Exclusively from Michael Pettis newsletter comes another warning for Canberra’s boundless China faith.
Since January I’ve been writing about – and trying to figure out – the strange happenings in the Chinese copper market. The issue has been a regular topic of conversation in my central banking seminar at Peking University, where much of the most imaginative analysis I’ve seen has been done.
The Financial Times Alphaville has also done a great job of reporting on the subject, but for those who don’t remember, China had been importing for many months far more copper than was needed for real use – and this in spite of a huge surge in domestic infrastructure and real estate development which has boosted the demand for copper. Imports continued even when London prices exceeded Shanghai prices by more than the equivalent of China’s value-added tax.
Instead of being shipped to end users, it seems that copper was being stockpiled in warehouses. Why? One possibility of course was pure speculation. If you think domestic Chinese copper use is going to soar, and with it prices too, then it might make sense to buy copper and hoard it. But there seemed to be a lot more hoarding than normal, and anyway with London prices often above the tax-adjusted Shanghai prices, why would anyone want to speculate on foreign copper when it could be bought more cheaply domestically?
It turns out, that the copper purchases were not entirely, or even mainly, speculative. They were part of a financing scheme for companies that, in spite of the avalanche of new lending occurring both within and outside normal RMB lending, were having trouble accessing bank credit.
This difficulty in accessing credit is, by the way, noteworthy enough. Everyone says credit conditions in China are tight but, as I wrote last week, it is hard to think of credit “tightness” in the context of such ferocious credit expansion. What is happening here in China is not that credit growth is too slow, but rather that infrastructure and real estate investment is so high that it has overwhelmed the available sources of credit.
But to get back to copper, it seems that credit-starved companies were importing copper because they could obtain trade finance or some other sort of foreign financing, and then used the physical copper (or warehouse receipts, I guess) as collateral for domestic borrowing. The financing was continually rolled over. Buying copper was just a way to borrow for companies that needed loans and were otherwise unable to get them.
As I mentioned two weeks ago, when I discussed this in February with a senior executive in a major commodities company, he responded by saying that he thought the same thing might also be happening in soya. Borrowers are resorting to some fairly convoluted and expensive ways of obtaining short-term credit largely because they cannot obtain financing from the local banks.
That doesn’t mean there isn’t liquidity in China. There is tons of it, but much of the credit is being disintermediated because of constraints on bank lending. For example on Saturday the South China Morning Post had this article:
Just two years ago, mainland investor Jim Zhang finished capital-raising for his first real estate private equity fund. Today, he is calling on fellow investors to contribute to his fourth real estate fund. “There is a lot of liquidity in China. Many wealthy individuals are interested in investing in real estate private equity funds in anticipation of a positive market outlook in the long run,” he said.
Later in the same article Raymond Wang, head of investment at DTZ’s Northern China division, is quoted as saying “Fund-raising is easy as liquidity is strong.”
So China’s problem isn’t that liquidity is tight – how could it be with so much credit expansion and hot money inflow? The problem is that much of the real investment growth seems be funded outside the normal lending channels.
So far I am just rehashing the old story I’ve written about before on the role of copper in raising financing. But on Tuesday my friend and co-instructor in the central bank seminar, Logan Wright of Medley Advisors, sent me a Reuters headline garlanded with exclamation points: “Chinese copper exports up 1133% ytd, 36,768 tons in March vs. lower imports of 192,161 tons…net refined copper imports down 30.6% ytd.”
Apparently copper exports in the first three months of 2011 have soared, even as China is still importing copper. So what’s going on? I can’t say for sure, but if our copper-financing story is right, then this strange round-tripping sort of makes sense.
Here’s how it works. Even when London prices are above Shanghai prices, companies eager for loans are importing copper in order to get back-door financing, whereas local traders, noticing that domestic demand isn’t strong enough to justify those import quantities, and perhaps eager to arbitrage the prices, are selling copper abroad. The weird distortions in the banking system, where credit isn’t rationed by price but by quantity and hierarchy, has turned China, at least temporarily, into a revolving door for copper imports and exports. This is great for copper traders, of course, but perhaps not so good for the overall economy since someone has to pay for those outsized trading profits.
There’s some great digging here and the analyis is fair enough. But what worries me beyond the fact that the real economy is once again subsidising trading profits is what happens when China has a growth hiccup? Some of you may recall the spectacular warning given by Oliver Wyman at Davos. From Alphaville:
However, it is already apparent that increasing commodities prices are also creating inflationary pressure in China, which is exacerbated by China holding its currency artificially low by effectively pegging it to the US dollar. This makes commodities look like an attractive hedge against inflation for Chinese investors. The loose monetary policy in developed markets is similarly making commodities look attractive for Western investors. This “commodities rush” is demonstrated in the right-hand chart below, which shows the asset allocations of European and Asian investors. A recent investor survey by Barclays also found that 76% of investors predicted an even bigger inflow into commodities in 2011.
Based on the currently inflated commodity prices, commodity producers in countries such as Brazil and Russia have clear business cases for investing in projects to dig more commodities out of the ground. As competition to launch such projects increases, the costs of completing them also starts to rise, with the owners of mining equipment and laborers capitalizing on the increased demand by charging higher rates. Because a portion of the demand for the projects is not coming from the real economy, an excess supply of mining capacity and commodities will be created.
So as soon as investors start to doubt what constitutes ‘real’ demand for commodities and what’s pure speculation, they’ll head for the exits en masse, which will lead to a collapse in commodity prices, abandoned development projects and bank losses.
And then we’ll have banks that need to be bailed-out by sovereigns, and sovereigns that need to be bailed out by … well, you get the picture.
Just imagine what happens to copper supply, then, when the Chinese have just such a wake up? And Professor Pettis goes further. He looks into the likely trigger:
And while we are on the subject of commodities, I thought I would swipe and rearrange a table I saw in a very interesting (and alarming) April newsletter by GMO’s Jeremy Grantham, on the global commodity outlook. The table below lists China’s share of the global economy.
And here is the Grantham table:
Professor Pettis goes on:
What is most noteworthy about these tables, of course, is the disproportion between China’s share of global GDP and China’s commodity consumption.
The tables give a very good sense of what might happen to global demand for various commodities as China rebalances. For example if investment growth slows significantly, as I expect it to do some time probably after late 2012, this should seriously reduce global demand for a lot of non-food commodities, especially cement, iron, and other building materials.
Take iron, for example. If Chinese demand declines by 10%, this would represent a reduction in global demand of nearly 5%. I am not an expert in the commodity markets, but I guess that supply and demand considerations are fairly finely balanced, and a 5% reduction in demand should have significant price repercussions – especially if a material part of Chinese demand represents stockpiling and this stockpiling is reversed.
Notice I stress non-food commodities. As I see it, a dramatic slowdown in growth is a necessary part of China’s rebalancing as Beijing brings investment levels down sharply, but almost by definition rebalancing means that household consumption growth must outpace GDP growth, and so a slowdown in GDP growth will mean a much softer slowdown in consumption growth.
If I am right, this implies that if China is able correctly to rebalance – no easy task, but very possible – then we should not see a sharp drop in the growth rate of household income and household consumption even if GDP growth slows sharply. Rebalancing effectively requires a transfer of wealth from the state and corporate sector to the household sector, and this will cushion households from the worst effects of a drop in investment.
Note however that this means that the state and corporate sector must bear far more than their share of the cost of a slowdown in growth. This of course is only fair given that over the past three decades they received far more than their share of overall growth.
It also means that food consumption will continue rising as Chinese households move up the income scale. That is why although I am very bearish over the medium term for non-food commodity prices, I am a lot less bearish about food prices.
Needless to day this is a bad news, good news story for Australia. I doubt very much a surge in our food exports would be enough to offset declines in metals and ore. Another danger is that such a shift would pose a big political challenge to China. Any which way you look at, though, it cries volatility.