Streetwise Professor

Commodity prices on Chinese exchanges, especially for ferrous metals, have been skyrocketing in recent weeks. Rebar, iron ore and coking coal have been particularly active, but thermal coal and cotton have been jacked too.

In response, the Chinese authorities are cracking down on speculation.  Exchanges have raised margins in order to attempt to rein in trading. The government is making ominous statements about speculation and manipulation. And we know what can happen to speculators who fall afoul of the government.

Ironically, prices never appear to be just right, by the lights of the Chinese authorities. Last summer, and earlier this year, speculators were allegedly causing stock prices and commodity prices to be too low. Now they are causing commodity prices to be too high.

This is a case of the Chinese authorities playing Claude Rains in Casablanca, and ordering a roundup of the usual suspects. Speculators make convenient targets, and they appear to be the proximate cause: after all, their trades produce the rapidly rising prices.

But the speculators are merely the messengers. If the Chinese authorities want to find the real culprits, they need to look in the mirror, for the speculators are responding to the most recent lurch in Chinese economic policy.

Put simply, after the economic slowdown of the second half of 2015 (a slowdown masked by fraudulent official statistics, but evident nonetheless), the government pushed the panic button and fell back on its standard remedy: injecting a burst of credit.  Some estimates put the Chinese debt to GDP at 237 percent. Since GDP is likely also an overstated measure of national income, due to fraudulent statistics and the fact that the losses on past investments have not been recognized (in part because much of the credit is pumped  into zombie companies that should be bankrupt) this ratio understates the true burden of the debt.

The surge in credit is being extended in large part through extremely fragile and opaque shadow banking channels, but the risk is ending up on bank balance sheets. To engage in regulatory arbitrage of capital rules, banks are disguising loans as “investments” in trust companies and other non-bank intermediaries, who then turn around and lend to corporate borrowers.  Just call a loan a “receivable” and voila, no nasty non performing loan problems.

There is one very reasonable inference to draw from this palpably panicked resort to stimulus, and the fact that many companies in commodity intensive industries are in desperate financial straits and the government is loath to let them go under: today’s stimulus and the implied promise of more in the future whenever the economy stutters will increase the demand for primary commodities. The speculators are drawing this inference, and responding accordingly by bidding up the prices of steel, iron ore, and coal.

Some commentors, including some whom I respect, point out that the increase does not appear to be supported by fundamentals, because steel and coal output, and capacity utilization, appear to be flat. But the markets are forward looking, and the price rises are driven by expectations of a turnaround in these struggling sectors, rather than their current performance. Indeed, the flat performance is one of the factors that has spurred the government to action.

When the Chinese responded to the 2008-2009 crisis by engaging in a massive stimulus program, I said that they were creating a Michael Jackson economy, one that was kept going by artificial means, to the detriment of its long term health. The most recent economic slowdown has engendered a similar response. Its scale is not quite as massive as 2008-2009, but it’s just begun. Furthermore, the earlier stimulus utilized a good portion of the nation’s debt capacity, and even though smaller, the current stimulus risks exhausting that capacity and raising the risk of a banking or financial crisis. It is clear, moreover, each yuan of stimulus today generates a smaller increase in (officially measured) output. Thus, in my view, the current stimulus will only provide a temporary boost to the economy, and indeed, will only aggravate the deep underlying distortions that resulted from past attempts to control the economy. This will make the ultimate reckoning even more painful.

But the speculators realize that the stimulus will raise commodity demand for some time. They further recognize that the stimulus signals that the authorities are backsliding on their pledges to reorient the economy away from heavy industry and investment-driven growth, and this is bullish for primary materials demand going forward: the resort to credit stimulus today makes it more likely that the authorities will continue to resort to it in the future. So they are bidding up prices today based on those predictions.

In other words, as long as the Michael Jackson economy lives and stays hooked, its suppliers will profit.

So yet again, commodity markets and the speculators who trade on them are merely a lurid facade distracting attention from the underlying reality. And the reality in China is that the government cannot kick the stimulus habit. The government may scream about (and worse) the usual suspects, but it is the real cause of the dizzying rise in Chinese commodity prices, and the burst of speculation.