Pettis warns Canberra

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.

David Llewellyn-Smith
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  1. I suspected they were only stockpiling copper, but not reselling. You’ve got to hand it to the Chinese, it there’s a will, there’s a way.

    In regards to food, I’ve always felt it will be the next scarce resource.

    Here’s some info:

    World Bank President Robert Zoellick said back in April 16 that the world is “one shock away” from a crisis in food supply and prices.

    Costlier food contributed to riots across northern Africa and the Middle East that toppled leaders in Egypt and Tunisia. It also drove 44 million people into poverty in the past year.

    “Global food prices may rise 4.4 percent to a record by the end of the year, driven by demand for meat, oilseeds and grains used to make ethanol, adding to costs that mean inflation is accelerating from the U.S. to China.” The United Nations.

    According to Zurich-based Resilience AG, global corn stockpiles are shrinking the most in seven years, inventories of nine edible oils will drop to the lowest since 1974. “These stockpiles are being severely depleted,” said Adams, who correctly forecast gains in heating oil and gasoline prices last year.

    ‘China’s demand for corn will grow faster than supply in the next 10 years on rising production of livestock feed and biochemicals’ Grain News reported.

    If only our government, rather than throw money at questionable schemes, was able to implement the Ord river irrigation scheme. This involves irrigating the Murray River and centre of Australia through major pipelines from Lake Argyle in the northern part of Western Australia via the Ord river irrigation scheme. This man made lake captures the stupendous annual rainfall of the Kimberley (holds 9 times the capacity of Sydney harbour) and would help transform Australia into the food basin of Asia – if not the world.

    • Agree Again! Part of my commment 1 May on UE’s Housing Falls Accelerate post:

      “A government with no vision and a population that mostly doesn’t care.

      You ask “can we feed ourselves” – I don’t know but would guess that we just about could, if we had to. If we harnessed the massive seasonal waterflows of the north (think Kimberley region/Ord River) surely we could develop agricultural regions to rival the Nile delta of old. To do this would be an enormous project with a timeline of several years and cost billions. Potentially the benefits could be equally enormous.

      You can’t eat NBN connections…”

        • I think the stuff you are posting is great. Real big picture material. The beauty of this scheme is that we have no land borders unlike other countries who share a dependency on one of the ‘great’ rivers.

          A true win-win for Australia and the world. Turn this joint into the bread basket and get our act together on geothermal energy and solar power while we are at it.


    • Recently the Ord Catchment was holding >30x volume Sydney Harbour – following monsoonal rains. Incredible.

      Couple of interesting facts:

      – Before Dams were constructed the Ord River had been measured to flow at a peak rate of one million cubic feet per minute (this roughly equates to metropolitan Sydney’s daily water consumption passing by in about 26 seconds).
      – More than 70% of the stored water is wasted to the ocean to “maintain” the “wetland” that has been developed by the damming of the Ord River.
      – Currently only 380 gigalitres of the 11,000 gigalitres of water stored in Lake Argyle is allocated for irrigation.
      – Volume of water in Lake Kununurra (Diversion Dam) is roughly 95 million cubic metres.
      Volume of water in Lake Argyle (Main Ord Dam) is roughly 11,000 million cubic metres.
      – Could drain Lake Kununurra (Diversion Dam) and refill it from Lake Argyle once a week and never run out of water.

      This region, little known and underappreciated, faces some hurdles (eg salinity in areas) – this is where governments should be spending money.

      • My God, never heard about this, why doesn’t the person with all the info on Ord River project get this on the 7.30 Report or something to get it in the politicians agenda!

        The Ord – ‘Stone the Crows, not The Bloody Ord again!?’

        “After more than two decades of experimental farming at the Kimberley Research Station, the Kununnurra Diversion Dam, was finally completed in 1967. It allowed for the cultivation of the first irrigated farmland. Kununurra town was built nearby as the service and residential centre and a larger dam was built 25 miles south of Kununurra in 1970-72. It holds the main reservoir (Lake Argyle) for irrigation and possibly for eventual hydroelectric power generation.

        The main crop projected for the area was cotton, but this was abandoned by 1974 due to insect pests.

        Since then various other crops have been experimented with, but without much success. By the 1980s only ten percent of the possible irrigation area was under cultivation and the Ord River Irrigation Scheme had become Australia’s most costly and controversial irrigation project.”

        Give up fella!

    • When you look up ‘questionable schemes’ in the dictionary it says ‘see Ord River irrigation scheme’

      • Au contraire 3d1k, pricing carbon emissions is the only rational course of action for humanity, but unfortunately we live in an irrational world.

        The NBN I’m ambivalent about. Naturally I’d like to see ultra-fast internet everywhere, but I’m unsure what Australia would do with it. Watch more TV? Its not like its going to spur a wave of innovative technology startups, not when the dollar is at $1.10, and there’s so much valuable dirt underneath our feet!

        • Rational to introduce another level of bureaucracy, to further complicate the tax/transfer system, to impose additional cost on Australian industries, to allow exemptions to politically sensitive sectors, to compensate the disadvantaged for increased charges, to be virtually the only country on the planet to do so? All to ‘achieve’ a negligible (immeasurable?) reduction in carbon emissions?

          Irrational to think there has to be a better way?


      • “When you look up ‘questionable schemes’ in the dictionary it says ‘see Ord River irrigation scheme’”

        What makes you think this is ‘questionable’?

  2. That Grantham table is telling. The fact that China accounts for nearly half of Australia’s two major exports – iron ore and coal – shows just how inextricably linked we are to the Chinese economy.

  3. Nice stuff. Up until the GFC you could track China copper imports with the LME/SHFE spread. I’d been wondering why this had broken down. I have never convinced bulls that metals were a speculative play since the boosting of liquidity in 09. I continue to read ad nauseum that copper supply is, and will continue to be, in deficit yet the LME copper stockpile rises (as does SHFE). Chinese (internal) copper production has been rising by the way, which may account for the exports mentioned in the article. When this crashes copper is still a better place to be than other base metals. Marginal cost for copper producers is lower than the bottom in early 09, i.e. they’ll stay profitable. Not so other base metals where costs are higher as a proportion of price, e.g. aluminium, zinc, … and supply gluts exist e.g. aluminium and nickel (monster stockpiles).

    Regarding iron ore (disclosure I own shares in an iron ore producer) a lot of supply will be coming online over the next few years which should force down price regardless of what happens with steel production — which China totally dominates.

  4. While most speculator are happy enough with future contract, the Chinese speculators have to moves the physical stuff around since ‘speculation’ is banned by the Chinese Government.

  5. That Grantham table says it all. China accounts for nearly half of global demand for base metals. How exactly does the RBA think thats sustainable? Credit growth/fixed asset investment is really just disguising an accumulation of inventory.

  6. The Ord Irrigation area is impressive, and rice should become our new iron ore. To develop this region which has renewable hydro power and oodles of potential for tidal power is without doubt the soloution to many of this countries long term problems. The Fitzroy valley is a scheme which would be many times the size of the Ord. Unfortunatley we have leadership in Canberra that lack any real determination for grand ideas or direction for the future of this country