13th March 2014
Outbreaks of China pessimism are not unknown, or long-lived. Some high profile investors have been Cassandras since 2010, and even before. From a macroeconomic standpoint, and leaving aside the 2008/09 crunch, the mood darkened at the start of both 2012 and 2013, only to be reversed in short order. Last summer it returned, but only momentarily. In July 2013, Moneyweek ran a piece entitled ‘Everyone is bearish on China – is it time to start buying miners again?’, concluding that it was. And The Economist wrote a month later, under the title ‘A bubble in pessimism’ that while China’s economy was inefficient, it wasn’t unstable. It could evolve and expand simultaneously without succumbing to the eruptions that western capitalist nations had been through. Or, I suspect it implied, that other major emerging markets have experienced. By the time the Third Plenum had concluded in November, the consensus view brightened considerably, partly based on the presumption that the Party had embraced the zeal for major economic reform.
But here we are again. The Shanghai Composite index is struggling to stay above 2000 – a third of its value at the peak in November 2007 – and has been trending down from levels close to 3,500 at the end of 2009. Expectations for economic growth are still fairly high, but predictions get revised down every year. In the first two months of 2014, affected as usual by the New Year holidays, retail sales, fixed asset investment, output and credit creation have all come in weaker than expected. This isn’t unlike what happened at the start of 2012 and 2013, when sequential GDP growth dropped to a little over 6%, after which the authorities took steps to boost infrastructure and credit. This time, though, the economy and possible remedial policies look a lot more complicated. And also at a time when financial stress is rising, commodity prices are rolling over, the incidence of defaults is rising, and there is significant uncertainty about the outlook for interest rates and indeed, for the Yuan.(See, for example, my What’s going Yuan?, 25th February, https://georgemagnus.com/whats-going-yuan/). The implications for economic policy-making including with regard to the Yuan are as sensitive as I can remember, as I shall point out at the end of this piece.
Grin and bear it?
This is a ‘carpe diem’ moment for China, as it seeks to change China’s economic development model. It is most visible in the area of bringing market forces to bear in finance. The Peoples Bank of China has already announced that it expects full interest rate liberalisation by 2016. It is admitting privately owned firms to the financial sector that’s been the preserve of state banks until now. And it has been guiding the foreign exchange market into accepting a two-way market in Yuan trading. Other, more politically sensitive reform areas, for example, land, hukou, prices, services and energy, have taken a back seat by comparison, as we should have expected given that political reform has been ruled out.
Even within the context of financial reform, China has to be careful. If market interest rates were to rise too fast, or the carry trade should be reversed leading to large-scale capital outflows and liquidity stress at home, the knock-on effects on property, land prices, local government finances and heavy industries would be widespread and perhaps brutal under current circumstances.
In addition, if the authorities want to make allow market forces to take root as they have proclaimed, they need to be transparent and up-front about policy with regard to financial difficulties in local governments, large state enterprises, defaults and losses in general, and in the shadow finance sector. Premier Li said in a press conference on 13th March that people should be prepared for bond and financial product defaults as the government proceeded with financial deregulation and started to admit private sector players into the financial sector. But we don’t know yet that this ‘refresh’ applies to local governments and large state enterprises, where over-capacity and financial stress are becoming increasingly burdensome as growth slows. Or where the official tolerance threshold is for slower growth.
Most recently, Chaori Solar Energy Science & Technology Co., a private manufacturer of solar cells, became China’s first company to default on a bond, when it couldn’t make a full coupon payment on 7th March. And hard on its heels, Haixin Steel, a private and the largest mill in Shanxi, in the heart of China’s coal producing area, was unable to repay loans due last week. Solar manufacturing, coal, and steel are just three industries suffering from chronic over-capacity and growing financial difficulties. In some cases, the spillover effects go far beyond the individual companies’ debt repayment capacity. Many companies are both borrowers and, through the shadow finance sector, lenders to, or guarantors of debts owed by other companies, including suppliers or end purchasers. This raises the risk of a chain of defaults that is impossible to evaluate.
Commodity price fall-out, and what it means
The early consequences of these developments include a sharp fall in most base metals prices that is sending ripples from Perth to Peru. Copper has stolen the headlines, falling 10% in a week, but the weakness this year has been evident in most of the metals complex, spanning both non-ferrous and ferrous metals. We shouldn’t be surprised. It was always the case that this would happen once China’s slowdown was a) confirmed and b) liable not to be reversed in a major way via new credit creation and infrastructure initiatives. The latter is still clearly more tenuous than the former, but it feels a reasonable proposition for the moment at least. The reason is that China’s consumption of base metals is about 40% of global production. What producers and miners enjoyed on the way up, has clear consequences on the way down.
If you want to look at some good tables ranking the vulnerability of emerging countries to China, you could do worse than check Craig Botham of Schroders’ views summarised at http://blogs.ft.com/beyond-brics/2014/03/13/ranking-em-vulnerability-to-china/#axzz2vlzb3Xby. According to this, Chile, Columbia, Russia, South Africa and Peru are the most exposed, but few countries in Asia get off lightly, or Brazil for that matter. And while Australia doesn’t figure, of course, Perth should. And because of other concerns people have about the lack of demand in Australia ex-Perth, creeping weakness in employment, and looming instability in housing and mortgage markets, this is definitely a ‘watch-this-space’.
Looking at copper, half of China’s usage is accounted for by infrastructure and construction, and a further third by consumer and industrial goods. To the extent this reflects China’s development model, i.e. with an emphasis on fixed investment and exports, respectively, it is clear that economic rebalancing away from these sectors to household goods and services must entail a significant fall-out in terms of the commodity intensity of growth.
China’s consumption of other commodities also accounts for a hefty share of global production, though not as large as for base metals. In the case of non-renewable energy resources, the proportion is 20%, and for major agricultural crops, it’s 23%. (IMF, China’s Impact on World Commodity Markets, http://www.imf.org/external/pubs/ft/wp/2012/wp12115.pdf). China’s significance arises not only because its consumption represents such a large share of metals production, but also because of the intensity of its usage. So, for example, if you look at the IMF paper, you can see the consumption of base metals per capita over time set against real GDP per capita for a group of countries and regions. China commodity intensity has ben growing rapidly and is unusually high for a country at its stage of development, especially when judged against some of its peer group, including Brazil.
There’s also a murkier side to Chinese commodity consumption that hinges around the use of copper especially as collateral for loans, or access to finance – and also as a means of raising finance abroad and bringing it on-shore to spend or lend. In a nutshell, this revolves around the purchase of copper abroad, using trade finance, and subsequent sale generating a capital inflow. In reality, it’s more complicated but still classified as speculation. (see for example, a 2011 explanatory piece by FT Alphaville’s Izabella Kaminska, http://ftalphaville.ft.com/2011/03/15/514921/simply-amazing-commodity-collateral-shenanigans-in-china/, and more recent ones by David Keohane at http://ftalphaville.ft.com/2014/02/21/1778262/still-waiting-for-that-china-copper-unwind/, and Lucy Hornby at http://www.ft.com/cms/s/0/a8e4ed88 a9cc-11e3-8bd6-00144feab7de.html#axzz2vlzSk7Mr)
It is self-evident that if base metals prices fall far enough, all participants in the credit chains will suffer losses, and that if they fall too far, distressed sales could send stronger ripples through the heavy industry complex, and metals import sectors as well as to global producers. Add an end to the carry trade of raising cheap US dollar finance abroad, and you can see why a lot of people are talking – wrongly – about a Chinese Bear Stearns or Lehmans moment. It’s wrong because the consequences of what is more accurately a Minsky Moment are highly unlikely to compare with the financial implosion that erupted in the West in 2008/09. China’s financial system is state owned and guaranteed, the country is a net creditor with a high savings rate, and it has financial resources-a-plenty with which to recapitalise banks, and finance losses. But – and it’s an important but – there will be a cost in terms of growth, jobs and the pace of development, and poignantly to the whole rebalancing agenda. Someone, after all, has to pay for a banking crisis, and the household sector is the most likely to do so through further reductions in nominal and real interest rates precisely when China’s market aspirations call for the opposite.
Some people argue that short-term problems aside, the future for base metals remains rosy since China is so far behind the US, Europe, and Japan when it comes to per capita comparisons of electric power consumption, automobile ownership, rail track, highways and bridges and so on. This is a little naive, given that it neglects the important point that high per capita infrastructure levels have to generate productivity growth and be commercially viable. But you could make the case that the structural demand for steel, iron ore, copper and much else will in time sustain metal prices over the longer term. Perhaps.
What should concern us in the foreseeable future are the words of none other than Li Xinchuang, Executive Vice-Secretary of the Chinese Iron and Steel Association to the effect that over-capacity is so severe that it is ‘probably beyond anyone’s imagination’ (China Steel Overcapacity Beyond Imagination – Official, http://english.caijing.com.cn/2014-02-26/113960476.html). Also note that in a survey published late last year of 3,545 enterprises conducted by the State Council’s Development Research Centre, 71% of respondents said that overcapacity in iron and steel, aluminium, cement, coal, solar panels and shipbuilding was ‘relatively’ or ‘very’ serious. (Overcapacity poses major risk to China’s economy, http://www.globaltimes.cn/DesktopModules/DnnForge%20-%20NewsArticles/Print.aspx?tabid=99&tabmoduleid=94&articleId=828902&moduleId=405&PortalID=0). And if China is serious about what Premier Li has called a ‘war on pollution’, then commodity intensity of China’s economy and its GDP growth has already peaked.
Pondering these things, you could come away feeling that the ‘everyone is bearish about China again’ feeling at least has foundations. The thing we never know, though is whether China’s leaders, many of whom understand these circumstances only too well, share the view that they should grin and bear it, i.e. that there’s nothing they should or could do about them. From bitter and historical experiences, we all know the better time to take your economic pain is early, rather than ‘extend and pretend’ and deal with more complex and damaging economic outcomes later. Whether you take it sooner or later invariably comes down to political judgement and capacity. It’s too soon to say that China won’t blink at some stage, re-energise the economy with more infrastructure and housing spending, new credit creation, and perhaps even, Heaven help us – or emerging markets more to the point – a depreciation of the RMB thrown in for good measure as part of a stimulus programme. We must all hope they don’t blink, because the consequences of doing so will be ugly in Peking, as well as from Perth to Peru.