Tuesday, November 17, 2009

China hogging commodities?

Guambat is in his second read of John Mauldin's Outside the Box report for this week, and reckons he'll need another read or two to have it soak in to the dry sponge which is Guambat's brain. This week it is an eclectic piece from Eclectica November Fund Commentary by Hugh Hendry.

It covers a lot of ground, as does Guambat's not insignificant ruminative midsection.

The bits that stuck out to Guambat concern China, the US dollar and the Australian market's stock in trade, commodities. Some of those bits:
Ten years ago it was unthinkable that the dollar would prove so fragile. Recall that back then, when the euro was first launched in 1999, it promptly lost 31% of its value against the greenback. The subsequent reconstruction of modern China, though, intervened. In order to finance the emergence of a new economic superpower, an abundance of dollars was needed. Have no doubt that had we not had the dollar as a reserve currency, the rise of China would not have been as swift nor as decisive.

America's trading partners have come to rely upon the bounty of dollars necessary to recycle their trade surpluses and thus finance their growing prosperity. This was done even at the expense of domestic American job losses.

Do not forget that the Chinese could replicate equivalent currency baskets to SDRs at any moment. Instead, they continue to recycle almost three quarters of their trade surplus back into dollars. This is not coercion but simple commercial pragmatism. They know full well that neither Europe nor Japan nor Britain nor Switzerland nor the rest of Asia are willing to sacrifice the implicit loss of manufacturing jobs. They understand that it is only the US that is willing to embrace the benefits of comparative advantage that arise from international trade.

Another popular argument is that the emerging economies have to urgently diversify their immense dollar reserves. And so the Chinese are colonising the African continent in the pursuit of commodities and the Indian government has just agreed to buy 200 tons of the IMF's gold hoard.

Is this not a reincarnation of the 1980 trade of the brothers Hunt? It is hardly an exaggeration to suggest that China, for all intents and purposes, is already the commodity market. For despite providing less than 8% of global GDP, China accounts for more than half of the world's steel production and more than half of global seaborne iron ore freight.

Accordingly, China shares the same risk as the world's largest pension schemes. An over- leveraged American consumer does not return to his/her manic buying of old. As William White, former chief economist of the BIS, has argued:
Many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

The Chinese have opted, like the Hunt brothers did, to double up.

Much is made of the comparison between today's balance sheet recession and Japan's demise back in 1989. Despite their bubble never coming close to matching China's prominence in industrial commodities, the loss of Japanese economic growth in the 1990s was nevertheless a major factor in the waterfall crash in commodities. This plunge ultimately saw oil trade for as little as $10 per barrel in the next decade. Just consider how much more devastating the experience would have been had they gone very long the commodity market in 1989 rather than golf courses.

Over the last decade, each marginal dollar of debt has generated less and less marginal income. We knew that there would be a "zero-hour" for the economy when the creation of new debt would not contribute to GDP growth. The government's reaction to last year's demand shock has been to increase its own leverage. But, with the economy operating at its zero-hour, we believe this incremental leverage will actually have a negative impact. That is to say, the public sector will fail in its attempt to bring the economy back to its previous level of nominal GDP. In this scenario, the outcome will disappoint the market's expectations, which are rampantly bullish as evidenced by this year's dramatic re-pricing of risk assets.

Japan has championed both Friedman and Keynes. They have built bridges to nowhere and dropped Yen notes from helicopters for twenty years and still they have nothing to show for it. Clearly the additional return from Yen debt in Japan is close to zero and it exposes the nightmare of interventionists everywhere.

It all really comes down to your take on the ratio of total debt-to-GDP. If you believe, like I do, that it peaked in 2007 then the repercussions are enormous. The leverage does not necessarily have to come down (after peaking in 1932 at 300% it troughed 20 years later at 150%). Rather, it may well be that low interest rates allow the mountain of debt to continue to be serviced. This has been the Japanese experience to date. However, everything in our economic life exists at the margin, and the consequences of just maintaining the leverage constant would be a very low delta in nominal GDP growth. Consider that the Japanese, under these very circumstances, have managed to grow nominal GDP at just 1% compound since 1990.

This is why China's mad dash for commodities and its investment splurge this year is so worrying. The Chinese are building capacity to meet a world where US nominal GDP is $25trn in ten years time from its $14trn today. I fear they could be in for a nasty shock.

Consider the steel market. Now with China having been on such an expansionary tear, it may not surprise you to hear that finished Chinese steel prices today trade below their production cost. It is quite chilling to note that steel production in America is on a par with output back in 1938, when GDP was a mere 7% of its current size.

However, with an active steel futures market in China turning over $15bn a day (consult the Bloomberg page ), speculative fears concerning the dollar have overcome the paucity of industrial demand in the west.

Of course, it is not just steel. Consider the aluminium market. the aluminium situation mimics that of steel, but with an even mightier inventory overhang. Four and a half million tons reside at the London Metal Exchange, perhaps 20% of world ex-China annual capacity. It is probable that 75% of this surplus stock is accounted for by financial players exploiting a contango.

To make matters even worse, the Chinese have stopped importing and are eager to ramp up domestic aluminium production. They have the capacity to produce another 13mt annually, which is equivalent to 52% of global production.

Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. But clearly the consequences for corporate profitability are very poor. The alarming thing is that my opponents (see Ferguson et al.) believe that government bond yields are going much higher. Effectively, the world's bond vigilantes are going to punish the Fed and tighten monetary policy. It is almost as if the world's greatest speculators are agitating for their own demise. It is my contention that the leverage of the economy is only tenable if interest rates stay low and yet, whilst I believe some of them agree, they still fervently expect a rise.

The anecdotal evidence of the doubling up of US Treasuries with hard commodities assets has been reported around the web, but without any traction in MSM.

China’s Pig Farmers Amass Copper, Nickel, Sucden Says (Update1
Private investors in China, the world’s largest metals user, have stockpiled “substantial” quantities of copper as the government ramps up stimulus spending to spur the economy, according to Sucden Financial Ltd.

Pig farmers and other speculators may have amassed more than 50,000 metric tons, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, wrote in an e- mailed report after a visit to China. That’s about half the level of inventories tallied by the Shanghai Futures Exchange, which stood last week at a two-year high of 97,396 tons.

Sucden’s estimate underscores the difficulty analysts face in gauging metals demand in China amid increased speculation by retail investors, whose holdings remain outside the reporting framework undertaken by exchanges. Private investors in China also had as much as 20,000 tons of nickel, Goldwyn wrote.

“People who have nothing at all to do with the copper trade have been buying copper as a store of value, much like they would with gold,” said Jiang Mingjun, an analyst at Shanghai Oriental Futures Co.

The metals holdings by pig-farmer investors and other private speculators give “the impression that there is strong demand in China,” said Jiang at Shanghai Oriental. “But it is actually those who take a pessimistic view of the economy and are looking to preserve their wealth who are buying.

For more specific anecdotes, have a look at this post: Pig Farmers and China Monetary Inflation Are Making Brent Nervous. It includes pictures and anecdotes "excerpted from a China Central Television Channel (CCTV) program documenting private speculation and hoarding of metals throughout the country," together with a link to a Chinese version of the text. The blog post concludes,
I do not know how or when the base metal prices will re-equilibrate to the reality of end demand—whatever that is. What is obvious is that gold and now base metals have become speculative investments that in addition to being bought as hedges against inflation and a falling US dollar are the latest get rich quick scheme. The end result is that absent the faith that metals and markets are all headed higher, we here at Exploration Insights are finding it difficult, although not impossible, to find value in junior mining and exploration companies.

Hot money on the other hand is not.

Michael Pettis, in Asia EconoMonitor, looks at China's railroads as well as its pig farmers and comes away unimpressed with the state of the bally-hoed Chinese economic recovery.
This is a large part why many analysts are not impressed by China’s investment-driven growth. Not only is much of it explicitly aimed at increasing production, much of the rest of it is implicitly likely to reduce consumption.

Although not as particularly analyzed, some of the nagging doubts about the China-led global recovery are being expressed.

Doubts emerge on China's domestic growth
The emerging giant's demand for Australian iron ore and other commodities has been crucial to keeping Australia’s economic expansion on track through the financial crisis.

“They’ll continue to consume commodities at a higher than normal rate and that will be good for commodities,” said ANZ head of commodity research Mark Pervan. “But at some stage, there has to be someone using these commodities. And that is a risk.”

Looking at official statistics, a sudden drop-off in demand would seem to be the last thing for Australian resource companies to worry about.

Chinese industrial production grew 16.1 per cent in the year to October, according to the National Bureau of Statistics of China, in data released this month. The official data also showed heavy industrial output rose 18.1 per cent year on year.

But even these numbers have caused analysts to question the sustainability of China’s growth.

At this pace, heavy industrial output would be doubling every four years, said Fat Prophets commodities analysts Nick Raffan.

“If it held at that level for a decade, you'd be looking at four times the current level of imports in eight years time, and I don't think any country is ready for that in terms of infrastructure."

Ah, yes. Those inscrutable official Chinese statistics.

Meanwhile, the US and China are playing a game of pot and kettle. The US wants China to devalue its yuan, which would lead to some unpopular labor issues as its exports become less competitive, and China wants the US to raise its interest rates to strengthen the dollar, which would implode whatever there is in the way of green shoots in the US housing and other credit markets, not to mention the strung out commercial real property sector and the overleveraged private equity guys.

Obama Prods China on Yuan But Hu Silent on Issue

China Trade Ministry Says Yuan Gains Call ‘Not Fair’ (Update1)

A Dollar Warning From Asia
Federal Reserve officials sometimes sound as if their only worry is the domestic U.S. economy, but their gusher of dollars is starting to have serious consequences for the rest of the world. Nowhere is this more evident than in Asia, where President Obama is getting an earful from leaders this week about what all those greenbacks are doing to their economies.

Many of these nations peg their currencies, formally or informally, to the greenback. So they are getting a huge dollar liquidity kick from the carry trade, in which people borrow U.S. dollars at exceptionally low U.S. interest rates and invest them for higher returns elsewhere.

As a result, Asia's stock markets are outstripping U.S. and European bourses by a country mile. Shanghai alone is up nearly 80% this year-to-date. Hong Kong property is climbing through the roof, with one recent apartment sale mooted at $57 million. Foreign investors are even getting enthusiastic again about one of the most corrupt emerging markets around—Indonesia—and dubbing it the "new China."

Lest we forget, it was the use of the cheap-ass yen as the beast of burden for the carry trade that was instrumental in propelling the West's markets to bubble bursting proportions, just a very few years ago.


John Mauldin has also revisited the world's experience with the Yen carry trade in his Thoughts from the Frontline, Nov 20th. His conclusion is that the dollar has been down so long it looks like up to him, maybe, perhaps, sometime or other or not:
Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears.

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