Commodities watch

There's been a number of reports about projected oversupply and weak demand for various commodities in the last week due to China slowdown concerns, including zinc, steel, sugar, stainless steel and copper.  Interestingly for copper, Chinese traders are now reported to be re-exporting excess stocks of copper which had been acquired for speculation and financing.

Copper financing to slow?
There are two aspects here; firstly the giant inventories of copper which have been sitting in Chinese warehouses for the last year or so and second, future expectations of price declines (hence the desire to ship now).  On inventories there was much comment about the excess supply of copper in China last year.  Holdings data were unreliable and diverged with market estimates.   The divergence (and the distortion it caused on pricing) was noticed back in 2010 and was initially seen as being due to trading strategies, which sought to profit from the difference in prices between the London and Chinese metals exchanges or to construct hedges against inflation or currency risk.  One story by Bloomberg back in 2009 identified that pig farmers in China were acquiring stocks of copper and other metals to offset Chinese monetary stimulus measures.

But the inventory story was more complex.  During 2011 it emerged that stocks of copper had also been used as cheap collateral for loans to companies and property lenders which were struggling to get loans from regular domestic Chinese banks as Chinese banking authorities sought to restrain credit in the overheated economy.  Such financing contained increased risks and during the year Chinese regulators sought to slow down such financing schemes, closing down some activities directly.

Fast forward to 2012 and speculation has continued, as this detailed investigation by Reuters explains:

At Shanghai's Waigaoqiao port, a sprawling 10 square kilometer free-trade zone, thousands of tonnes of copper cathode plates sit in stacks turning green after years of exposure to the elements.
"They don't get shipped to end-users because they were bought for speculative reasons," said a warehouse manager at the port, who would only give his surname Zhu, standing in the port's control room overlooking yards piled high with metal....

And regulators have only been partly successful in restricting this market.  As the Reuters article points out, use of copper financing schemes is popular while credit is so contrained in the Chinese economy and there are limited other regulated sources of finance.

So why the sell offs?  On the demand side it seems that copper traders also anticipate falling prices and demand this year.  In particular, investment bank China International Capital Corporation indicated in an interview today  its expectation of slower demand growth of copper as the Chinese government maintains restrictions to slow the property market (while copper futures fell on inflation expectations earlier in April).  It seems possible copper may follow aluminium which has had a "profitability downturn" as the industry is struggling in China amidst overcapacity with CICC predicting a quantity surplus this year.  As has been seen in other markets for aluminium, conflicting interests between users and speculators may coalesce around warehoused stockpiles so there could be more comment and conflict arising in the copper warehouses of Shanghai.

Holding onto copper...for now

Rise of the Redback

This week saw the launch of the widened trading band of the Chinese currency, the Yuan (Renminbi) which is part of a number of financial liberalisation measures aiming to increase the convertibility of the Yuan and to help open up the Chinese economy and bolster economic growth.  A fuller review will be conducted in the future but it is worth pointing out that copper financing may continue to be encouraged by flows of speculative capital or "hot money" which can fund commodity-based trades and that until full convertibility exists between domestic and offshore yuan deposits, traders seek to profit from any mispricing.

Initial feedback suggests there has been no increased volatility in the currency during the first days of the new regime, but a statement from an official at the State Administration of Foreign Exchange, indicates they are remaining wary of further inflows.

China's adventures

Intrigues and dramas
This week saw news from China dominating broadcasts as political and economic affairs escalated.  The cracks in Party unity were exposed following the arrest of Gu Kailai for the murder of Neil Heywood, a British businessman who had assisted her and her husband, Bo Xilai, the former mayor of Chongqing and popular politician who was dismissed from the Central Committee and the Politburo of the Chinese Communist Party (following his dismissal from the position of mayor of Chongqing).

News services struggled to delve into the political circumstances underlying Bo's dismissal, subsequent reports have looked at allegations of corruption involving Bo and his associates, long term rivalries with other factions in the ruling elite and the significant business dealings of his wife as well as the circumstances of Mr Heywood's death.  Needless to say there was as much intrigue and mystery as a feudal saga.

One way to navigate the landscape in China (c) Chooseco LLC

An interesting economic statistic
Meanwhile there was much talk about the lower than expected first quarter GDP figure of 8.1% released on Friday for which there wasn't a consensus.  The range of views on the GDP figure included:


i) the Chinese economy is re-accelerating: DBS Bank of Singapore seem to be the strongest proponent of this view, mostly relying on GDP and inflation growth.  Definitely too bullish - Zerohedge, the economics website, tweeted that DBS overestimated the GDP number at 9% in an advance research note (and labelled DBS a "3rd tier research firm").  DBS may have a point regarding inflation (see below).

ii) the Chinese economy is growing, but at a slower pace:  Richard Jerrum, economist at the Bank of Singapore painted a favourable picture of the Chinese economy based on low inflation, sufficient capital investment and decent property growth (with means to stimulate) in an interview with Reuters.  The World Bank echoed this in its favourable report on Thursday which cut its growth forecast to 8.2 per cent for 2012 emphasising the success so far in cooling the property sector and remaining available tools for the central bank to inject liquidity.  This would be the case for a "soft landing" which the World Bank predicted as highly likely.  And Standard Chartered's Stephen Green also favoured a soft landing, expecting continued capacity for growth across the economy, a strong labour market and broad scope of tools available to the central bank.

The problem with the soft landing view its critics say, is that the underlying assumptions are simply not true, i.e. inflation is high, the property market is in a slump and the central bank does not have as many tools at its disposal (or as much scope to use them).

iii) the Chinese economy is contracting or not growing:  One key point for the hard-landing proponents is that there is simply too big a credibility gap to take statistics of the Chinese economy at face value.  The FT Alphaville blog published a short but interesting article (inspired by the above book on China) detailing a number of recent statistics which showed significant variation depending on their source or were significantly inconsistent with related statistics. The notable example was the Purchasing Manager's Index (a measure of manufacturing activity) - the official Chinese figure showed expansion while HSBC's figure showed contraction.

There was equal scepticism from some towards the inflation figures (via the Consumer Price Index which was recorded at 3.6% for March (announced at the start of the week). Not only was this number higher than expected, but Patrick Chovanec commented in an interview with Bloomberg prior to the release that a figure of such magnitude seemed vastly understated and as evidence he noted the 33% increase in the cost of his milk supply (although on Twitter he added that he thought it was due to increased delivery charges rather than the milk itself!).  More seriously he noted that in all his recent discussions with business people across China he did not come across an outlook of low inflation and higher growth consistent with a soft landing.

Meanwhile although Stephen Green's team have done some updating research which showed a recent pick up in construction activity and improvements in sentiments of developers this was tempered by research suggesting that activity is being driven in a large part through financing from less regulated shadow banking, including loans from investment trusts, which may not be a sustainable source of finance. And as mentioned in the FT Alphaville note, this week saw what could be the first bankruptcy of a property developer in China.

And a couple of articles in Reuters pointed out that tools of the central bank to stimulate demand had already been brought into use since 2011 (through cuts to the amounts of capital the banks hold, the required reserve ratio, in 2011) with resulting significant amounts of new lending likely to complicate the central bank's monetary operations in the future.  Jeremy Stevens, an economist for Standard Bank in Beijing summed up the mood:

Overall conditions seem to have stabilized, but it wouldn't take much to push sentiment in the wrong direction...

In any case due to factors like the excessive extent of local government debts and the shadow banking sector it was argued by James Kynge in the Financial Times last year that the powers of the central monetary authorities to control the supply  and price of credit are "tenuous".  A couple of others were more upfront - Satyajit Das wrote a follow-up piece to his last effort in the Australian media where he referred to recent Chinese growth as an "illusion", while economist Jim Walker in an interview with Reuters stated "economies don't have soft landings".

iv) the Chinese economy has reached the bottom and is rising again (though not necessarily fast): This view was put forward by a number of people who considered the possibility of a hard landing but had felt optimistic with recent figures. Some examples included Karine Hern of East Capital (from the property perspective) and Zhiwei Zhang of Nomura who revised his bearish estimate on GDP growth this week on a view of increased economic output and lending.  As the Beyond Brics post noted (and was noted elsewhere) the significant growth element of consumption included government spending which may have distorted the measure showing stimulus rather than genuine growth.

The verdict from the markets was negative - stockmarkets worldwide slumped on the expectation of lower growth going forwards, especially as the GDP figure was the lowest comparatively in a number of years.  Noel Roubini's report picked up on this and in a tweet he commented that the GDP figure may in fact have been 6.9%.

Unlike in the adventure books where the reader can flick through to see what outcome will occur following his choice, we will have to wait and see.

An economy falling short?

The 4 billion dollar question
Like other emerging markets China is affected by significant levels of corruption and fraud across government and private enterprise.  Many different misdeeds have been reported in recent times, including endemic seizures of land from farmers and individual owners and theft of funds by government officials and employees from ministry coffers and state-owned enterprises (to the tune of $123 billion since the 1990s and more recently an alleged $2.8 billion from the Railways Ministry).  Premier Wen Jiabao recently told the State Council that corruption was the greatest danger facing the ruling party, while in his piece on land seizures for the BBC Damian Grammaticas pointed out that the combined wealth of delegates at last month's National People's Congress was ten times that of the US Congress.

Last year saw the rise of the China short sellers, a group of analysts mostly based in the US, who successfully targeted Chinese companies with overseas share listings - publicising evidence of fraud and/or inaccurate accounting and then profiting from short positions when the prices of the respective companies' shares fell.  One of the most notorious China short sellers, Carson Block (through reports of his company Muddy Waters Research) helped trigger the collapse in share prices of a number of Chinese companies, most notoriously with Sino-Forest Corp., which filed for bankruptcy last week.  Not giving up without a fight, Sino-Forest sued Block and his research outfit for defamation seeking $4 billion in damages and costs, questioning Block's tactics.

Block, confident the defamation action will fail took time out with CNN to announce that he had turned his focus closer to China - to Chinese companies listed in Hong Kong rather than in the US or Canada.  There appear to be similar signs of concern as was for the short sellers' first round, including  auditor resignations, so expect more of the same.  Interestingly there were also a few soundbites on the general state of the Chinese economy which Block called a "fixed asset bubble".

A solid foundation...on the world's newest and highest suspension bridge in Hunan

What is concerning about the short selling episode is there seem to be many of the same factors as were present in the US housing crisis of 2007-8, including failures in regulatory oversight, manipulation of obscure legal structures, failures by professional advisers, greedy investors, outright fraud and, in the end, significant value destruction.  An investigative report by Bloomberg last year illustrated the rise of the short sellers -  starting at least as early as 2009 when they started to scrutinise  the public accounts of certain Chinese companies which had been able to list their shares in the US and Canada without preparing a full disclosure.   

The trick the Chinese companies had used to list in the US was the process of a "reverse merger" (or reverse takeover), pioneered back in the early 2000's, involving the Chinese company acquiring an empty US shell company which had a small sharemarket listing enabling the combined US-Chinese entity to sell further shares.  It was cheaper than the Chinese company listing itself and involved less scrutiny.  And as detailed in this Reuters special report, a whole industry of advisers arose to facilitate the Chinese companies' speedy entry into the US capital markets:

...That industry hinges on a handful of leading "shell brokers" such as Halter who purvey paper companies; investment banks who specialize in financing a firm after a reverse merger; and auditors, usually small shops, who are lightly regulated in the U.S.--and not at all in China and Hong Kong...

While the regulators have clamped down on the use of structures like the reverse merger, the advisers, including the auditors remain liable to accusations of negligence and even fraud.  One key adviser, Benjamin Wei, whose firm New York Global Group structured a number of such deals was reported to be the subject of an investigation by the FBI in January, while auditors Deloitte, KPMG and Ernst & Young have faced scrutiny for their signing off of the accounts, in Deloittle's case, in respect of Hong Kong listed companies aswell.  An interesting piece in FTAlphaville gave some details of current attempts to deal with management conflicts at one company as outlined in letters to the shareholders.  Meanwhile regulators struggle for other solutions to protect investors.

Getting the numbers wrong

A few news reports appeared towards the end of this week suggesting other people looking at the China market are also making miscalculations in their assessments of certain companies and industries.  Reports of oversupply (in whole or in part related to the Chinese market) appeared in relation to various commodities including alumina, logs, coal, iron ore and goods and services like hotel rooms in the resort city of Sanya and automobiles.

Looking for growth (Qilai Shen/Bloomberg)

It will be interesting to see what the second quarter will bring.