Xie: Chinese Banks Funding Commodities Speculation, Casting Doubt on Recovery

Andy Xie, writing for Cajing, questions the durability of China’s recovery. He argues that much of hte upsurge in lending, which was one of the developments that cheered commentators, is fueling asset speculation, in this case in commodities, Reports this spring has suggested that as much as a third of the new lending was going into the stock market.

Observers have argued that China is stockpiling commodities as a diversification strategy., Xie adds an important tidbit to this equation, that banks are lending against commodities, using mortgage-like structures, and argues that the current price levels of commodities are a function of easy credit, not fundamentals.

From Cajing.com.cn:

China’s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

Commodity prices have skyrocketed since March….The weak global economy can’t support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.

Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.

Financial demand alone can’t support commodity prices. Financial investors can’t take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.

Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn’t work.

For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China’s size. They’ve made everything open to speculation.

There’s little doubt that China’s bank lending since last December has driven speculative inventory demand for commodities. Chinese banks lend for commodity purchases, allowing the underlying commodities to be used as collateral. These loans are structured like mortgages.

Banks usually have to be extremely cautious about such lending, as commodity prices fluctuate far more than property prices. But Chinese banks are relatively lenient….

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term….

The iron ore market has been brutal for China, partly due to China’s own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly.

For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008…..

China’s local governments have been obsessed with promoting steel industry growth….But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China’s steel industry is structured to hurt China’s best interests.

As steel demand collapsed in the fourth quarter 2008 and first quarter 2009, steel prices fell sharply. That should have led to a collapse in ore demand. But the bank lending surge armed Chinese ore distributors, giving them money for speculating and stocking up….

What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business…

As the economy weakened in late 2008, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money may have flowed into asset markets. It is part of the phenomenon of the private sector withdrawing from the real economy into the virtual one.

It’s worrisome that businessmen have become de facto fund managers and speculators. This happened 10 years ago in Hong Kong, and since then the city’s economy has stagnated. Some may argue that China has SOEs to lead the economy. However, private companies account for most employment in China, even though SOEs account for a larger portion of GDP. Now, the government is spending huge amounts of money to provide temporary employment for 2009 college graduates. If private sector employment doesn’t grow, the government may have to spend even more next year. The government is using fiscal stimulus and bank lending to support economic recovery. But the recovery may be a jobless one. China needs a dynamic private sector to resolve the employment problem.

We are seeing a dark side to the lending surge as commodity speculation hurts the economy. More lending may lead to higher commodity prices, threatening stagflation. Cheap loans benefit overseas commodity suppliers, not necessarily the Chinese economy. Lending policy should consider this self-inflicted damage.

Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.

This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.

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10 comments

  1. Snoring Beagle

    I like this fella. I like the way he writes and the way it passes through my bullshit filter.

  2. bb

    i am perplxed. why commodities are bubbling again according to Xie?
    is it not true that commodities are what we eat, use to heat, dress ourselves, take us around?
    is it not true that commodities are what governments cannot produce out of thin air?
    why should raw goods stay cheap relative to unwanted and oversupplied finished goods like homes, cars, mattel toys etc.?
    all those have to be recycled to make any use of them.

  3. skippy

    Did China shoot it self in the foot buying/stock piling commodity's, hence giving the Australian mining sector a bump, right when they were negotiating with Rio Tinto. They defiantly want a hand in price determination.

  4. Doc Merlin

    Wow someone who doesn't shovel the keynesian (sp?) BS. Your arguments go from a much better direction.

    While I am not positive that I am convinced, you definitely influenced me. I will have to check some of the commodity companies I own stock in and see what their production costs are. Also if these prices are truly purely speculatory, we should see a lot of selling on the side at lower prices to people who are not willing to pay inflated Chinese prices. Time to do some research.

  5. Independent Accountant

    YS:
    I see something else. China is not buying commodities, but selling dollars and putting the proceeds in anything but paper. China has decided the dollar is doomed and is getting out now to preserve some value out of its dollar hoard.
    Errata: gold is $936 per Troy ounce, copper, $2.24 per pound. These prices are $30.10 and $0.00493 per gram, a 6,105 to 1 ratio. Therefore copper is 1 / 6,105 as valuable per unit weight as gold. 5,000 times less valuable means copper was 1 – 5,000 = -4,999; -4,999 X $936 = -$4,679,064 per ounce, a negative price.

  6. mxq

    There is plenty of data to support this…whether it be "strategic" or "private" speculating…either way, its hording:

    Chinese imports on a volume basis (per JPM):

    As of April (year over year):
    Copper: +148%
    Iron Ore: +33%
    Aluminum: +2107% (not a typo)
    Coal: +167%
    Oil: +14%

    There is no possible way they are actively utilizing (aka generating genuine demand) for those commodities with exports down a massive 25% and power generation down 3-4%.

    In fact, Bloomberg reported:

    "China’s State Reserve Bureau will probably stop buying copper, pushing down prices after a 63 percent rally this year, according to a trader at Zhejiang Honglei Copper Co…China’s demand will fall in the next quarter and imports will decline…“SRB’s purchases are coming to an end,” Zhao said. Prices have rallied and SRB has met its stockpiling target, he added, without elaborating…“Even with the stimulus package, Chinese copper demand is unlikely to grow beyond 10 percent this year,” Zhao said. Annual demand has expanded between 10 percent and 20 percent in the past five years, he said."

    Just like distillates during the first half of last year, the SRB is hording commodities like there is no tomorrow. All the more reason to believe Xie's assertions.

    The point is, what we have seen in commodities over the past 6 months is a mirage. Real, end-demand for this stuff just isn't there.

    Furthermore, commodities are extremely volatile as an asset class. Doubling and halving every six months is way more risky than the dollar, which might depreciate 15%-20% over the long-run. That's one of the reasons why i'll never understand why commodities are so hot.

    (no positions)

  7. George C. Shinopoulos

    I don't see China's action in stockpiling natural resources as speculative. Rather, I see the continued investment by China in the US dollar as speculative. Chinese investment must increase the price of some asset, you pick which ones.

  8. Independent Accountant

    GCS:
    That's my point. The Chinese see the dollar as a speculative piece of paper, not something which will retain its value over the long run like commodities.

  9. bob

    The commentators I listen to most on China do not make much of the chinese posturing on the "paper" of the united states. The US dollar is still way ahead of anything else they can buy in China. Its major value coming from the fact they can get the dollar out of china. China does not trust china. The Chinese, and the rest of asia trust china less than the US. The US may be bad, but the US dollar market size and scope is so far ahead of anything else that it makes an alternative at least 20 years away, in my opinion.

    China may not like the dollar, but their other alternatives are worse.

    On commodity speculation. Most commodities have a shelf life. Food that is 5 years old is not food anymore.

    Iron ore or other industrial commodities have a negative real yield, they cost money to store. In a crowed place, the cost to store them increases.

    China is taking a snow storm mentality, they are stocking up on what they are going to need eventually, they don't have any more productive way to spend the dollars.

    "The Chinese see the dollar as a speculative piece of paper, not something which will retain its value over the long run like commodities."

    It is not a mutually exclusive situation. Commodities do not always retain their value over the long term, there are plenty of examples of that.

    This is a common logic trap that the chinese banks are falling into. "Well, they are buying commodities, we can give them a loan for that, worse comes to worst, we can sell the iron ore and get the money back." At what price?

    How much is a pile of Iron Ore going to be worth in a country that has been stockpiling it and really has no productive demand for it? How much are the banks really going to be able to get for it if/when the loan goes bad?

    The only people who need iron ore are people selling steel. China has a long history of subsidizing the steel industry, and dumping product onto the world markets when it needs to get rid of it. How much do you think those state owned companies are going to be paying for iron ore to make steel that they are selling at a loss?

    If I am China I can also "take" iron ore from you, and let you subsidize the companies I want to keep alive. Shipbuilding is already being subsidized there.

    Its only worth what you can sell it for, and for at least the near term, that sale will take place in dollars. Sure there are things that get bought and sold in other currencies, but all of that is on the margin. The dollar may be bad, but it is still the best that exists.

    The thought of the people who 5 years ago were flag waving "ultra-americans" now calling the dollar BS is so funny to me. I am not now, and never will be half the "american" that you are. You may be right wing, but you were not right then, you are not right now, and you continue to demonstrate your clear lack of attachment to reality. Horay Mr. Murdock, the Australian ultra-american.

    Yes, we do have very serious issues with the our fiscal and monetary outlook, but we are still the least worst choice. Sometimes, that is all it takes.

  10. ultarnerd

    Hi bob.
    No I do not agree, I do believe that the US dollar is also a speculation.If you argue its less risky than other currencies well maybe I do not really know and do not care as I have put most of my money into silver and a bit of gold.
    Its a risky one too.Gold can go down but dollars can go to zero and stay there never recovering.Copper and lead etc should go down too but they are not also money and that's where gold and silver differ.

    Its too much for me to print it all here so look up c-gold and goldmoney.com and do a Google search to find out how the US has been hostile to these company's providing a competing form of currency to the US dollar especially if they are US located.

    Also see the forum http://marketwatching.forumup.co.uk/index.php?mforum=marketwatching.
    These posters used to hang out on the Marketwatch blogs but recently created this alternative site due to claiming they were unfairly censored.
    Believe me this whole thing about gold and money wreak of conspiracies.I have lots more to say on this but need to be doing other things but everyone should be protecting themselves with at least some money in gold, just in case.If I save a few people then my time has been well spent.

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