Streetwise Professor

August 2, 2009

A House of Cards?

Filed under: Commodities,Economics,Energy,Financial crisis — The Professor @ 9:31 am

For those who, like me, are skeptical of the solidity of China’s economic growth and the basis for the commodity rally, this article is for you:

Copper’s 76 percent rally this year may soon end on signs that China has stockpiled more than it can use in new homes, cars and appliances.

Inventories monitored by the London Metal Exchange posted their first back-to-back  weekly gains since February, increasing 8.3 percent from an eight-month low.  Sumitomo Metal Mining Co., Japan’s second-largest smelter, said Chinese imports are slowing after record purchases boosted domestic supplies, and U.S.  copper-scrap exporters report shipments to Asia are dropping.

. . . .

Refined copper imports by the Chinese more than doubled to 1.78 million metric tons in the first half and reached a monthly record of 378,943 tons in June, customs data show.

“China’s copper imports are likely to fall in the second half of this year because it bought so much in the first half, the government has stopped buying and demand from end-users may not be as big as people anticipated,” said  Zhao Mingwang, manager of futures trading at Zhuji, China-based Zhejiang Honglei Copper Co., which produces about 100,000 tons of wire and rods a year. “The imports were so large it’s hard to fathom where it all went.”

Most of the gains in LME-monitored inventories during the past month reflect the eightfold jump in the volume of material in warehouses in Singapore and South Korea, the closest to China.

. . . .

Inventories monitored by the Shanghai Futures Exchange more than doubled this year, sparking concern the pace of consumption in China hasn’t kept up with imports.

. . . .

Imports may have exceeded manufacturing demand by as much as 1.3 million tons in the first half, Kaku said on July 24. “I don’t think copper prices climbed because of a dramatic improvement in supply-demand conditions,” he said. “I’m skeptical about a strong recovery in the market.”

. . . .

Chinese lenders responded to the economic slowdown by tripling loans in the first half of 2009 from a year earlier to 7.37 trillion yuan, according to the nation’s central bank.

The increased lending spurred demand for properties, helping home prices in 70 major Chinese cities rise for the first time in seven months in June. Passenger-vehicle sales climbed 26 percent to 4.53 million in the first half, while commercial-vehicle sales fell 0.5 percent to 1.57 million, the China Association of Automobile manufacturers said July 9.

Dollar Slide

Investment in fixed assets, including water and road projects, jumped 34 percent to 9.13 trillion yuan, the National Bureau of Statistics said. Spending on capital projects accounted for 87 percent of China’s economic growth in the period, according to Morgan Stanley Asia Ltd. Chairman  Stephen Roach, who is based in Hong Kong.

This all suggests that the 8 percent (annualized) Chinese growth in the second quarter is far less than meets the eye.  It is the result of unleashing a flood of credit to finance “capital projects,” the quality of which is highly dubious; tripling the quantity of loans, to an amount representing 40 percent of the loans already on bank balance sheets, inevitably means that a large fraction of these loans are financing uneconomic projects.

Think about it.  Chinese banks are lending three times as much during the most severe world economic downturn since the depression as they did when the Chinese economy was booming last year.  A tripling of lending would inevitably lead to the financing of numerous negative net present value projects even in normal times.  In current circumstances, the waste of resources must be astounding.

As I’ve written before, massive government stimulus like that being undertaken in China and being funneled through the banks can lead to increases in measured output.  But the return on the projects funded is usually negative, and substantially so.  In other words, you pay people to dig holes, and buy cement to fill them in, the expenditure counts as economic “output,” but all you’ve got in the end is cement filled holes that will not do what capital is supposed to do: provide a stream of benefits into the future.

What’s more, when a large fraction of these projects come a cropper, this dramatic expansion of credit will leave the lending banks with a slug of bad debt, forcing the government to: (a) bail them out, or (b) watch them fail or turn into zombies, thereby constraining their ability to finance viable projects in the future.

In other words, the Chinese have responded to a financial crisis caused in large part by an excessive creation of credit in the US and Europe by engaging in their own excessive creation of credit.  The great exporting nation has thus imported the Hair of the Dog theory of economic policy:  Respond to one massive distortion by creating one’s own.

I don’t see how this can end well.  I understand the tremendous social pressures that make the Chinese leadership feel compelled to engage in this policy, but they are, in my view, just deferring the day of reckoning–and arguably making it far worse.

And since the commodity rally is based in large part on Chinese purchases, this also means that the rally is considerably overdone.  Indeed, another Bloomberg article suggests that the copper market (and arguably, other commodity markets as well) is the economic equivalent of a crack addict, dependent on a continuing supply of Chinese government largesse:

Copper climbed in Shanghai, after falling the most in two and a half months yesterday, as China’s central bank damped speculation it would curb lending, boosting the demand outlook for raw materials.

Futures tumbled yesterday as speculation the Chinese government would limit bank loans sent the country’s stock market plunging by the most in eight months, dragging base metals lower. Equities rallied today after the central bank said it will maintain a “moderately loose monetary policy,” aiming to consolidate the nation’s economic recovery.

“The tightening of bank lending has been the major fear in the minds of copper importers and dealers,” Lin Xu, analyst at China International Futures Co. in Shenzhen, said by phone today. “So the reiteration of a loose monetary policy from the central bank helped sentiment.”

Just further illustration that the Chinese are riding the tiger.  It’s damn hard to get off.  The problem is, you can’t ride it forever.

The statistics in the first article regarding the immense quantity of copper imports are truly staggering; perhaps the ChiComs have a special affinity for the Red Metal;-)  Note that China’s imports during a worldwide recession are double what they were when the Chinese economy was booming in 2008.  Stocks in LME warehouses are also beginning to increase even as prices are increasing.  (The same is true for other metals.) Oil inventories are also increasing.  And for the most part, these measured inventory increases do not include Chinese stocks.  Thus, commodity prices have been supported by massive Chinese stocking.  Chinese consumption, such as it is, and as indicated by the inventory build it is far less than their purchases, is driven by a massive stimulus that is not sustainable for an extended period.  The signs of recovery in the US, Europe, and Japan are faint, at best.   And even a recovery in manufacturing in the OECD, or an increase in OECD consumer demand that would give a jolt to Chinese output for export, would have to work through massive stocks in order before any price-supporting fundamental tightness occurs.  Other measures of demand, such as ocean freight rates, have been flat.

Commodity prices and inventories can move together if there is a spike in economic uncertainty that leads people to increase their demand for precautionary inventories: the only way to accommodate the increased demand for inventories is to raise prices to discourage consumption and encourage production.  But if anything, the main metrics of economic uncertainty–such as the VIX volatility index–have been declining while commodity prices have been increasing.  Price volatility for oil and other commodities was at historic levels in December of last year.  (Oil price volatility was higher during December than during the 1990-1991 Gulf War.)  So, increases in uncertainty/risk cannot explain the co-movement of prices and inventories.

All of this suggests that there is considerable downside risk in commodities.  The markets are supported by a Chinese stimulus program that even many Chinese officials recognize is not sustainable, and which is leading to sectoral distortions.  The stimulus has encouraged a buildup of inventories that will weigh on the market for a long time.  The signs of recovery in the US and elsewhere in the OECD are very fragile.  Even the slower than expected decline in US GDP in the second quarter is somewhat misleading as it conceals weaker than expected consumption.  Fundamentals remain very weak, and the market is dependent on extreme Chinese fiscal and monetary policy.  That translates into serious risk of a big selloff in commodities.

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  1. 1. I think now is an excellent time for nations with big FOREX reserves to stock up on strategic metals. Sure beats buying more US Treasuries.

    2. What evidence is there that these infrastructure capital projects consist of digging holes and filling them with cement? That might be the case in Japan or the US, which already have an extensive infrastructure, but that is not the case in China where there’s still plenty of room for road, rail, etc expansion, especially in the less developed rural hinterlands. As such the Chinese stimulus will almost certainly be more effective in the long-term than the US one.

    Comment by Sublime Oblivion — August 2, 2009 @ 2:50 pm

  2. Don’t disagree that that’s why China is doing what it is re metals. I’ve been asserting that since at least May, when the commodity rally began.

    S/O, underdeveloped infrastructure or not, there is no way in hell that a tripling of the rate of loans, and a 40 percent increase in the stock of bank lending, will be directed at worthwhile investments. It is already fueling real estate and stock bubbles (see my posts from earlier this week). It is also being thrown at businesses willy-nilly. Most of it will be pissed away.

    And as is the case in Russia, in China a good deal of infrastructure spending goes into private pockets. China is not as bad as Russia in this regard (faint praise), but spending on infrastructure ~=creation of worthwhile infrastructure.

    The ProfessorComment by The Professor — August 2, 2009 @ 4:51 pm

  3. Looks like it is an entire worldful of kool aid drinkers. Or atleast those who give such an impression. It is more reasonable as you point out that most of this ends in private pockets. I have an eerie feeling that Goldman Sachs would reap a record profit in the next quarter by shorting copper big time.

    Comment by Surya — August 2, 2009 @ 5:11 pm

  4. On June 26 2009, Jeff Immelt, the CEO of General Electric, called for the United States to increase its manufacturing base employment to 20% of the workforce commenting that the U.S. has outsourced too much and can no longer rely on consumer spending to drive demand. [21]

    Is this also part of the reason for the consumer being so broke?

    Comment by Surya — August 3, 2009 @ 12:22 am

  5. I found an interesting pattern in the Gini coefficient. It was at the highest levels before each of the past 3 recessions (current, 90-91, 80-82). During the recession, the coefficient dropped and then showed a big jump at the end of the recession.

    * 1929: 45.0 (estimated)
    * 1947: 37.6 (estimated)
    * 1967: 39.7 (first year reported)
    * 1968: 38.6 (lowest index reported)
    * 1970: 39.4
    * 1980: 40.3
    * 1990: 42.8
    * 2000: 46.2
    * 2005: 46.9
    * 2006: 47.0 (highest index reported)
    * 2007: 46.3 [7]

    Strangely there seems to have been a reset during the Great depression. In 1929 the level was 45 and by the time the world war II ended it was down to 37.6.

    Perhaps income disparities and the associated consumer weakness spurs a recession. The weak big wigs get crushed and get mixed with the middle class. Thus the coefficient jumps after the recession. After certain unsustainable levels there is a big reset.

    Comment by Surya — August 3, 2009 @ 1:04 am

  6. It will be interesting to see how the Brezinskites, Sorosians, and demintern do-gooders react when the governments in the former USSR they wanted to overthrow are backed by Beijing rather than the dark heart of Muscovy. Even the Sorosians can’t compete with China when it comes to country buying! See this Asia Times article for an example:

    Now it transpires that the “reset” might take the US’s policy towards Russia back to the 1980s and towards president Ronald Reagan’s triumphalist thesis that Russia could not be a match for the US, given its deeply flawed economic structure and demography and, therefore, the grater the pressure on the Russian economy, the more conciliatory Moscow would be towards US pressure.

    As Stratfor, a US think-tank with links to the security establishment, summed up, the great game will be to “squeeze the Russians and let nature take its course”.

    There is already some evidence of this coordinated Western approach toward Russia in the European Union’s “Eastern Partnership” project, unveiled in Prague in May, the geographical scope of which consists of Armenia, Azerbaijan, Georgia, Moldova, Belarus and Ukraine, and which aims at drawing these post-Soviet states of “strategic importance” towards Brussels through a matrix of economic assistance, liberalized trade and investment and visa regimes that stop short of accession to the EU but effectively encourages them to loosen their ties with Russia. Indeed, the EU thrust has already begun eroding Russia’s close ties with Belarus and Armenia.

    An immediate challenge lies ahead for Moscow as the parliamentary election results in Moldova have swept Europe’s last ruling communist party from power by pro-EU opposition parties. The US and the EU have kept up the pressure tactic of April’s abortive “Twitter revolution” in Moldova to force a regime change that puts an end to the leadership of President Vladimir Voronin, who has pro-Moscow leanings. The EU has made generous promises of economic integration to Moldova and Moscow made a counter-offer in June of a US$500 million loan.

    However, in a stunning development, China entered the fray this month and signed an agreement to loan $1 billion to Moldova at a highly favorable 3% interest rate over 15 years with a five-year grace period on interest payments. The money will be channeled through Covec, China’s construction leviathan, as project exports in fields such as energy modernization, water systems, treatment plants, agriculture and high-tech industries.

    Curiously, China has offered that it is prepared to “guarantee financing for all projects considered necessary and justified by the Moldovan side” over and above the $1 billion loan. In effect, Beijing has signaled its willingness to underwrite the entire Moldovan economy which has an estimated gross domestic product of $8 billion and a paltry budget of $1.5 billion.

    The Chinese move is undoubtedly a geopolitical positioning. In an interesting tongue-in-cheek commentary recently, the People’s Daily noted that “under the [Barack] Obama administration, the meaning and use of ‘cyber diplomacy’ has changed significantly … US authorities … stirred up trouble for Iran through websites such as Twitter … [Secretary of State Hillary Clinton] said that this is the essence of smart power, adding that this change requires the US to broaden its concept of diplomacy”.

    Comment by Vic — August 3, 2009 @ 9:30 am

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