Streetwise Professor

January 6, 2015

Whither Chinese Commodity Demand? Your Guess Is As Good As Mine

Filed under: China,Commodities,Economics,Energy,Politics — The Professor @ 8:40 pm

Commodities are down broadly: Oil gets the headlines, but most major commodities-especially industrial commodities-are down, with iron ore leading the pack. The main driver is Chinese demand: perhaps it’s more accurate to say that the main brake is slackening Chinese demand. Forecasting the course of future Chinese demand is challenging, because there is a huge political component to it.

China has long followed a commodity-intensive, investment-focused (including construction and infrastructure), credit-fueled economic model. It has long been recognized that this model is unsustainable because it is fraught with imbalances. There have been signs that China has recognized this, and in particular the new Xi government is attempting to to navigate this transition, signaling a desire to transform to a consumption-based model with growth rates in the 6-7 percent range rather than 10 percent (though analysts like Michael Pettis say that growth rates in the 3-4 percent range are more realistic.)

One sign of that is the central government’s recent attempts to rein in local governments that borrowed heavily through “local government funding vehicles” (“LGFVs”) to support local infrastructure, housing construction, and industry. Clamping down on LGFVs would be one way of steering China’s economy away from the investment-intensive model:

China’s local government bond issuers face judgment day as authorities in the world’s second-largest economy decide which debt they will or won’t support.

Borrowing costs soared by a record amount last month before today’s deadline for classifying liabilities, on speculation some local government financing vehicles will lose government support after the finance ministry starts reviewing regional authorities’ debt reports. Yield premiums on one-year AA notes, the most common ranking for such issuers, jumped a record 98 basis points in December.

Premier Li Keqiang has stepped up curbs on local borrowings just as LGFVs prepare to repay 558.7 billion yuan ($89.8 billion) of bonds this year amid economic growth that’s set for the slowest pace in more than two decades. The yield on the 2018 notes of Xinjiang Shihezi Development Zone Economic Construction Co., a financing arm in a northwestern city with 620,000 people, climbed a record 63 basis points in December.

But there are mixed signals. Today China announced a $1 trillion stimulus:

China is accelerating 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) this year as policy makers seek to shore up growth that’s in danger of slipping below 7 percent.

Premier Li Keqiang’s government approved the projects as part of a broader 400-venture, 10 trillion yuan plan to run from late 2014 through 2016, said people familiar with the matter who asked not to be identified as the decision wasn’t public.

. . . .

The projects will be funded by the central and local governments, state-owned firms, loans and the private sector, said the people. The investment will be in seven industries including oil and gas pipelines, health, clean energy, transportation and mining, according to the people. They said the NDRC is also studying projects in other industries in case the government needs to provide more support for growth.

The NDRC’s spokesman, Li Pumin, said last month China would encourage investment in those areas.

So which is it? A transition to a less-investment intensive model, implemented in large part by reducing the use of credit by local governments? Or continuing the old model, to the tune of $1 trillion over the next couple of years?

Commodity traders want to know. But given the opacity of the Chinese decision making process, it’s impossible to know. The signals are very, very mixed. No doubt there is a raging debate going on within the leadership now, and between the center and the periphery, and decisions are zigging and zagging along with that debate.

I see three alternatives, two of which are commodity bearish. First, there is a transition to a more consumption-based model: this would lead to a decline in commodity demand. Second, there is a crash or hard landing as the credit boom implodes due to the underperformance of past investments: definitely bearish for commodities. Third, the Chinese keep pumping the credit, thereby keeping commodity demand alive. The third alternative only delays the inevitable choice between Options One and Two.

In brief, for the foreseeable future, the most important factor in commodity markets will be what goes on in Chinese policymaking circles. And insofar as that goes, your guess is as good as mine.

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  1. In order to keep demand constant, stimulus has to increase exponentially (interest on existing stimulus debt needs to be paid as well)- not very easy given a debt to gdp approximating 300%…

    Comment by Viennacapitalist — January 7, 2015 @ 9:51 am

  2. My guess is option 3 followed by 2 followed by 1. If the Chinese want to rival the Americans, they’ve gotta do the right thing after exhausting all the alternatives, right?

    Comment by Ivan — January 7, 2015 @ 11:09 am

  3. The third option not only delays the inevitable, it makes it all that much worse. For The Chinese who have sense of recent history, it was the bungling of monetary policy that led to hyper inflation under the KMT that did as much as anything to strip its legitimacy in 1946-47.

    Enough to make (almost) one feel sympathy for the policy Wonks in Beijing.

    Comment by sotos — January 7, 2015 @ 1:42 pm

  4. In Beiging, it must be the policy Wongs.

    Sorry, could not help it. Merry Christmas!

    Comment by Ivan — January 7, 2015 @ 2:06 pm

  5. @Ivan-1. Policy Wongs. LOL. 2. Yes, I agree, 3->2->1. @Sotos-Yes, the more they stimulate now, the bigger the comedown later. I have called China the Michael Jackson economy, being kept alive on stimulants that keep you going for a while, but the longer they’re taken, the more hideous the side effects. I think they know that, but can’t kick the habit. Right now China is like the old stock cartoon of a junkie with an angel on one shoulder and the devil on the other. Can’t make up its mind.

    The ProfessorComment by The Professor — January 7, 2015 @ 8:04 pm

  6. It’s not like this general sort of problem hasn’t come up before with industrializing countries. The extra dirigisme of China makes the whole thing more attributable to policy, but debt-fueled over-investment booms followed by panics are hardly unique to China. All the bien-pensant experts seem to believe that there exists a policy mixture starting now that would enable the Chinese to thread the needle and hit sustainable growth without a crash. I’m not so sure, even discounting the political aspects of the situation and I’m doubtful when those aspects are included.

    Comment by srp — January 8, 2015 @ 9:36 pm

  7. Srp’s got it right. What’s more amusing is that most of these commentators are probably unaware of China’s recurring history of brutal inflation and banking crises since liberalization; Chinese banking is in the world hall of fame for peak crisis NPLs, featuring recovery rates that would make a latter day Madoff investor feel good about their losses.

    This is a structural feature of Chinese finance and the incentives are the same they ever were. This ‘stimulus’ is a nonsense announcement, a repackaging of existing spending plans and unfinanced mandates for spending by local governments, who are already over-levered and dependent on the real estate economy for cash. The impact of declining land sales is lagged and will start registering as fiscal tightening in Q1-Q2, unless offset by another central government push. I don’t think this happens, as the stimulus button is probably just about worn out at this point, and Xi Jinping seems to be wary of the risks of continuing to reach for more juice, lest he enable more reckless spending by local party capos.

    More interesting for me at this point are the second and third order impacts. The implications for Europe and oil are pretty poor. Coal will probably never come back from this, and seaborne iron ore is toast for a decade or more.

    I am however, massively short a variety of Chinese and related securities, so I may not be the most objective voice on this one…

    Comment by Nick — January 11, 2015 @ 9:36 pm

  8. @Nick & @srp-I have long been a China skeptic, even dating well before the financial crisis (hence my Michael Jackson analogy), due specifically to my belief that their financial system is a disaster waiting to happen. I have been waiting long enough to doubt my prognostication at least a little, but I do think it is inevitable.

    I am also quite surprised that more people aren’t skeptical about the viability of a system that though not centrally planned perhaps in the old way, is still largely centrally directed and manipulated, with the banking and capital markets being the most heavily manipulated, and the sources of the biggest distortions and imbalances.

    The three commodities that you mention, @nick, are also the three that have been down hardest in the past 7 months. They are the most China-driven.

    The ProfessorComment by The Professor — January 11, 2015 @ 9:48 pm

  9. I think its not even so much a question of manipulation (although there is certainly plenty of fraud and outright theft) as one of incentives. State banks allocate the overwhelming majority of capital and prefer to allocate to SOEs which borrow evergreen capital at below-market rates, enjoy subsidized energy costs, and receive direct cash handouts. And yet, in spite of these (or perhaps because of) these advantages, not to mention an ability to arbitrage environmental and labor standards as well as IP law, most of these businesses fail to earn even their highly subsidized cost of capital, as, like the banks, they are primarily a tool for policy and self-enrichment for the political elite.

    But yes, there are still plenty of elements of central planning that remain; the cheerily named Central Commission for Discipline Inspection, for example, must sign off on all executive appointments at state banks and key SOEs. One of the best ways to determine whether a supposedly private enterprise is truly independent of the Party is to see how often management is rotated, as SOEs generally feature a revolving door of appointees; at one point in the airline industry I recall all of the CEOs rotating jobs.

    Comment by Nick — January 12, 2015 @ 9:29 pm

  10. @Nick-Matter of semantics. By manipulation I mean the financial repression that directs capital to banks at low rates, and then, as you say, the banks allocate the capital to favored firms. Other price distortions (e.g., subsidized energy prices) are also a form of manipulation. That’s also what I mean about central planning. Important prices aren’t set by market forces, but by fiat.

    The ProfessorComment by The Professor — January 12, 2015 @ 10:21 pm

  11. Sorry, I didn’t mean to nitpick and hope my little addendum wasn’t misinterpreted; I just enjoy proselytizing on China’s one-sided embrace of free market institutions for fun and profit.

    I also get extremely sensitive about this distinction because I’ve presented this perspective to China bulls who have turned it around as a straw man and presented me as an out of touch ideologue who is trying to claim China is a Stalinist, command-and-control economy. As you point out, its a much more subtle, if in the end perhaps no less distortive, mechanism of control.

    Comment by Nick — January 18, 2015 @ 9:17 am

  12. @Nick-No sweat. No misinterpretation or pique at nitpicking on my part. Just wanted to clarify: I understand how my comments might be misunderstood. I definitely think that we are on the same page.

    I just don’t see how you can massively distort prices for long periods of time without baleful consequences. It’s just a matter of time before those consequences appear. This is particularly true when it comes to asset prices/interest rates/capital markets, because misallocations of capital have very long-lived consequences.

    The ProfessorComment by The Professor — January 18, 2015 @ 12:37 pm

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