Impacts of External Oil Supply Shocks on the Chinese Economy

Refereed paper presented at the ACESA2006 Emerging China: Internal Challenges and
Global Implications, Victoria University, Melbourne, 13-14 July 2006


Impacts of External Oil Supply Shocks
on the Chinese Economy

Yun-kwong Kwoka, Yanchun Zhangb

aSchool of Accounting, Economics, and Finance, Deakin University, Australia
bDepartment of Economics, San Francisco State University, USA
yun-kwong.kwok@deakin.edu.au, yanchun@sfsu.edu


Presenter’s biography: Dr. Yun-kwong Kwok


Lecturer of Economics,
School of Accounting, Economics, and Finance
Deakin University, Melbourne


PhD, MA, University of Virginia
MPhil, BSSc, Chinese University of Hong Kong

Research
interest:
international economics, macroeconomics

Publications:

Kwok, Yun-kwong, "Global Factor Trade with Differentiated
Factor Prices and Factor Intensities," Canadian Journal of
Economics, forthcoming (August, 2006).

Kwok, Yun-kwong, "To Save or To Consume: Linking Growth
Theory with Keynesian Model," Journal of Economic
Education, forthcoming (Spring, 2007).

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Impacts of External Oil Supply Shocks
on the Chinese Economy

Yun-kwong Kwoka, Yanchun Zhangb

aSchool of Accounting, Economics, and Finance, Deakin University, Australia
bDepartment of Economics, San Francisco State University, USA
yun-kwong.kwok@deakin.edu.au, yanchun@sfsu.edu

May 10, 2006

Abstract: Using the data since China’s economic reform, this paper investigates the
impacts of external oil supply shocks on the Chinese economy.

Keywords: Chinese Economy, Oil Shocks, Real GDP

1. Introduction

China’s dependence on imported oil has increased at a fast pace along with its
unprecedented high rates of economic growth in the past two decades. The question we
are interested in exploring in this paper is how the oil supply bottlenecks could have
affected and would affect China’s economic growth. Due to the increasing international
linkages under the new wave of globalization, this question becomes important not only
to China, but also to the whole world because the global economy is becoming more and
more closely tied to the economic performance of China.

Motivated by the concern of the Chinese economy’s vulnerability to external oil
market fluctuations, this paper investigates the impacts of exogenous oil supply shocks
on China’s real GDP growth and inflation rate. This study helps us understand the
linkage between resources inputs and Chinese economy and will contribute to optimizing
China’s long term development strategy.

2. Oil and the Chinese Economy

For more than twenty-five years after the commencing of economic reform in
1978, China has been continually growing at a rapid rate. Based on World Bank’s World
Development Indicators, between 1978 and 2004, China’s annual real GDP growth rate
was 9.5 percent on average.

Accompanying this rapid growth, China’s demand for oil is also increasing
rapidly. As shown in Figure 1, China’s consumption of petroleum has increased from
around 1.7 million barrels per day in early 1980s to over 5.5 million barrels per day in
2003. In 2004, China’s oil consumption rose to 6.5 million barrels per day and had
surpassed Japan as the world’s second-largest oil consumer.1

Though not as well noticed as its skyrocketing demand for oil, China is in fact
also one of the largest oil producers in the world. The production of petroleum in China,

1 Source: Energy Information Administration (2005b), Non-OPEC Fact Sheet.

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which is also plotted in Figure 1, has increased from around 2 million barrels per day in
early 1980s to around 3.5 million barrels per day in early 2000s. According to Energy
Information Administration (2005a) and BP (2005), China was ranked the sixth in oil
production in 2003 and the twelfth in proved oil reserves in 2004.

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Figure 1: Oil production and consumption of China, 1980-2003.2

Nevertheless, despite its steady growth over the past two decades, China’s oil
production can no longer fulfil its own demand since early 1990s. As shown in Figure 1,
China’s oil consumption has passed its oil production in around 1992-93. Figure 2 shows
the net imports of crude oil and petroleum products of China since the economic reform.
Again, in around 1992-93, China has transformed from a net oil exporter to a net oil
importer.

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Figure 2: Net imports of crude oil and petroleum products of China, 1980-2002.3


2 Source: Energy Information Administration (2005a), International Energy Annual 2003.
3 Source: International Energy Agency (2004), IEA Oil Information 2004.

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As the Chinese economy is becoming more relied on oil imports, it is also
expected to be more vulnerable to external oil shocks. Figure 3 shows the Brent crude oil
price from 1982 to 2005. For over two decades since its economic reform, China is facing
a relatively stable external oil price. Nonetheless, since 2002, the oil price has risen from
around USD20 per barrel to more than USD60 per barrel in 2006. As a result, the issue of
energy security concerns China. Actions have been taken by the Chinese government to
mitigate the economic and political risks of external oil supply disturbances. These
actions include initiating its strategic oil reserves program, diversifying import sources
(Bahgat 2005), investing in foreign oil production facilities (Yates 2005), and attracting
foreign investment in Chinese energy activities (see further discussions in International
Energy Agency 2000, Downs 2004, and Zweig and Bi 2005).

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Figure 3: Brent crude oil spot price (quarterly average), 1982-2005.4

Due to the increasing international linkages in the new wave of globalization, the
global economy is closely tied to the economic performance of the Chinese economy.
Motivated by the concern of the Chinese economy’s vulnerability to external oil market
fluctuations, the following sections investigate the impacts of past oil shocks on the
Chinese economy.

3. Methodology and Data

This paper is going to study the relationship between exogenous oil shocks and
two China’s macroeconomic aggregates: real GDP growth rate and the CPI-inflation rate.

Although it is the recent increase in oil price that worries the general public, its
impacts cannot be analysed by running a regression of the real GDP of China directly on
the oil price. This is because the world oil price may be endogenous with respect to the
real GDP of China. In fact, there are suggestions claiming that it is China’s rampant
demand for oil that causes the world oil price hikes. Though this claim has yet been
proved, this paper avoids making any assumption about the exogeneity of oil price.
Instead, this paper adopted the data of exogenous oil supply shocks compiled by Kilian
(2005a) as the explanatory variable.

4 Source: International Energy Agency (2006), IEA Energy Prices and Taxes 2006.

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Kilian quantified the oil supply disturbances through the following procedures.
Firstly, he examined the historical political incidences, such as wars and civil unrests,
faced by major OPEC countries. Secondly, he estimated what the oil production levels of
these OPEC countries would be if there were not these political incidences. To do so, he
extrapolated the pre-political-incidence oil production levels of these countries based on
the production growths of other similar oil-exporting countries that are not affected by
the political incidences. Finally, he aggregated the differences between the post-political-
incidence oil production levels and the counterfactual production levels across OPEC
countries to form the estimated OPEC oil supply disturbances.5 The share of this
estimated OPEC oil supply disturbances in the world total oil output gives a normalized
measure of the oil supply disturbances. The exogenous OPEC oil supply shock is given
by the change in the normalized oil supply disturbances.

Figure 4 plots Kilian’s exogenous OPEC oil shocks since 1978. We can see that
the major oil shocks since the economic reform in China are during the Iranian
Revolution in 1978/79, the beginning of Iran-Iraq War in early 1980s, the Gulf War in
1990/91, the Venezuela Civil Unrest in 2002, and the Iraq War in 2003.

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19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 200
Year

Figure 4: Exogenous OPEC oil supply shocks, 1978-2004.6

Since China’s quarterly real GDP data is only available after 1995 Q1, their
estimates are adopted from Abeysinghe and Rajaguru (2004). Abeysinghe and Rajaguru
recovered the quarterly real GDP for China from a forecast evaluation. They applied the
technique that stemmed from Chow and Lin (1971), Fernandez (1981), and Litterman
(1983) to China’s annual real GDP data, which are available since 1978 (China Statistical
Yearbook). Their methodology involves running a regression of annual real GDP on
annual related macroeconomic series (nominal M1 and nominal total external trade) and
thereafter using quarterly related series to predict quarterly real GDP. Since China only
publishes quarterly nominal GDP on a cumulative basis and the converted real GDP
growth rates, Abeysinghe and Rajaguru have to first convert both nominal GDP levels

5 Advantages of this approach of quantifying oil supply disturbances are detailed in Killian (2005a).
6 Source: Kilian (2005a), http://www-personal.umich.edu/~lkilian/.

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and real GDP growth rates into quarterly figures and then used 1997 as the base year to
recover their quarterly real GDP series.

The quarterly real GDP figures published in Abeysinghe and Rajaguru (2004) are
not seasonally adjusted. We apply the Census X12 method (multiplicative), which is the
standard method used by the U.S. Bureau of Census to seasonally adjust publicly released
data, to construct the seasonally adjusted real GDP figures for China.


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Figure 5: China’s Real GDP Data, 1978Q1-2002Q3.

The quarterly CPI-inflation data is extracted from the IMF’s IFS database. The
data is only available from 1987Q1.

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Figure 6: China’s CPI-Based Inflation Data, 1987Q1-2005Q3.

4. Empirical Results

In the paper, we use a linear regression model to study the relationship between
exogenous oil supply shocks identified by Kilian (2005a) and China’s real GDP growth
rate and CPI-inflation rate. We regress the two macroeconomic aggregates individually
on an intercept, four lags of the dependent variable, and eight lags of the exogenous oil

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supply shock. The number of lags is consistent with the assumptions used by Hamilton
(2003) and Kilian (2005a). Our interest is to calculate the implied impulse responses,
which will measure the causal effects of the exogenous variations in oil supply.

The regression analysis will be based on seasonally adjusted real GDP data
(1978Q1-2002Q3) and CPI-based inflation data (1987Q1-2004Q3). We follow Kilian
(2005a) to treat the oil production shocks as strongly exogenous. The effects of oil shocks
on China’s real GDP and inflation rate are estimated using the following two linear
regressions:

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The error terms are serially uncorrelated. “Provided that the exogenous oil supply
shock regressors are not correlated with any omitted variables, the implied responses will
measure the casual effects of the exogenous variations in oil supply.” (Kilian 2005a)


The OLS estimates of the above two regressions are listed in Table 1 and Table 2:

Table1: The Linear OLS Regression of RGDP Growth Rates
on Lagged RGDP Growth Rates and Lagged Oil Production Shocks



Parameters
Estimates
Robust Standard Errors
?1
0.139168 0.13152
?2 0.256304
0.105414
?3 0.312631
0.124037
?4 -0.07106
0.152256
?1
0.084144 0.085098
?2 0.123515
0.07709
?3 -0.03543
0.106186
?4 -0.1022
0.063824
?5 -0.13369
0.079665
?6 -0.07592
0.08073
?7 0.007976
0.071146
?8 0.170983
0.084053
?
0.853872 0.423663

Table2: The Linear OLS Regression of Inflation Rates
on Lagged Inflation Rates and Lagged Oil Production Shocks


Parameters
Estimates
Robust Standard Errors
?1
1.510853
0.143529
?2 -0.46552
0.331433
?3 -0.27173
0.341836
?4 0.145652
0.154299
?1
0.177407 0.358583

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?2 0.039816
0.35339
?3 -0.46002
0.181784
?4 0.446563
0.328251
?5 0.329356
0.165966
?6 -0.30521
0.294021
?7 -0.03583
0.219336
?8 -0.14262
0.326431
?
0.355121
0.206288

Based on estimates, we simulate the path of real GDP growth rate and CPI-based
inflation rate to assess the impact of an exogenous 10% reduction in global oil production
as in Kilian (2005a).

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3
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Figure 7: Dynamic Effect of a 10% World Oil Supply Disruption
on China’s RGDP Growth Rate

Figure 7 shows the response of real GDP growth rates responding to an
exogenous 10% drop in world oil production. From the figure, we can see that a negative
oil supply shock causes a sharp decrease of the real GDP growth rates in the first four
quarters (i.e., the first year). This is not surprising because as China is taking up the role
as the “world factory,” it is more and more relying on petroleum imports.

Nonetheless, Figure 7 also shows that China can soon recover and resume a
positive growth in the second year. An explanation of that is that China is also well
endowed with oil and other oil-substitutes. For example, China is one of the countries
that endowed with the largest coal reserves. A negative oil shock can soon causes an
increase production of coal and other oil-substitutes. It may also stimulate industries to
adjust their production process and explore the ways of using other natural resources.

The negative oil shock may still have some negative impacts on China’s real GDP
growth in the long run, but it soon dampens after two years.

Figure 8 exhibits the response of China’s inflation rate after an exogenous 10%
disruption in world oil production. From the figure, we can see that a negative oil supply
shock causes a significant deflation. This shows that a negative oil shock may have a

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much larger negative impact on the aggregate demand rather than on the aggregate
supply. Figure 7 shows that a negative oil shock may not have a huge negative impact on
the real GDP which implies that the negative impact of world oil disruption on the
aggregate supply may not be huge. But if the negative oil shock can cause a huge
negative impact on the aggregate demand, such as the consumer’s confidence, than it will
result in a deflation over time. When the aggregate demand drops faster than the
aggregate supply, the general price level will drop.

inf
4.0000
2.0000
0.0000
1
2
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6
7
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9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-2.0000
-4.0000
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Figure 8: Dynamic Effect of a 10% World Oil Supply Disruption
on China’s CPI-Based Inflation Rate

5. Conclusions

This paper investigates the impacts of exogenous oil supply shocks on China’s
real GDP growth and inflation rate. The results show that a negative oil supply shock
does not seem to have an as significant negative impact on China’s real GDP growth as
that on other industrialized countries. A reason of this can be that China is also well
endowed with natural resources, especially coal, a major substitute of oil. Anther reason
is that our data sample is not long enough and, over the major time horizon of our
sample, China had not transformed into a complete market economy yet. Further studies
in the future is strongly suggested, when more data is available and when Chinese
economy converges closer to a standard market economy.


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