‘Old school’ sectors struggling in China, Macquarie’s Hamilton says

VANCOUVER — At the Association for Mineral Exploration British Columbia’s annual Mineral Exploration Roundup convention Macquarie Group’s head of commodity research, Colin Hamilton, discussed China’s economy, the Chinese government’s “supply-side reform” strategy, and what it all means for the mining industry.

This year began with sharp falls in Chinese stock markets and depreciation in the yuan. Conditions haven’t improved since then amidst weakening industrial conditions and contractions in productivity. China’s economic growth fell to 6.8% in the fourth quarter of 2015, which places the world’s second-largest economy at its lowest expansion rate in nearly 30 years.

The Shanghai Composite Index fell more than 20% to start the year, wiping out last year’s gains and placing the index at its lowest point since 2014.

“The Chinese government is really poor at interacting with financial markets. They are good at many things, including running a controlled economy,” Hamilton commented. “China has pretty much made a big shift in its foreign exchange strategy and just didn’t tell anyone about it. Eventually we determined we were talking about a currency basket, but we’ve seen the move hurt commodity prices and global confidence.”

The struggle China’s government is having controlling the country’s economy has a lot to do with its evolving industrial and service sectors, and demographic changes that are familiar to developing countries.

Hamilton noted that the nation’s service-based industries are strong, with a 12% annual growth rate, while the “old-school industrial” sectors, which include extractive industries, have fallen into negative growth territory.

“If we look at nominal U.S. dollar gross domestic product growth in China, we see the main concern for the government. The six resource-based provinces are all near, or in, recession. That’s where we’ll see no value added and no profit growth,” Hamilton said. “China is developing like any other economy. You get growth in the service sector in the tier-one and tier-two cities, and everyone wants to move there. Managing that process will probably be China’s biggest challenge.”

The Chinese government has acknowledge a familiar problem across the global resource sector: overcapacity.

As a result policymakers have moved toward a strategy Hamilton calls “supply-side reform,” which lowers business costs, and limits corruption and red tape.

The situation is exacerbated by debt problems. According to Macquarie’s data, only half of China’s companies paid off high debt levels in 2014, and that number likely shrank to 25% in 2015.

“If you think there is a lot of pain in the global mining industry, it is probably worse in China. Just like every other resource economy in the world, you’ve seen capital expenses pull back in the country,” Hamilton continued. “This is the start of dealing with an overcapacity problem. We have not seen permanent mine and smelter closures as of yet, but … we saw material steel capacity cuts. These are great things because they will help solve global imbalances. We’re just not sure how quickly we’ll see the impact.”

The good news for global miners  is the Chinese government is keen on keeping the country’s current growth rate.

If the economy limits its raw resource overcapacity and triggers a rebound in base metals demand, this should relieve prices for global copper producers, Hamilton argued, noting he was “pretty comfortable” that Chinese demand would get “sequentially better” over the next three to four months.

The cutbacks in copper supply are a global phenomenon. Hamilton noted that Chilean government-owned copper giant Codelco hasn’t seen copper output expand since 2004, as the Chilean government has cut back on capital expenses for expansion. 

“Things will finally come to a head due to the negative outlook by credit markets in terms of commodities … we’ll see supply cuts accelerate over the second half of this year. Everyone will try to sell assets at the same time, but there just aren’t buyers,” Hamilton said.

“It may take years to rebalance our current commodity markets, but it starts with a rise in oil prices, which can provide the stability to move forward and lead the cycle, he said.

“We still see growth in copper markets, unlike something like steel, which we believe has peaked. Copper demand in construction is still going up year-on-year in China.”