China seeks to boost oil prices

Oil prices could rise as steps taken by China to reduce the risk of inflation boost domestic demand for commodities, according to Bank of America's Merrill Lynch.

The Chinese central bank last week unexpectedly raised the proportion of deposits that banks must set aside in an effort to restrict excessive liquidity. In a further attempt to control inflation and avoid asset bubbles, China is likely to allow the yuan to strengthen against the dollar, according to Merrill's research, boosting demand for commodities such as oil.

"Tighter money in China could be bullish for commodities," said Merrill analysts, including commodity strategist Francisco Blanch, in a report dated January 15. An appreciation of the Chinese yuan will make the US-denominated oil prices cheaper in local currency."

China is more likely to use a stronger yuan to manage the need for tighter monetary policy than higher interest rates which would cut oil consumption, according to the research note.

The report said higher interest rates would be negative for oil demand.

"While we estimate that a 25bps hike in the 1Y lending rate would bring down Chinese y-o-y oil demand growth rates by one to two percentage points, our Asian economics team expects only one moderate interest rate hike in the fourth quarter of 2010. This is partly because the US Federal reserve needs to keep dollar interest rates unchanged for an extended period of time to help the ailing economy. As a result, much higher interest rates in China would only encourage further hot money flows," said the report. "The reversal of Chinese policy cannot in itself be positive for commodity markets. With demand in OECD economies falling off a cliff at the height of the economic and financial crisis, Asian demand from China and India was able to absorb the excess barrels. As the demand recovery in the United States and in Europe, particularly outside heating oil, is still lagging, Opec keeps on sending its barrels eastwards.

"Likewise, Chinese imports of industrial metals are still growing at very strong rates, supporting global demand growth which outside China is anything but inspiring. If this liquidity were to be withdrawn quickly, the marginal buyer could disappear, and spare production and refining capacity could quickly depress spot prices and weigh on time-spreads. In fact, in response to the news of tighter monetary policy in China, commodity prices sold off sharply. (With inputs from agencies)

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