available in the market and to compete against international banks that will be able to enter it more freely in 2007 as a result of China's commitments to the World Trade Organization.

Where does China stand on its commitments to the WTO?
December 2004 will mark the third anniversary of China's accession. Over the past three years, the country has moved to meet the core commitments it made at the time of entry, and it is largely on schedule. Nonbank auto finance companies have been established, for example, foreign life insurance companies have been permitted to operate in more cities, retail opportunities have opened up, and regulators act far more transparently. The one major case in which the United States took China to the WTO for violating a resolution—refunds of value-added taxes on semiconductors—was recently resolved. China is also opening itself up much more extensively to foreign agricultural products, including genetically modified ones. Farm exports to China, such as soybeans from the United States and Brazil, are therefore increasing rapidly. What's more, the country is becoming adept at using the WTO rules to its advantage, with about 20 investigations begun last year, mainly against Japan and South Korea.
The financial sector is expected to open up largely as planned, with the major changes coming in 2007, when greater foreign involvement in domestic retail banking will be allowed. Also scheduled for liberalization are the various forms of asset and funds management, but this move is likely to have a less immediate impact, since the subsector is relatively small today.
In a number of instances, different sorts of barriers remain. So, for example, while foreign retailers can establish stores almost anywhere, they must meet local-planning requirements to fit in with a city's financial and development programs. Unfortunately, these requirements are vague and open to subjective implementation.
Also, in several sectors—including telecommunications—the regulatory function still hasn't been fully separated from the government or the operator. The resulting conflicts of interest may hurt competition and, at a minimum, add to the kind of uncertainty that can hold back investors. The Chinese government could enhance its credibility among foreign investors by accelerating the move to more clearly separate regulators and by encouraging them to operate more transparently.
The resolution of the semiconductor dispute suggests that beneath the rhetoric, neither the United States nor China wants to rock the boat
In any case, trade conflicts will continue to arise; the recent conflict over imports of Chinese furniture into the United States is an example. But the resolution of the high-profile semiconductor dispute suggests that beneath the rhetoric, neither country really wants to rock the boat. Although the United States runs a big trade deficit with China, US exports to it have been growing by 30 percent annually since it entered the WTO. Exports from China to the United States rose by almost a third from 2002 to 2003 alone. Trade is also growing strongly between China and the European Union, Japan, and China's neighbors in Southeast Asia.
To what extent are gaps in the protection of intellectual property holding back foreign investment?
At some level, money speaks louder than words. China's $53 billion a year in foreign direct investment suggests that foreign executives find the situation at least manageable, though clearly nothing to celebrate. The core issue is enforcement. The central government has largely followed through on its WTO commitments by creating a stronger policy framework for protecting intellectual property. However, the will and the ability to enforce the policy at the local level are often modest, to the continuing dismay of many foreign investors.
Foreign companies are moving to protect their intellectual property by setting up wholly owned enterprises, now that requirements for joint ventures are diminishing in most sectors. The absence of a partner looking over your shoulder obviously reduces opportunities for infringement but still leaves open the possibility that a product could be duplicated later on. In general, a wholly owned enterprise gives much greater protection for process-based intellectual property than for products.
There are still high-profile examples of intellectual-property theft, such as the copying of a complete foreign-car design. Fake DVDs remain readily available, as do counterfeit golf clubs. And, clearly, in some cases consumers or businesses believe that they are buying legitimate products but actually get poorly performing counterfeit ones. This can damage the image of a brand and remains a big concern, particularly in consumer goods. Procter & Gamble, for example, notes that businesses that actually export counterfeits have sprung up in the past two years.
But as retail channels become more professional, fake products are unlikely to take as large a share of the market as they did in the past. Counterfeit goods are more likely to end up in kiosks or mom-and-pop shops than on the shelves of the Chinese stores owned by the world's largest retailers. The number of intermediaries in the supply chain may even drop to zero, with manufacturers delivering directly to retailers, thereby eliminating the chance of counterfeiting. There is a similar trend in high tech: as Dell's direct-sales model takes off and is copied by others, distributors no longer have opportunities to install fake hardware or software in PCs. Customers—including government departments—that want genuine products with guarantees are learning to buy direct.

What progress have Chinese companies made in improving their corporate governance?
You have to separate the progress made by individual CEOs and CFOs from what's happening at the institutional level. Chinese executives on the whole take their responsibility for having shares publicly listed, particularly internationally, in an incredibly serious way. There is a passionate desire to understand what moves share prices and what motivates investors, as well as a serious commitment to communicating with them through road shows.
At the institutional level, less progress has been made. Strong, dominant personalities run many companies. Although this may help communicate seriousness of intent to foreign investors, these leaders are also prone to make management decisions instinctively, with little input from other senior executives or outside directors. The few independent directors tend to have less weight in corporate governance. A related problem is the issue of capital structure. Many enterprises that were once entirely in government hands have a fairly small free float—for example, 23 percent for China Mobile Communications, 21 percent for China Telecom, and 10 percent for PetroChina. Most of the remaining shares are now in unlisted holding companies ultimately controlled by the central government.
Another challenge related to corporate governance is the growing role of regulatory authorities. The financial sector's regulator, which is considered to be on the leading edge, has become clearer about rules and responsibilities and is increasingly effective in carrying out enforcement. But in energy, power, and telecommunications—where regulators play an important role in other countries—the regulators are less effective and their powers more modest. As a result, companies may put investments on the back burner because of delayed or ambiguous regulatory decisions or a continuing bias in favor of incumbents.
How much progress has China made in restructuring its state-owned enterprises?
Restructuring has advanced more quickly than is generally recognized. The contribution of state-owned enterprises to China's gross domestic product was only 17 percent in 2003, for example. Yet some of the largest state-owned enterprises have become extremely profitable: the energy company PetroChina had operating profits of $12 billion in 2003, while the telecom companies China Mobile and China Telecom made $6 billion and $4 billion, respectively. These companies, operating in infrastructure-based sectors, are world leaders in scale and help offset the losses of state-owned enterprises in declining industrial sectors. Even the basic-materials sector—coal and steel—has undergone a substantial turnaround in profitability during the past few years.
The profitability of these companies provides a financial breathing space the government can use to restructure and shrink underperforming state-owned enterprises. Meanwhile, the process of selling them off and shutting them down continues. Struggling companies tend to operate in relatively deregulated and highly competitive markets where they face both local private and foreign competitors.
A lingering concern is the concentration of declining, money-losing state-owned enterprises in places such as northeast China, where only a limited amount of industry has sprung up to replace lost jobs. Such areas have the greatest potential for social unrest.

Will China's biggest companies become competitive threats outside the country?
Potential global champions from China will come in two forms. First, the domestic giants, including the telephone and oil companies, may well expand internationally, usually on the basis of an infrastructure or license advantage at home. Companies in the telecom sector are already the world's largest in terms of subscribers. They are generating mountains of cash and have increasingly high aspirations, although they currently remain cautious about international expansion because they see it as a high-risk move that few telecom companies anywhere have managed successfully. As for energy and basic-materials companies, their priority is winning access to raw materials, and they are investing, for example, in Africa, Australia, Brazil, and Indonesia. Today they compete or partner with the world's leading resource businesses.
The second type of global champion could come from a more entrepreneurial background: companies formed as a result of intense competition in China's technology and consumer electronics sectors, for example. These companies have typically built strong leadership positions in the Chinese market over the past 10 to 15 years and now face increasingly world-class competition at home from the multinationals.
Companies in this second group have three choices. First, they can expand in China, an approach that requires them to enter new product categories, since they have very high market share in their existing ones. That could be a struggle because they, like companies anywhere, may not have the skills or knowledge to compete in new products, and price competition in many categories is already cutthroat. These companies can also expand internationally in their core product categories, taking on global players head-to-head. Some, such as Haier and TCL, are moving forward, but for most this strategy will take many years to execute, given the need to develop international marketing skills—specifically, branding and distribution. The third, and to most the least appealing, choice is to continue along the present lines and run the risk of becoming, at best, a leading regional player. That's not an attractive option for the ambitious leaders of successful Chinese companies.

As companies look to expand internationally, they face many questions: Should they grow organically? Pursue mergers and acquisitions? Sell branded or unbranded products?
But the biggest challenge these enterprises face is to develop, at the required pace, capable managers with international experience. The current leaders often have a very China-specific background. They know how to win there because they understand local consumers and businesses very well, but that doesn't necessarily equip them to compete in the global market. Identifying and developing qualified people could take a lot of time.

Can China meet its energy and food requirements?
China faces important challenges over the next few years in obtaining sufficient inputs of basic materials to sustain its economic development and to meet the broad needs of its consumers. Other than coal, China isn't rich in most basic materials, and its rising demand has recently driven up the world price of many commodities.
The need for energy sources is an important factor in China's relationships with its neighbors and with lands farther afield. Its growing ties to Central Asian countries, for example, are very much shaped by their energy reserves and by the desire to construct pipelines to its coastal areas. China has historically had close relationships with many African countries, including Sudan, and Chinese oil companies have made substantial investments to develop Africa's oil infrastructure. China's increasingly close ties with the Middle East are highlighted by the start of direct daily flights from Shanghai to Dubai and Doha. As a result of all this, there's little question that multinational oil and gas companies face more competition for access to reserves.
A parallel need is for China to expand its food supply. Urban sprawl is eating up agricultural land at the rate of one percentage point a year. Compounding this pressure is the trend for farmers to switch their production from basic cereals to value-added vegetables or livestock as Chinese consumers eat more meat and fish. Higher incomes in rural areas and the reemergence of price inflation for basic foodstuffs are recent results of this movement.
The country has thus run down its historical cereal reserves and become a major importer of agricultural products. Food imports accounted for about 9 percent of total food consumption in 2003, up from about 7 percent in 1998. Food-exporting nations and their agribusinesses will benefit from growing Chinese demand, while China could increasingly influence world commodity prices as well as consumer prices in the exporters' home countries. Such additional agricultural exports could help undercut the anti-Chinese protectionist sentiment now bubbling up in various countries.

It started with China's investment in US Treasury...

I am not an economist. I did most of my works in business strategy. But I got interested in the issue of RMB exchange rate, and started reading blogs of some economists and writers. A recent discussion posted by Michael Mandl (see 1 and 2) of Businessweek and Brad Sester raised an interesting issue. I see it a little differently and here I am trying to present my view from a "business" perspective.

One of the issues under discussion is on the implications of the increasing foreign ownership of US treasury. Some view this as "selling away your country", some believe there is nothing to worry because it is not a "zero sum game". Dr. Sester believes one should compare external debt to external credit (and assets), plus perhaps export values (minus import). He is therefore concerned that US may have to sell off the country when the debts are due. Dr. Mandl believes that, to answer Dr. Sester's question, the meaningful parameter one should look at is the net worth of a nation. I am not an economist. So I simplify the problem by imagining US as a corporation (US Inc), and look at the cashflow of this corporation. My result is in agreement with Dr. Mandl's, with some caveats.

The Financial Model

1. Let's use the usual financial parameters and tools for a business corporation to describe US as a country, including its government, corporations and residents. We can find analogy for all the usual financial parameter for a country, including Net Worth(NAV), Cashflow, NPV, etc. In particular, one can view the Treasury bonds as corporate bonds, and selling of subsidiary/asset of a company as selling of corporations (e.g. Unocal) or other assets (e.g. Rockefeller Center), foreign assets (gas fields in Asia owned by Unocal) can be considered as minority investment in companies controlled by other "Inc", etc.
2. Selling and buying assets in "fair market value" is business activities among corporations. It should also be considered as normal commerical activities among these "Inc"s, as are trading of physical goods, services, or equity stocks.
3. When one tries to address Mr. Sester's concern of "selling off the country", one wants to consider if there is a scenario that the company has to sell its assets in a "fire-sales". In normal circumstances one would not, unless the "Inc" is under severe financial pressure due to major disruption in the market (e.g. financial melt-down, natural disaster). Therefore, one should look at the cashflow of the Inc, i.e., whether the Inc can afford to pay off the interest and principal of these external debts. The answer is obviously "yes" in the case of US Inc, because the debt is denominated in US$. US government can always issue domestic bond to pay off its foreign debt (or even print more paper money :) ). Mr Sester's concern will be valid if the bonds are denominated in Euro or RMB.
4. To look more closely into the issue of the ability to deal with the debts in future , what really matters is the future "cashflow". i.e. The amount of inflow (domestic earning, earning from foreign investments (external credit/asset), revenue from export) - outflow (payment of interest, principal, and for import). If one generates more cash inflow than the payment, one should not worry about Dr Sester's concern.
5. Example: let's assume my net asset is $100. I owe $15 debt. I own $20 credit/asset under other people's management (is equity a reasonable analogy?). So my gross at home under my own name is $95. My net is $(95+20-15=100).
   Is this good or bad? I would say it depends on the return for each piece.
   If my $95 is yielding 3% a year, and $20 4% a year, $15 debt i pay 2.5% a year. I would definitely issue more 2.5% bond and buy more asset that yields 4% if i could, provided I can find these deals. Because I am now sure I have the cash to pay my interest in the future. However, if the yield % (interest rate and investment return) are reversed, borrowing more is not a good deal for me.
6. In an efficient market traded by "rational" managers one should be striking for the maximum return. (I have ignored the volatility in future for simplicity) each person/Inc will try his/its best. Therefore, for these Inc's only the combined long term return should matter (domestic and external asset asset yields - debt interests + trade balance, where trade includes revenue for intangible goods such as services).
7. Now the question should be: is US trying its best (collectively, govt and enterprises) to secure the best long term return? By borrowing money cheaply via bond issuing and use the cash raised to finance investment for better return?
8. Dr Mandl used DCF (discounted cashflow) to demonstrate that the total wealth of US is still increasing. So one should not worry about foreign debt, as long as the increase in domestic wealth surpass the increase in foreign debt. If my total net worth increase, it does not matter if my debt increse, because my gross asset would have increased more. I agree with his conclusion in principle. However, I believe the DCF calculation at such a macro-level may be problematic. There are a few ways to prove his point that it is not a zero sum game. One can use book value (i.e. valuing assets such as housing price based on the most recent transaction), market value (e.g. market capitalization of stock and market price of asset, incorporating current value and anticipated future cashflow by the market) or NPV (Net Present Value, using DCF, Mandl's method). Calculating NPV involves a number of assumptions. The result usually attracts debate and controversy. (how many reports from Wall Street analysts do you believe?) Since the market price is equally likely to go up or down, there is no reason to adjust it up or down. I see the current market value as the most reliable measure of value
9. To justify the claim that the debt help to increase wealth, one probably could compare the ROCE (return on capital employed = GDP / Total Asset Investment) and the bond interest rate
10. Dr Brad DeLong believes external debt vs future export still matters. I agree, but I want to add that US domestic value (including land and home) also matters, mainly because these debts are denominated in US$.
11. Dr Sester's claim that one should look at external debt vs external assets. I think there is a value to look at this ratio, especially if neither conutry has control on the exchange rate (even through regulating internal interest rate), or when there is a short term squeeze such that you cannot convert your domestic earning to fill the difference in cashflow. In fact, the more appropriate measure is external interest due to external debt vs return generated by external asset. Even in this case one should include surplus in domestic calue creation (not to mention that all these external debts are denominated in US$ for US).
    

Other discussions

• What about China? China has been taking FDI in large sums all these years, and the FDI generates return for the investor and also for China (employment, corporate expenses, to a much lesser extent, tax, etc). They are "selling" themselves in a way. This is what the Chinese leaders maybe thinking: as long as the future return can be justified for the land and the tax/etc concession I have given away, I am willing to owe more debt. China had virtually no external asset when they began 25 years ago. I believe they even took some loans back then. Now they have external assets in terms of US treasury, to a large extent due to the help of these FDIs. China's ability to attract FDI has been well praised internationally
• What China should really worry is a sudden depreciation of US$, in that case all its investment in US Treasury Notes will become worthless. Therefore, it is another reason to revaluation RMB before it is too late
• A question: do you call Australia selling its nation when it exports its irn ore? Or Saudi selling its nation when it exports oil?