Barclays: Hard landing in China unavoidable as stimulus deemed unsustainable

In a recent issue of Commodities Weekly, China economists at Barclays argue that slowing growth, waning business confidence and a recent tightening in liquidity conditions have increased the risk of a hard landing in China.

The economists contend that the central government in Beijing — led by Premier Li Keqiang, who took power in March — has “taken a different policy path from its predecessor,” with a strategy of “no stimulus, deleveraging and structural reform.” 

The Barclays report says that “during the past three months, the new government has resisted repeated calls for new stimulus because it believes state-led investment is no longer sustainable. Instead, the authorities are making efforts to control financial risks, especially the flow of credit that could be fuelling asset bubbles.

“Since taking office the new government has demonstrated its commitment to reforms and bringing China into a more market-oriented economy,” they continue. “While good for the longer term, the implementation . . . could point to further downside risks for both economic growth and asset prices, including the exchange rate.”

The team at Barclays forecasts China’s gross domestic product (GDP) will grow 7.4% in 2013 and 2014, and believes that “a period in which quarterly growth drops briefly to 3% at some point in the next three years is an increasingly likely scenario.”

They note that growth so far this year in industrial activity, which makes up about 40% of the country’s GDP, has been “below expectations” — down from 20% in 2010 to 9% recently — and underscores the importance to Beijing of finding “new growth drivers.”

In terms of financial stress, Barclays economists point out that, driven by companies and local governments, leverage “rebounded” in the last two years, reaching 200% of GDP. Not only do many Chinese banks “lack sound liquidity and market risk management,” they add, but “a significant amount of new financing was used to roll over debt to cover interest payments or bad debts, and a significant amount of liquidity circulated within the financial sector a number of times before it reached the real economy — Small- and medium-sized enterprises, developers and local governments — at a much higher cost.”

In terms of base metal demand, Barclays modelled a “rather extreme” 4% annual fall in Chinese demand for aluminum and copper. In that scenario, the global refined copper market surplus would rise to 1 million tonnes from the current base-case surplus of 100,000 tonnes, they maintain. For aluminum, the surplus would increase to 3.5 million tonnes from the base-case surplus of just under 1 million tonnes.

The Barclays team estimates that under such a hard-landing scenario, copper prices could drop to US$2,553 per tonne, which is more than 60% from current prices. Lead could fall to US$850 per tonne and zinc to a little over US$1,000 per tonne — a 40–50% drop from current prices. Aluminum prices could slip 30% to US$1,234 per tonne.

As for the impact on Chinese metal production, Barclays asserts that a hard landing “could imply a large oversupply of copper concentrate, implying a big increase in treatment charges, which could lead to a squeeze in miners’ margins,” and lower prices “would hurt copper miners, which have been enjoying good margins since the financial crisis.”

The report says that “squeezed margins and concerns about Chinese consumption could lead to further capital expenditure (capex) cuts, cancellations, delays and deferrals of projects. Miners have already been on a cost-reduction exercise, cutting capex spending, and these cuts could be impactful, as by the middle of this decade demand is expected to catch up and fresh supply is sorely needed.”

But it’s not all bad news. Gold could benefit from a hard landing in China, Barclays argues.

“A hard landing could shake faith in the government and lead to a big fall in CNY-denominated assets, which could mean gold becomes important for domestic investors to hedge what we think they will view as a greater set of risks than previously.

“It could be the trigger in moving China away from being a country that increases purchases at festivals — or when inflation is high or when there’s a big fall in international prices — to one where gold is added more consistently to portfolios.”