Ending a super-cycle

Metals update
Following the last post there were some more signs of China-related noise in the copper and commodities markets.  The ever vigilant FT Alphaville team reported on a note out from Standard Chartered detailing their visit to a warehouse in Shanghai which was stuffed to sinking with copper and aluminium (with some revealing photos).  Meanwhile there were reports today of new research from Nomura's China metals and mining analysts which found that after adjusting for GDP (rather than usual per capita bases) they predicted flat or low growth in China for metals.

As always, the picture for commodities is not unanimous, with teams at RBS and Barclays Capital positive to bullish on prospects for the materials sectors.  But as reported previously there do seem to be growing distortions in the commodities markets.  For the copper market, this was discussed in detail by BBC Radio back in 2011 (who spoke to industry users, staff at bursting warehouses and analysts at both bullish and bearish institutions) while FTAlphaville recently had some helpful background on unusual moves in the copper and oil markets.

Looking across different reports there seem to be four factors which could have been driving the stockpiling of metals in China (until recently):

i) domestic loan collateral and financing schemes: As set out in the last post, Chinese financial authorities have tightened the limited availability of bank credit making alternative financing schemes through informal lending popular.  Many schemes use warehoused copper or other metals as collateral for loans.

ii) schemes to arbitrage price differentials in commodities markets:  There has been specific comment on the price differential between the London and Shanghai prices for copper, and that arbitrage trades can impact on the price.  As explored in the last post, market based schemes can involve "re-export" of surplus copper from domestic warehouses in Shanghai, but in fact the copper only travels to other bonded and private warehouses which hold non-domestic (bonded) stocks.

iii) schemes to manipulate market prices of commodities: As explained in this piece by Reuters, it is a "time-honoured technique" amongst commodity traders to use private and non-disclosed inventories to restrict the apparent (and official) supply of a commodity, gain control of a substantial portion of the remaining "official" supply and then squeeze prices higher.  The article mentions current suspicions that certain traders are engaging in the practice and shifting large volumes into private warehouses, "off-warrant", creating the appearance of tight supply.

iv) schemes to arbitrage differentials between domestic ("onshore") and foreign ("offshore") exchange rates: Although China is undergoing financial liberalisation, with the movement to a more flexible yuan/renminbi rate, there still exist discrepancies between deposit rates and currency prices which can be exploited with stored metals used as collateral.  The previous Reuters investigation gave some detail on this.

End of the commodities super-cycle
With such distortions as excess inventories and incomplete price discovery it is not surprising that headlines have referred to an end of the commodities "super-cycle" - the continuation of high commodity pricing trends beyond levels suggest by fundamental indicators and drivers (which included sustained high Chinese demand).  An article in the Australian mentioned the example of one mining company topping up its own production with market purchases to meet demand, while the Financial Times considered outcomes for mining sector investments following a downturn.

Aside from the immediate hit to shareholders, there could be a couple of other impacts.  First it could be argued that in addition to the commodity traders, a number of large banks, including JP Morgan, Barclays and BlackRock could be exposed to kickback from inventory shielding schemes as they have significant warehousing and commodity investment operations.  Some have argued that certain banks which have large commodity ETF funds predicated on rising commodity demand are keen to maintain high prices to encourage subscriptions to their ETFs, regardless of fundamentals.  Hence some of the derisory comments on social media as to the slightly concerning tone of a Blackrock client blog this week which argued that it is "critical for the global economy that China lands softly".  The related growth of commodity backed structured financing does carry some risks as discussed here.

Also, it seems possible that speculation and arbitrage in the Chinese currency between offshore and onshore markets may complicate the liberalisation of Chinese exchange rates and the economy.  Martin Wolf explored the risks and complexities of liberalisation back in February, and it will be looked at in more detail in posts to come.  Meanwhile Fraser and Howie in their book Red Capitalism noted that non-convertibility of the Chinese currency is one of the pillars maintaining financial stability, with uncertain consequences if removed.

Thanks to the reader who identified the BBC Radio link!

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.

All those reserves....

Flow on effects
A recent comment from one reader questioned the likely effects of a China slowdown on some of its key trading partners.  As has been discussed previously there is concern amongst exporting economies of the effect of a China slowdown.  The previous week saw negative reaction to BHP executive Ian Ashby's comments of flat predicted Chinese steel demand, while recently the currency and stock markets in Canada, Australia and New Zealand have all declined on expectations of lower Chinese growth.  The FT Alphaville blog had some interesting figures out from researchers showing the growth of imports into China as exports have stagnated and which also singled out Australia and Brazil as having a particularly high share of their exports to China thereby making them vulnerable to a slowdown.

For Canada, which has a US focus but is vulnerable through commodity prices and by the fact that many Chinese companies and companies with China exposure are listed on its sharemarkets, this piece from Reuters had a couple of soundbites from researcher Murray Leith at Odlum Brown in Vancouver:

...The Canadian stock market is very geared to economic growth in China. If China slows, commodity prices moderate and because resource stocks constitute close to half the index that has negative implications....

It will be interesting to see how this develops.

Keeping a big rock in place
To a more long term issue, a fairly common point reached in China discussions in the size of the country's foreign reserves. They're huge, over $3 trillion and are considered by most to provide a sufficient firewall for any potential crisis the country faces.  A lighthearted survey by the Economist of just how many enormously sized things such an amount could buy is here.

Substantial foreign reserves have been de rigeur for emerging market economies for over a decade - in order to protect against fluctuations and rapid devaluations which can follow foreign investors quickly withdrawing direct investments (including speculative capital flows or "hot money") compounded by short sellers wading in to make quick profits betting on further declines in the midst of a crisis.  The lesson many Asian and emerging market countries drew from the Asian Crisis in 1997 was to build up an arsenal of foreign reserves to out-buy any speculators and compensate for any rapid capital flow shortfalls in future.

This need for security against financial contagion seemingly dovetailed nicely with China's longstanding trade policy, which is to achieve large trade surpluses by relying on an undervaluation of its currency, the Yuan or Renminbi (RMB) in particular with its largest trading partner the US (and its currency, the dollar).  As Krugman explained early on in the crisis, this policy wasn't necessarily anticipated or deliberate, but certainly China was locked into accumulating foreign reserves early on - with one problem being that China's reserves were concentrated in US dollars (through China's holdings of US Treasury Notes or debt) which made them vulnerable to falls in the dollar.

At the time there were calls to expand the use of Special Drawing Rights as an alternative to US dollars, although these fell silent and China's planners instead launched the internationalisation of the RMB, which is now used in trade settlements, some instruments and limited capital flows.

China's FX agency...has a few spare yuan down the back of the desk...

However steps to liberalise the capital regime have been gradual and even with some diversification by China into currencies such as the Euro and some overseas M&A, China's gargantuan foreign reserves still have weaknesses.  They do still hold a large position in US Treasuries which would be hard to liquidate (lest their remaining US dollar reserves would fall in value).  The amount of dollars they have to buy makes maintaining the currency peg - buying up all the excess dollars, expensive, while the Central Bank also has to  drain the resulting excess resulting RMB liquidity from the financial system by "sterilising" (requiring banks to buy debt or increase the amount that they must hold in reserve), an imprecise procedure when the Central Bank uses the same tool to conduct domestic interest rate policy.

In general there is no transparency about the precise nature of the reserves and the extent to which the reserves are in fact reinvested into domestic entities (and therefore less valuable) is not known (though Victor Shih has speculated).

The Rising Sun in the Currency Wars
A quite disturbing risk is that China might be unwittingly drawn into the ongoing "currency wars" and in particular a devaluation of the Japanese Yen.  The term "currency wars" came into frequent use in 2010 (Guido Mantega, the Brazilian finance minister used the term often) to describe the series of quantitative easing by developed country central banks (especially the UK and US) to lower their exchange rates and restore competitiveness relative to emerging markets.  Developing countries and especially emerging markets responded by introducing capital controls and restrictions, seeking to fight the tide of liquidity as investors moved money from developed to developing economies to seek returns.

Japan (like Switzerland) was seen as a safe haven, having a sound economy and currency which was seen as still a good store of value.  With increasing flows the value of the Yen has risen to very high levels, eating into the already declining competitiveness of Japan's export industries.  Coupling with a now crippling level of debt and effects from the earthquake, the Bank of Japan has also been involved in easing although it may not be done yet.  A few are now speculating that i) Japan has further easing to do and ii) China may feel the need to respond with its own devaluation to ensure its currency remains cheaper than Japan.  As Mike Dolan points out for Reuters, devaluing the RMB will bring China into conflict with the US, while Andy Xie argues that a big Yen devaluation could cause China's banking system to sink.  It is not clear how Andy imagines the collapse - whether by loss of confidence or speculation however there seems to be enough to at least mount a rebuttal to Michael Pettis who last year in a podcast stated that there was no doubt China's foreign reserves would be sufficient to repel any currency contagion.

And right now?
Of course a country's capital account is in flux and it is worth taking into account money flowing out from a country as well as in.

This year has seen a reversal in that China's foreign reserves shrank for the first time since 1998, while the slowing rate of RMB appreciation has seen China's central bank struggling to find a balance between trying to dampen the impact of investors withdrawing from bets on appreciation and inadvertently causing uncertainty which could encourage substantial capital outflows:

The central bank wants to widen that band to allow greater two-way flexibility, discouraging investors from taking one-way bets on yuan appreciation by bringing speculative capital into the country....But China's central bank still lives in the long shadow of the Asian financial crisis, when sudden outflows of capital brought neighbouring countries to their knees.

Further complicating the picture is the very hard to estimate extent of capital flight which anecdotal evidence suggests is high - "The errors and omissions in China’s balance of payments ($60bn in 2010) suggest tens of billions might be involved in such capital flight though it is difficult to distinguish between hot money outflows and capital flight".  A thorough analysis presented in an interview by Victor Shih, is here.