S&P on a China disaster

Late last week, Standard and Poors (S&P) released a 22-page report entitled The Potential Risk of China’s Large and Growing Presence In Commodities Markets, which warns that record high commodities may represent an unsustainable bubble at risk of correcting in the event of a significant slowdown of the Chinese economy  (hat tip Interest.co.nz for the link).

The report undertakes a detailed analysis of China’s influence on world commodities markets, with particular emphasis on copper, aluminum, steel, coking coal, iron ore, crude oil and soybeans.

In relation to Australia’s two largest exports – iron ore and coal – S&P notes the following and provides the below tables:

China accounts for a disproportionate share of world iron ore and coking coal demand, accounting for 60% and 52% of world consumption, respectively, in 2010…

The country imports more than half of the amount it uses of each of these raw materials.

And China’s insatiable demand for iron ore and coal has pushed contract prices to record levels (see below RBA chart).

Although S&P’s outlook for the Chinese economy is favourable over the next few years, it does hypothesise about a range of risks that could conceivably lead to an abrupt deceleration of Chinese growth and sharp falls in commodity prices. These risks include the following [my emphasis]:

Government economic policy misteps:

A present risk is that Chinese policymakers might overreact to rising inflation both in consumer and real estate prices…

Ultimately, the risk is that the government could tighten policy too much and trigger a sharp economic slowdown. Due to its highly centralized economic management, China has to rely largely on direct administrative policy tools, such as industry-specific control measures, credit controls, and regulatory restrictions for macroeconomic management. The impact and potential side-effects arising from the use of such tools are hard to predict. Chinese policymakers have in the past mitigated this risk by adopting gradual changes. If these changes begin to increase in size or speed, significant economic volatility could result.

In such a scenario, demand for commodities could fall precipitously as investment is curtailed. In 2004, for instance, China halted the initiation of all new major investment projects for several months. Ultimately, if there were signs that the economy were slowing much more than intended, preserving employment could once again emerge as the top policy priority, arguing for an easing of investment restrictions. However, just the abruptness of policy reversals could increase perceptions of uncertainty among businesses and consumers.

Bank system asset quality problems:

In addition, the banking system poses a greater contingent liability than for other, similarly rated sovereigns, reflecting relatively lax underwriting standards at some banks. As a result of various stimulus programs, 2009 alone saw a 33% increase in domestic credit, with a significant amount of borrowing concentrated in companies owned by local governments. Many of these public enterprises have weak financial profiles and undertook projects that have not been profitable. We see some risk that a sharp increase in nonperforming loans, brought on by an unexpectedly abrupt economic slowdown or other shocks, could damage bank balance sheets in China.

Standard & Poor’s places China’s potential gross problematic assets in the range of 25%-40% of total banking system assets

As long as economic growth remains at high-single-digit rates, we expect the banking sector to be able to work off the credit costs associated with the recent lending boom without state support. If a large economic shock were to hit China in the near future, however, we believe problems in the banking system have the potential to weigh significantly on economic growth.

I am not sure that I agree with the final point. While it has been widely reported that China is drowning in a sea of overcapacity, thanks largely to its state-sponsored building frenzy in the wake of the financial crisis, and that many of the loans used to finance these projects were uneconomic, the suggestion that China can some how grow its way out its malinvestment and non-performing loans seems circular and nonsensical.

Hasn’t much of China’s recent growth been on the back of the very projects that have given rise to the banks’ non-performing loans – i.e. the massive fixed asset (mal)investment?  And if this fixed asset investment were to slow, by extension, wouldn’t China’s economy also slow? To quote Jim Chanos, China is “on a treadmill to hell because 50% to 60% of GDP is construction… they’re really hooked on this sort of heroin of real estate development”

Back to the report.

External shocks:

One shock that could trigger a severe Chinese economic slowdown is a steep drop-off in external demand for Chinese products–and with it a decline in Chinese domestic investment tied to the export sector. That in turn could be provoked by a global double-dip, a rise in protectionist measures, or some second-round effects from a geopolitical event…

Any renewed global slowdown would certainly affect China materially. We would expect the manufacturing sector, which accounts for a large proportion of employment, would shed a large number of jobs as export orders weakened, notwithstanding government measures seeking to minimize job losses and to create new jobs for those who become unemployed…

Were any of these three scenarios to unfold, we currently believe that China could see economic growth in the range of 4%-5% for a sustained period.  However, we see little likelihood of growth weaker than this or of an actual recession. Again, the extent of government control over the economy, and the financial resources China can command in responding to a downturn, support the view that it can mitigate adverse developments.

S&P then has a stab at predicting the impact on commodity prices from a severe downturn in China, using recent history as a guide for the extent to which commodity prices might fall.

Strong demand in China and other commodity-hungry emerging markets, and the nascent economic recovery elsewhere, have helped to propel prices of key commodities to records or near-records. This, in turn, has led to surging earnings and operating cash flow among most producers, which have plowed with much of their earnings back into capacity expansion…

Given the size of the production capacity expansion that expectations of continuing strong growth in China have set in motion, a rapid deceleration of China’s consumption of those commodities could quickly leave the global market beset by excess supply. Moreover, a rapid deceleration of economic growth in China is highly unlikely to occur in isolation. Even if the downturn initially were precipitated by purely domestic developments, contagion
effects would surely drag down other economies-–particularly considering the emergence of China as a major importer of consumer goods over the past several years…

We believe the following represent potential floor prices for the metals discussed above:

  • Aluminum: $0.65-$0.70/lb, compared with about $1.20 presently
  • Copper: $1.50-$1.75/lb, compared with about $4.10 presently
  • Iron ore: $85-$95/ton, compared with about $170-$175 presently
  • Coking coal (seaborne at mine): $100-$120/ton, compared with about $180 presently

You will notice above that S&P estimate falls in iron ore and coal prices of up to 45% in the event of a sharp China slowdown. Imagine what falls of this order of magnitude would do to Australia’s trade balance, budget position, national income, and growth? Think of the impact of Queensland’s floods on Australia’s coal exports and GDP and then multiply this effect many times over.

Finally, S&P ends the report with a warning to commodities producers:

Though such severely depressed pricing is only hypothetical, if it occurred, we would expect the credit quality of commodities producers to again come under pressure, as during the past recession. The most vulnerable companies would naturally be those that are already lower-rated due to such factors as lack of product diversification plus high financial leverage.

Personally, I believe that Michael Pettis’ commentary last year on the relationship between high external debt, commodity prices and asset prices, is far more relevant to Australia [my emphasis]:

With inverted debt [structures], the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times…

Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline. This makes the good times better, and the bad times worse…

Inverted debt structures leave a country extremely vulnerable to debt crises…Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.

This is especially a problem for countries whose economies are highly dependent on commodities. Not only are commodity prices volatile, there is a long history suggesting that global liquidity dries up at the same time that commodity prices collapse. This is a deadly combination for highly indebted economies with big commodity sectors…

Countries with a lot of short-term debt, external debt, and asset-lending-based banks, especially large amounts of real estate lending, are far more vulnerable than they might at first seem because the debt burden is likely to soar at the worst time possible – just when everything else is going wrong…

In fact some of the recent “star” sovereign performers may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets [Australia?]. These kinds of debt structures ensure that good times are magnified, but they also ensure that bad times are exacerbated…

When the economy is doing well, rising asset prices make existing loans seem less risky and encourage riskier debt structures (i.e. loans whose servicing cannot be covered out of minimum expected cash flows) because creditworthiness seems constantly to rise. But once the crunch comes, asset values and creditworthiness chase each other in a downward spiral.

Let’s hope the China perma-bulls in Treasury and the RBA are proved correct and that China continues its current growth trajectory. Otherwise, Australia could find itself facing significantly reduced export income, a credit crunch, and sharply falling asset values.

Cheers Leith

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Unconventional Economist
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  1. “The country imports more than half of the amount it uses of each of these raw materials.”

    I just have this funny feeling when the China story is all said and done that these guys are sitting on so much of the minerals that it will cause a collapse. They are storing so much of these that it will cause a major crash in commidities. I dont have any charts or anythings to back it up. Every now and then I read articles that talk about how much they are buying doesnt add up to how much they are consuming. Time will tell.

  2. “To quote Jim Chanos, China is “on a treadmill to hell because 50% to 60% of GDP is construction…”

    Lets face it. China can not continue down this path regardless of how much money they print or have in reserves. I dont think you will ever get the Chinese to consume to much its not how they are. They need to increase their consumption from their people which is not working. They cant continue building and building and building. They are at a point now that inflation is taking its toll and are really painting themselves into a corner where they will soon enough have no options. I think when they do fall its going to be much worse than what Japan went through in the 80/90s. This will devastate Australia. I dont think China is on a treadmill to hell it is a time bomb ticking away to go off. Australia, Canada and Brazil are standing right next to it.

  3. In the case of oil, as pointed out by
    American economist James Hamilton, the high price of oil eventually led to marginal supplies from South America, Asia, and Canada being brought online in May to compensate for higher demand and the supply disruption in Libya. In other words it took some time but eventually higher prices produced more production capacity to meet demand.

    In terms of Australia where metals and coal are big, there will be more marginal supply out of other areas of the world to meet higher prices. A slowdown in China isn’t a necessary condition for commodity prices to fall. I remember low commodity prices of the mid ’90s even when the world’s economy was growing well.

    China tapping on the brakes with a flood of new supply sources coming online would be a 1-2 punch. But if the brakes don’t get tapped I wouldn’t be sanguine about commodities.

  4. Jumping jack flash

    LBS I agree. I read somewhere, probably on here, that China was simply buying our minerals as a hedge against US dollar devaluation.

    After the money stops being printed and things stabilise then China reveals its massive stockpiles and demand stops for a few years during which China’s investment pays off. They either use or sell their stockpile. Either way they won’t need ours.

    It made sense to me. They own trillions of US dollars and other US monetary instruments, they surely wouldn’t sit idle while the US trashed them accidentally or on purpose.

    • In terms of “hoarding” metals, not all commodities are “hoardable” because they eventually degrade or take up too much warehouse space. If China keeps on “hoarding” the world will keep bringing on more and more capacity.

      I’ve seen much debate around the demand side of the market — China — but not too much on supply: how quickly can the world bring new capacity online for these commodities?

  5. The false assumption seems to be that price (for exchange traded commodities) is determined by economic demand/supply.

    Don’t disagree with their assessment of iron ore and coal but base metals are a speculative casino.

    They mention aluminium and copper in the box above. There is a glut of aluminium. Base metals don’t trade on supply/demand fundamentals. Having said that their price calls look reasonable but a tad low when compared to the lows of the GFC. At the GFC lows some metals were trading below cost. A weak US dollar and higher costs puts a longer term higher floor under the price.

  6. Maybe a clue to the future is how the Chinese cornered the rare earth market by forcing prices down, made the American operations uneconomical, then purchased other operations or took major positions, ie Lynas and Arufura, then restricted supply.

  7. The problem with China is that nobody has a clue just how much government and industry base metal inventory goes unreported. Because there is no transparency in their inventory reporting (like everything else), you can’t tell what is and isn’t a bullish signal. Despite there obvious contempt for accurate information, they somehow think they need a credit rating agency (Dagong), going around the world rating sovereigns… comical.

  8. Having visited China recently, it only reinforced my earlier view that it is the Mother of All Bubbles.

    Just unbelievable malinvestment over capacity and stratospheric values.