China’s property crash versus Wall St’s commodity mania

There’s not much point repeating a couple of good posts from ZH on the China property situation given they capture my thoughts so here they are. First up, the Chinese property crash is getting worse fast:

Having already suffered the fastest drop on record, Chinese junk bond markets – where property developer issuers dominate – were routed once again as fears about fast-spreading contagion in the $5 trillion sector, which drives a sizable chunk of the Chinese economy, continued to savage sentiment. Meanwhile, China Evergrande Group’s offshore bondholders still had not received interest payment by a Monday deadline Asia time, Reuters reported citing sources.

But while Evergrande’s default is now just semantics, and one week after Fantasia shocked bondholders with a surprise announcement it too would stuff creditors just weeks after it had said its liquidity was fine, which sent its bond plunging from par to 74 cents in seconds…

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More localised support can be expected. But this is not going to be enough to turn around what is now clearly a systemic crisis for property developer funding. Only ending the “three red lines” policy will do that now. Will China do it?

I don’t think so. Why? It can’t. Another ZH post:

Back on Sept 30, China stunned markets when reeling from soaring energy prices, widespread blackouts, mass factory closures and a shortage of coal – it’s most popular source of power – Beijing ordered energy firms to “secure supplies at all costs.” Local producers did not need a second invitation to do just that, and in less than two weeks, the Chinese thermal coal futures have soared by over 16% to an all time high, spiking above 1,500 yuan per ton overnight, where the jump triggered even more stops ensuring that the move higher would continue.

The move in Chinese coal prices, seen in its long-term context, has been nothing short of staggering.

But while we can certainly admire the view from up there, that doubling in coal prices in just the past month is terrible news for Beijing which is under increasing pressure to cut rates or ortherwise ease financial conditions to contain – or “ringfence” in the parlance of our times – the “disaster” taking place in the Chinese bond market, the commodity price inflation means Xi’s hands may be tied for one simple reason.

Historically, Chinese coal prices – due to their core role as the anchor of China’s energy-intensive economy – have been the asset the most closely has correlated with Chinese wholesale, or factory gate inflation, also known as Producer Prices. And while we wait to get the latest Chinese CPI and PPI print this week, we can already predict what it will be either next month or the month after.

While coal prices were relatively contained one month ago, they have since then exploded. And if the historical correlation between Coal prices and PPI holds, were may be soon looking at a tripling of China’s PPI, which from 9.5% Y/Y in August, is about to soar to 30% or more.

Needless to say, if Chinese PPI does hit 30%+, even if CPI somehow stay in the single digits, the results would be catastrophic: profit margins would collapse, the plunge in already thin cash flows would lead to even more defaults and supply chain bottlenecks, even as the scramble to obtain commodities “at any price” keeps pushing costs – and PPI – even higher. Meanwhile, if producers do try to pass on some of the costs and CPI spikes (the gap between CPI and PPI was already record wide before the recent surge in coal prices).

… then Beijing will have social unrest on its hands. And all this is happening as China’s property sector desperately needs a massive liquidity infusion which is – you guessed it – inflationary.

And while China may be facing its first “galloping inflation” PPI print, it’s only downhill from there, because as Citigroup wrote over the weekend, power cuts (with over 20 provinces, making up >2/3 of China’s GDP, have rolled out electricity-rationing measures since August) and contractionary PMI “seem to suggest China could enter into at least a short period of stagflation.”

Some more details from Citi on the recent blackouts:

The three NE provinces were hardest hit, with power cuts from factories to homes. Costal manufacturing and export hubs like Guangdong, Jiangsu and Zhejiang were also seriously impacted. The outages are attributable to:

  • 1. Electricity supply shortage. Thermal power (73% of total power production in 21H1) was limited by the low supply and surging prices of coal. China’s coal industry just emerged out of a prolonged de-capacity and is subject to tighter safety regulations. The geopolitical tensions (e.g., between China-Australia) and the COVID disruptions (e.g., in Mongolia) affected coal imports. Coal inventories in key coal-handling ports like Qinhuangdao are now around the new lows since the supply-side reform.
  • 2. Export-led industrial boom. China’s uneven recovery, with electricity-consuming industrials (67% of total power consumption in 2020) outpacing services (16%), pushed up the power demand.
  • 3. “Dual energy control”. To peak carbon emissions by 2030, the NDRC added more effective incentive measures for the “dual control of energy consumption and intensity” – for example, missing the targets may lead to delays or suspensions in the NDRC’s approvals of new energy-intensive projects for localities. Such measurable KPIs appear even more important amid the ongoing reshuffle of local officials ahead of the 20th Party Congress (in 22H2). China aimed to cut energy intensity by 13.5% during 2021-25 and by 3% in 2021. Total energy consumption growth is capped at 2.9% for 2021, which would require a more aggressive intensity reduction by 5.3%. The barometer released by the NDRC on August 17, showing 19 provinces lagging behind, further served as a wake-up call for local governments in achieving their “dual control” targets.

This led to a series of factory shutdowns and production cuts in energy-intensive and high-emissions sectors. Other than executive orders and window guidance, the cut of electricity supply has been used by some as a policy tool. It’s exerting material impacts on sectors like steel, non-ferrous metals, cement, glass, coking, chemicals, industrial silicon, paper making and electroplating, among others.

What are the implications?

As noted above, Citi believes that “China seems to be entering into at least a short period of “stagflation”:

  • 1. PPI inflation to remain elevated. The supply disruptions in the peak season should outweigh the demand weakness induced by the property down-cycle in the near term, keeping energy and industrial prices up. Citi expects PPI inflation to stay above 9% toward the year-end; we expect it to more than double from 9% in coming months, leading to catastrophic results for profit margins.
  • 2. Inflation divergence to deepen. Power rationing and production cuts may drive up consumer prices more directly than the market-based pass-through from PPI shocks. However, lingering public health risks still hold back the recovery of services. Recent regulatory actions may also reduce household expenses on education, healthcare and other services. The room for pork price declines has narrowed, but the down-cycle hasn’t bottomed yet. These would help keep CPI muted. The enduring PPI-CPI divergence would squeeze the profit margin of mid/downstream sectors, especially SMEs.
  • 3. China as an exporter of inflation. China’s environmental initiatives can be inflationary for the world over the medium term. The tight supply of industrial products would prompt the government to prioritize domestic demand over exports by, for example, cutting export tax rebates (already done for steel). The impact of disruptions with manufacturers/suppliers/assemblers would ripple through global supply chains (think electroplating for electronics as an example).

As a result of the above, Citi warns that China’s growth risks tilted toward downside; the bank recently downgraded its growth forecasts to 4.9% (vs 6% previously) for 21 Q3 and 4.5% (vs 5.1%) for 21 Q4 earlier, but it did not anticipate the abrupt widespread power-related production cuts. Some high-frequency activity indicators (e.g., daily crude steel outputs) have weakened quickly since.

And the pièce de résistance, Beijing is now trapped: if it eases, inflation – already at nosebleed levels – will soar further crushing margins and sparking a deep stagflationary recession; if it does not ease, the property market – already imploding – will crater.

There is the rub. China is trapped. But look through the ZH hysteria. It is only trapped for the next few months while it sorts out more energy supply and allows property deflation to hit demand.

The question is, how will China not waste this crisis? Will it buckle and stimulate property and risk an even larger energy bubble that cascades through households as higher utility bills? Or, will it allow the property crisis to run on and deflate prices for a while culminating in an almighty energy crash?

We know China wants to structurally get off the property and commodity teat, and it is now operating under the rubric of “common prosperity”, so I think it will choose the latter and take more short-term pain.

The point at which it might break is if the financial system is dragged into the developer shakeout. A 10% correction in property prices won’t do that. Losing a few small regional banks to developers bad loans won’t, either.

So, I still think China presses ahead with property reform, endures a hard landing in the short-term and pops the Wall Street commodity mania.

We will see more incremental supports but the trajectory will remain down for construction.

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