China and Commodities - January 23rd, 2011
The London Brief
China and Commodities
January 23, 2011
This past week saw commodity prices under pressure because of higher than expected Chinese economic growth. That seems counter-intuitive at first. But if you are growing at a 9.8% rate versus a 9.4% estimate from economists and an 8% target, and inflation is surging, the impetus is to tighten liquidity.
There have been many precedents where China has over-done its tightening causing a "hard landing".
Given China's importance to the global economy and commodity prices, let's spend this week examining the different near-term scenarios ahead for China.
Will China Have a Hard Landing?
Fitch released a report in late November called, "The Impact of a China Slow-Down on Global Credit Quality". Working with a consulting group called Oxford Economics, they model a scenario where China's growth rates slow to 4.7% after a sharp tightening cycle. They estimate commodity prices would decline 20% in such a scenario with negative implications for global credit markets. Chinese property prices would fall 15%. The Chinese banking system could need to be recapitalized. In a recent report, Stratfor said the Chinese banking sector is sitting on $900 billion of non-performing loans. Others cite similar types of numbers. Centralized lending mandates and incestuous ties between the banking system and local government officials are a recipe for poor lending.
The International Energy Agency (IEA) said in their mid January report on rising oil demand trends: "More importantly, as far as oil demand is concerned, is whether such [Chinese] administrative measures will succeed in curbing inflation - or whether the government will be obliged to tackle the main cause of inflation, namely runaway bank lending, and by doing so inadvertently engineer a hard economic landing... if it were to occur, it would surely curb oil use sharply."
Generally China has shied away from rigorous tightening since the financial crisis. But a number of activities signal a much more aggressive stance towards the banking sector. Chinese banks have been given until the end of this year to bring onto their books CNY1.66 trillion ($252 billion) in off-balance sheet lending. The loans will need to be brought on-balance sheet at a rate of 25% per quarter. The People's Bank of China (PBOC) said Thursday only CNY420 billion ($63 billion) of the CNY2.08 trillion ($316 billion) sitting off bank balance sheets was recognized at the end of July. They also announced measures that trust firms must have risk capital that accounts for at least 10.5% of their outstanding trust loans issued under cooperation with banks. Trusts were a common vehicle by the banks to get around credit restrictions.
Chinese repo rates fixed at 7.3% on Friday after a 6.03% close on Thursday and a 2.56% close on Monday. This is the largest tightening in history ahead of the Chinese New Year (usually there is bank hoarding around this time of year).
The danger is that absent runaway bank lending, there could be a hard landing as property prices fall from a lack of credit.
Scenario 1: Keep Things the Same
Offsetting credit contraction is wage expansion. Guangdong was the latest province to increase its minimum wage 26% year on year. So there is more cash entering the system through higher wages. There is also CNY240 billion ($36 billion) of non-bank lending or 5.6% of total loans. The PBOC believes that the true scale of informal and underground bank lending is much higher. This lending could expand to help offset the decline in bank credit.
While inflation is rising, it has not yet created extreme social tensions. A "hard landing" is much more likely to create such tensions. China can muddle through with existing policies through the year by utilizing a combination of price controls and some appreciation of the yuan to keep inflation in the mid single digits.
Scenario 2: Appreciate the Yuan
China has a better alternative to a hard landing: a higher than expected appreciation of the yuan. Food prices and oil prices would drop in yuan terms and ameliorate inflation pressures. China is reluctant to do this because state owned enterprises (SOEs) and their over-capacity issues would become more evident. They would have to lay off workers. But it's better to provide transition capital to the workers laid off by SOEs and figure out a way to reallocate these human resources. China is experiencing labour shortages in many areas.
A higher yuan would also appease criticisms from the international community. Guido Mantega told the Financial Times that Brazil was preparing new measures to prevent the further appreciation of the real and would raise exchange rate manipulation at the WTO. “This is a currency war that is turning into a trade war”. Brazil accused the China and the U.S. of being the worst offenders. “We have excellent trade relations with China… But there are some problems… Of course we would like to see a revaluation of the renminbi”.
The Wall Street Journal reported on three signs from Hu Jintao's meetings in the U.S. that point to a change of stance with regards to exchange rate policy. First, China did not use the language of "maintaining basic stability at an equilibrium rate". In the past, this language had signalled that China was only prepared to tolerate 0.5% moves in the exchange rate (basically nothing). Second, Chinese officials talked about the importance of its broader goal of transforming its economic development model and the exchange rate. Finally, in the U.S.-China statement, China noted exchange rate flexibility "to promote the transformation of its economic development model".
A higher exchange rate would allow the U.S. and Europe to expand their export regimes and utilize more of the excess capacity in their economic systems.
Scenario 3: Hard Landing
China's monetary policy is ad hoc and there have been examples of over-shooting in the past. However, those historical instances were when there was no strong domestic development model to transition towards. China was arguably less mature in its use of economic tools. Today China is attempting to internationalize the yuan which can only truly happen if China allows for an exchangeable currency. Also whenever policy measures seem to overshoot, China immediately unwinds whatever they did.
Does the tightening of Chinese repo rates indicate that China is being tough? Possibly, but it also seems to be triggered by technical issues. Morgan Stanley noted that on Tuesday the PBOC suspended bill issuances and regular repo operations. Liquidity surged during the week to CNY249 billion ($38 billion). However, the latest interest rate hike locked up CNY350 billion ($53 billion) of liquidity creating a CNY100 billion ($15 billion) short-fall. The Chinese New Year is February 3rd through 9th and market liquidity generally becomes tight during this period as people withdraw cash from deposits. The PBOC responded by re-launching reverse repos last Thursday (about CNY50 billion ($7.5 billion)). The reverse repos were to specific banks indicating there are particularly weak institutions in the system. If the PBOC continues to tighten, there will be a vulnerable bank and it could force high financing rates and potentially a hard landing. But it's hard to draw a firm conclusion on this until after the New Year holiday and it would be surprising if the PBOC did not undertake operations to lessen the liquidity squeeze if it persisted past the New Year.
China and Oil Prices
If China does not have a hard landing, then oil prices could go parabolic. Current oil demand was estimated at 87.7 million barrels per day (b/d) for the end of 2010. The IEA estimates OPEC has about 5 million barrels per day of extra capacity. Europe and America are recovering, so there should be no declines for 2011. In fact, there is some worrying evidence that perhaps oil demand may be going up. The IEA estimates that global demand could go up 1.6% in 2011. This would be 89.1 million b/d. Oil supply should only total 88.6 b/d by year-end 2011 but OPEC will be able to bring on part of its spare capacity to bridge the small gap. OPEC already is drawing on that a bit today as they say they now have less than 5 million b/d capacity.
However, the IEA seems too low on oil demand. The mid January IEA report showed that China's demand increased 12.6% year on year in October. Asia's oil demand has been growing at a blistering 7% pace mainly due to China. If we assume no growth in the OECD, 7% in Asia, 4% in the Middle East, 1.5% in Africa and 1.0% in South America, we get to a 2.6% increase in oil demand or an increase of 0.8 b/d from the 89.1 million b/d estimate. This would shrink OPEC's spare capacity to about 3.5 million b/d. It isn't difficult to now extrapolate that within 2 years later there is not enough supply to equal global demand. This includes 1% growth in non-OPEC oil supply, which could be aggressive.
Most importantly, there is no buffer for shock. If Iraq has sectarian strife that halves oil production, that is 1.2 million barrels/per day out of the system. The excess capacity is also a bit murky with most of it coming from a secretive Saudi Aramco. There is a lag before they can even bring it on. If OPEC misunderstands oil demand, the market could easily extinguish the spare capacity. We are entering a period where an oil shock is quite a high probability particularly towards year-end.
Summarizing the Scenarios
To summarize then, there are three Chinese scenarios in the near-term:
Scenario 1: China keeps things more or less the same with tighter bank lending but nothing draconian and some yuan loosening within market expectations (65% probability).
Justification: This has been China's policy the last few years and fits with its political theme of gradual change. China is worried about social instability that could be engendered by a hard landing. The next transfer of leadership occurs in 2012 and there is a traditional reluctance to rock the boat. Many of the decision-makers own property. Small upward appreciation in the yuan and price controls could stem inflation for the short term.
Commodity Price Impact: Very positive; food and oil price inflation should continue
China raises the value of the yuan to smooth inflationary pressures (20% probability)
Justification: If China feels inflationary pressures are getting out of control, it would be better from an economic perspective to go this route rather than create a hard landing from restricting bank lending. Sharp yuan appreciation could mean the PBOC needs to be recapitalized but if Hu Jint ao truly feels the dollar's days are numbered, best get on with it. The Chinese can not truly internationalize the yuan until the yuan becomes freely tradable. Given the leadership transition coming up, I think the leadership will want to avoid bankruptcies or restructurings in state owned enterprises so I feel there will be a reluctance for a sharp currency appreciation until after the power transfer.
Commodity Price Impact: Positive in dollar terms; deflationary in yuan terms
China tightens bank lending and it overshoots creating a hard landing (15% probability)
Justification: China has inadvertently created hard landings in past monetary policy decisions. Chinese policy-makers still don't want to change the peg. The PBOC may pressure for bank tightening worried about the losses they will take from exchange rate liberalisation. However, hard landings mean social tension, which you do not want during a leadership change.
Commodity Price Impact: Fitch says 20% down. Although I am sceptical about macro-economic models, I think it's probably accurate from an order of magnitude perspective. Agricultural commodities will also get hit.
The Chinese visit to the U.S. seemed to go well. Even Coke's CEO Muhtar Kent's gaffe when he toasted the Chinese President with "kanpai" instead of "ganbei" was met with laughter rather than insult.
In the meantime, I'll leave you with the following anecdote:
Madoff behind bars: Day One Prison roommate: Lemme get this straight, I give you one cigarette and next week you give me ten?!! Madoff: It’s that simple
London, January 23rd, 2011