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Over the past year or two, China has made major changes in its energy policy.

In the west, Beijing is investing billions to construct one of the world’s largest natural-gas pipelines. In the east, it is creating a strategic oil reserve.

Although these new initiatives are motivated by straightforward strategic and developmental goals, they are also being pursued with the specter of political instability in mind. Beijing is trying to cushion external economic shocks that could ignite inflation and nationwide instability.

In the 1950s and 1960s, Mao steered China toward self-sufficiency in food, industry and energy. For some years, China was mostly successful in this autarkic endeavor. But with the country’s economic reforms in 1978, Beijing realized that China could not and should not meet all of these needs domestically. China can buy most products, including energy, cheaply on international markets, fostering economic growth and raising living standards.

The country has abundant natural resources and is now the world’s third-largest producer of energy, but its needs have skyrocketed in recent years and its energy imports have grown steadily. China now ranks as the world’s second-largest energy consumer, behind only the United States.

Although China still relies heavily on coal as a source of energy, petroleum has been the fastest growing source. Indeed, China became a net oil importer in 1993 and currently imports 60 million tons of petroleum annually, equal to one-third of its total oil consumption.

Yet, Beijing is extremely worried about the consequences of over-reliance on foreign oil supplies. The pipeline and strategic reserves are two ways in which China intends to minimize this dependence.

After years of increase, Beijing now wants to limit its imports and expand its domestic energy capacity.

This policy is evident in the Xinjiang-Shanghai natural gas pipeline. The pipeline is an ambitious attempt to link China’s western gas fields located in remote Xinjiang province with the booming coastal cities near Shanghai.

The US$14 billion pipeline will stretch 2,500 miles and cross 10 provinces. Nothing on this scale has been attempted in China before. The pipeline will be the second-largest infrastructure project in the nation behind only the Three Gorges Dam project.

Although Beijing highlights the economic benefits, such as increased investment in the western regions and clean energy supplied to the east, several factors point toward political motivations for the project.

First, the government has outlined an unusually fast-paced timetable for construction. Some foreign investors would like to see a slower schedule, one that would give them time to develop the virtually non-existent natural gas consumer market in Shanghai. That would enhance the project’s profitability, something already in doubt.

Second, the cost effectiveness of the pipeline project is in question. Imports of liquid natural gas (LNG) from Southeast Asia would be cheaper than producing gas in the west and transporting it across the country.

The government also needs technical expertise and capital available only from large foreign investors such as ExxonMobil Corp., Royal Dutch/Shell Group and BP p.l.c. But in early September, BP—China’s largest foreign investor—withdrew its bid on the project for fear that the mega-project would not be profitable.

Beijing is pressing ahead with the pipeline for political reasons. Relying primarily on petroleum means that China would be exposed to price swings in the world market. To hedge dependency on petroleum, Beijing wants to quadruple natural gas usage over the next 10 years, bringing it from 2 percent of the energy mix to 8 percent.

China’s leaders also want to use a broad range of energy sources so that the impact of a disruption in one source would be minimized for the national economy. The pipeline will help meet that goal and serve as the platform for a national-gas distribution network.

The beneficiaries of the pipeline will mostly be urban coastal Chinese. East coast residents have led economic growth in China, but they are also the core constituencies of China’s Communist government. If they are upset, chaos can erupt.

Unrest in the densely populated coastal cities has been much more threatening to the regime than discontent in the inland regions. Thus, a steady supply of clean domestic energy helps ensure these coastal consumers will remain content.

Beijing has also initiated a strategic oil reserve designed to shield China from severe market swings and bolster its military strength. Starting from scratch, China intends to stockpile 8 million tons by 2005 and nearly twice that by 2010. However, this reserve is quite small in comparison to China’s needs. By 2005,

China’s annual oil consumption will rise to 243 million tons.

China’s foray into the world petroleum markets in the early 1980s has largely coincided with low world oil prices. China did not import large quantities during the Persian Gulf War when oil prices spiked. China became a net importer in 1993 when oil was cheap. The average price per barrel during the 1990s was about US$17.

China’s biggest imports came in the late 1990s when cheap US$9 or US $10 barrels were common. But prices rocketed to US$35 per barrel in March 2000 and now hover around US$27. This price spike came as a painful surprise to officials in China and has hurt the economy.

In an era when U.S.-China military relations have become tense, Beijing surely has national security concerns in mind when planning the reserve. The oil reserves will have direct relevance to China’s defensive capabilities, but China was on the brink of war with the Soviet Union for years and never sought to stockpile petroleum.

So why is Beijing now pursing these policies? Part of the reason is that the reserves can also mitigate consumer-energy price changes. Once completed, Beijing hopes that it will be able to draw down the stockpile when oil supplies are scarce, helping to limit upswings in price. The United States has come under pressure to use its reserves for this purpose, most recently in 2000.

Beijing’s leaders have realized that China’s growing dependence on energy imports could threaten China’s political stability. Social unrest and political protest during the 20^th century in China have coincided with high levels of inflation. In the 1940s, rampant inflation caused chaos and contributed to the end of the republican government. The severe social and economic dislocation made people believe that the government was losing control.

Decades later, the 1989 democracy movement was inspired by Beijing students’ concerns over corruption and government accountability. But, the movement sparked participation from urban residents and workers because high levels of inflation had hit the economy for the first time since the 1940s.

Hu Yaobang’s experiments with price flexibility unleashed large price increases in select sectors of the economy. As a result, inflation hit a high of over 28 percent. The increases were particularly high in urban areas and caused real income and wages to fall. For Chinese unaccustomed to price changes, the signs looked ominous.

The other major period of inflation during the Communist reign came between 1993 and 1995. Inflation levels came close to the 1989 levels (approximately 27 percent), but the social response was muted for two reasons.

First, immediately following the 1989 Tiananmen incident, public dissent was basically nonexistent in China. Second, this period coincided with China’s highest levels of economic growth. Thus, living standards were rising, even though prices were going up as well.

Inflation can hit the Chinese economy in three ways. One way would be an expansion of the money supply. As the government prints lots of money, prices begin to rise. But, this is not an immediate source of concern for Beijing, because the Bank of China has been pursuing a tight monetary policy over the last several years.

Beijing is so worried about inflation and has kept the money supply so tight that China has actually experienced moderate deflation. Although the money supply has grown, its relatively slow rate is outpaced by the expanding economy.

Another source would be through a major devaluation of the exchange rate that drives up the cost of foreign imports. This, too, seems unlikely for China. China is willing to aggressively protect its fixed exchange rate with its US$181 billion in foreign currency reserves, the largest in the world.

Another way for inflation to hit the economy is through higher energy costs. This is a classic example of cost-push inflation and is precisely what Beijing worries most about. Energy is a major input in the economy. When energy prices rise, the cost of production and transportation increases.

These higher prices then filter throughout the economy. The U.S. economy experienced this type of shock in the late 1970s with the Organization of Petroleum-Exporting Countries (OPEC) oil embargo and suffered from increased inflation and reduced economic growth.

A sharp rise in energy prices has two major effects. First, it makes production more expensive, creating a drag on economic growth. This is worrisome as Beijing is counting on high growth rates to mitigate the dislocation and unemployment associated with WTO entry.

Second, inflation affects consumer purchasing power and the standard of living. In an era in which Beijing has traded its bankrupt ideological mandate for authority based on economic growth, any economic backsliding is dangerous. Anything that generally reduces living standards on a wide scale, even if slightly, can threaten national stability in China.

Because of the authoritarian nature of China’s government, external economic shocks are more politically destabilizing to the country. In general, inflation and eroding economic conditions place tremendous pressures on political leaders. Democratic countries tend to absorb this pressure better than non-democracies.

The 1997 Asian financial crisis toppled several leaders in Southeast Asia. Even in the United States, recessions have cost U.S. presidents their reelection. However, China’s political system is poorly equipped to handle the fallout of an economic crisis.

This is a particularly delicate period for the Chinese leadership, as political transitions in Communist China are notoriously turbulent.

With a major transition of power expected in the next year or two, Beijing’s leaders cannot afford to suffer external shocks that broadly impact the welfare of its citizens. The pipeline and the oil reserves can help absorb outside shocks, but Beijing had better get busy stuffing those cushions.