Global commodity prices, economic activity and monetary policy: The relevance of China
Introduction
China is now the world׳s most populated nation, world׳s second largest economy and largest holder of foreign reserves. After decades of strong economic growth, industrialization and rising living standards, China has also become a dominant player in commodity markets.
On the physical side, the country has become the largest producer as well as a consumer of a wide range of commodities spanning agricultural, energy and metal markets. China is considered the largest agricultural economy in the world (USITC, 2011). In 2010, China was the world׳s largest producer of 11 out of 17 agricultural aggregates used in the Food and Agriculture Organization of the United Nations (FAO, 2013) statistical yearbook. Amongst these categories, China׳s share of global production accounted for 20.11% in cereals, 28.31% in rice, 17.63% in wheat, 21.73% in root and tuber, 51.70% in vegetable, 22.54% in tree nut, 20.09% in fruit, 19.50% in citrus fruit, 27.33% in meat, 30.13% in egg, milk and processed milk and 35.91% in fish. Although China is largely self-sufficient, it was the world׳s second largest importer of agricultural commodities after the US in 2009 (USITC, 2011). In the energy sector, China replaced the US as the world׳s largest primary energy2 consumer in the year 2011 (BP, 2013). In 2012, China consumed 21.92% of global primary energy, followed by the US with 17.70%. In the same year, the country was the largest coal and second largest oil consumer next to the US, accounting for 50.22% of the world׳s coal and for 11.71% of global oil consumption. While the lion׳s share of China׳s coal consumption is satisfied by its own production, only a small portion of its oil consumption is covered by domestic production, making it the second largest net oil importer after the US in 2009 (EIA, 2012). China is also a dominant player in global metal markets. In 2012, the country was the dominant producer of 22 out of 41 elements and element groups that are of economic value (BGS, 2012). In 2011 and in regard to the London Metals Exchange (LME) traded metals, China accounted for 39.96% of aluminum, 50.18% of lead, 42.47% of tin, 33.66% of zinc and 13.88% of gold mine production worldwide (BGS, 2013). Also in the sphere of metals, China has not only become the largest producer but also world׳s largest consumer of many metals and minerals (Pitfield et al., 2010).
Having emerged as a major player on the physical side, China also developed its commodity futures markets substantially. After the merger of 50 Chinese commodity exchanges into 14 in 1995 and subsequent consolidation into three in 1999, the trading volumes at these three exchanges have grown at an astonishing rate. According to data of the World Federation of Exchanges (WFE, 2013), the aggregate number of commodity contracts traded at the three commodity exchanges Dalian Commodity Exchange (DCE), Shanghai Futures Exchange (SFE) and Zhengzhou Commodity Exchange (ZCE) increased from 0.15 billion traded contracts in 2004 to 1.35 billion contracts in 2012, accounting for 42.84% of the global figure proxied by the total of commodity futures and option contracts traded at WFE member and non-member exchanges. In terms of notional turnover, the joint volume of the three exchanges also increased heavily from 0.71 trillion US dollars in 2004 to 15.29 trillion US dollars in 2012, accounting for 12.93% of the global figure.
Undeniably, China has become a dominant player in both, physical and financial commodity markets. With this development, global commodity markets have become increasingly exposed to macroeconomic developments in China. Many studies have pointed out that the rapid economic growth and industrialization of emerging market economies, particularly China, is pushing commodity demand and thus prices (Hamilton, 2009, He et al., 2010, Li and Lin, 2011, Radetzki, 2006, Roache, 2012). Although US commodity exchanges are still considered to dominate price formation in global commodity futures markets, with its increasing weight in commodity markets, China is acknowledged to play a remarkable and increasingly important role in the pricing of globally traded commodities (Liu and An, 2011).
Given China׳s weight in commodity markets and while several studies have pointed out that expansionary monetary policy is a significant driver of commodity prices (Akram, 2009, Anzuini et al., 2010, Belke et al., 2013, Frankel, 2008, Saghaian et al., 2002a, Saghaian et al., 2002b), it is surprising that no previous study has attempted to examine the role of the People׳s Bank of China׳s (PBC) monetary policy on global commodity prices.
To fill up the gap, the objective of this study is to shed light on the relevance of China in international commodity price dynamics. By focusing on both China׳s economic activity and monetary policy, this study explores the role of China in global commodity price dynamics from a macroeconomic perspective in general and analyzes its economic activity and monetary policy in particular. Our empirical analysis looks at the period from 1998 to 2012 and uses monthly data on industrial production and real interest rates to account for China׳s economic activity and monetary policy respectively. As for commodity prices, the study uses real commodity group spot price indices of the agricultural, energy, industrial metals, livestock and precious metals sector. Applying Toda and Yamamoto (1995) type Granger causality tests, we find that China׳s economic activity Granger causes global energy and industrial metals prices. Our findings from the Generalized Impulse Response Function (GIRF) analysis further suggest that energy and industrial metals prices respond positively to an increase in the economic activity of China and that agricultural as well as energy commodity prices overshoot after a drop of China׳s real interest rate. Our results confirm that macroeconomic conditions in China have become an important factor particularly influencing global agricultural, energy and industrial metals price dynamics.
The rest of this paper is organized as follows. The next section reviews the theoretical framework and briefly discusses the relevant literature. Section 3 presents the data and methodology used to investigate causal linkages and short-run dynamics between the variables in our model. Section 4 leads through the empirical results, followed by the conclusion in Section 5.
Section snippets
Theoretical framework and literature review
This study mainly builds on the theoretical model of commodity price overshooting developed by Frankel, 1986, Frankel, 2008.
Drawing on Dornbusch’s (1976) exchange rate overshooting hypothesis, Frankel, 1986, Frankel, 2008 developed the commodity overshooting model that provides a theoretical explanation why commodity prices overshoot their long-run equilibrium in response to an expansionary monetary policy shift. The theory assumes that the goods market is broadly divided into a sticky
Data
For the empirical analysis, we use monthly data from 1998M01 to 2012M12. The time period starts at the point when China accelerated banking sector reforms and officially replaced its credit quota system by a target system and interest rates started to be increasingly determined by market forces. The analysis considers five distinct commodity group indices as well as industrial production and real interest rate of China to account for economic activity and monetary policy respectively. Data is
Unit root test and lag length
In the first step of the analysis, we determine the maximum order of integration of the variables included in our model. Thereby a variable is said to be integrated of order n when it achieves stationarity after taking its n-th difference. In order to determine the order of integration of the variables, we apply the augmented Dickey and Fuller (1979) (ADF), Elliott et al. (1996) Dickey Fuller GLS detrended (DF-GLS), Phillips and Perron (1988) (PP), Ng and Perron (2001) MZα and Kwiatkowski
Conclusion
This study examined the causal linkages and short-run dynamics between commodity prices of the agriculture, energy, industrial metals, livestock and precious metals group, economic activity and real interest rate of China over the period from 1998 to 2012. The time period starts at the point when China accelerated banking sector reforms and officially replaced its credit quota system by a target system and interest rates started to be increasingly determined by market forces.
Results of this
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The views expressed in this paper are those of the authors and do not necessarily reflect the views of Four Elements Capital Pte. Ltd.