China's oil Catch-22

As the oil price rises, China's strategy over the past year of diverting money that previously would have been invested in US treasuries into buying oil and other commodities was a brilliant one.

But the high oil prices, and even more importantly food prices, will test China. Given that our economy is close to an appendage of China so it will also test us.

When Chinese leaders watch the Middle Eastern turmoil they are reminded of the events that led up to the Tiananmen Square revolt in 1989. A contributor to both the Tiananmen revolt and the Middle East turmoil was higher food prices. People close to the poverty line are ready to revolt when food prices rise. Australia has a vital stake in China making sure it does not fall into the Middle East trap.

HSBC's Australian Chief Economist, Paul Bloxham believes that the China inflation rate is one of the most important economic indicators for Australia because if it breaks out China will have to curtail demand – including demand for our exports – more than it would like. And the required harsh measures could have social consequences

However, so far so good. Last week China's CPI figures came in at 4.9 per cent last month which was lower than expected and within shouting distance of the 4 per cent target. But the latest economic data from HSBC warns that both output and input prices are rising at a faster pace and suppliers are taking longer to deliver.

Underlying China's appreciation of the food danger, the China State Council has boosted spending and subsidies on food production for low-income groups. It has also taken a series of steps to boost wheat production to overcome some of the climatic disasters. China also has a large state wheat reserve as a potential cushion. As China, step by step moves to lower economic activity by lifting interest rates and lessening funds for credit it hopes to lower inflation and take the pressure of food prices without harsh measures.

Right now most commodities including food are being boosted first, by supply problems and second, by availability of low cost US and Japanese money which finds its way into commodity speculation. China's purchases have inflamed the speculation and boosted the prices.

Yet the more commodities rise in price, the more Australia benefits. Yet the more they rise, the greater the danger to our largest customer.