The China paradigm and commodity demand

After hosting two days of meetings with government policy advisors, experts and consultants about China’s medium- to long-term demand for commodities, the Nomura Group concludes the country’s industrial demand is “moving to low or no growth, off what is now a very high base within twelve to twenty-four months.

“China’s incremental demand growth for industrial commodities [steel, copper and aluminum] is likely to slow much more than the consensus expects on a twelve to twenty-four month view,” China metals and mining analysts Matthew Cross and Ivan Lee write in a May 2 report to clients, after their visit to China last month.

The Hong Kong-based analysts at Nomura Equity Research argue that the massive fixed-asset stimulus measures Beijing imposed in 2008 have “pulled forward China’s metal-intensive construction demand, and will be a key cause of lower incremental demand growth rates going forward.” They believe that the last of the 2008 stimulus package projects will probably be finished this year.

“There was a general consensus among policy advisors with whom we spoke that 7% to 7.5% yearly gross domestic product (GDP) growth rates are sustainable until 2020, but with risk that GDP growth would drop to 5% to 6% each year unless the growth model is changed, making rebalancing a policy priority in China,” they say. The analysts also note that the policy advisors are concerned that if GDP growth slows, “household share of GDP will need to increase to prevent social unrest.”

Rebalancing China’s economy towards a consumption model will require investment to grow slower than the rate of GDP growth, however, which could have negative implications for commodity markets, the analysts argue. And China’s inability to rebalance quickly, they say, was the biggest concern expressed by the policy advisors with whom they met. This is particularly true given Beijing’s massive stimulus package in 2008, “which is increasingly being viewed as too large,” they say, “and having worsened the [structural] imbalances within China’s economy . . . making the task of rebalancing much more difficult.”

The analysts point to a number of warning signs about the economy, including the large decrease in fixed asset investment by local governments, which fell to a 6.4% growth rate in the first quarter of this year, down from 45% in 2009. They also pointed out that tax revenues brought in by local governments fell in the first quarter of 2012 because of weaker real estate markets. Some policy advisors suggested that “the strict housing policy will need to be relaxed, otherwise local governments will be unable to repay interest on loans.”

Downstream demand for industrial commodities remains weak, meanwhile, and overcapacity and overconsumption are becoming major issues. “Downstream demand remains relatively weak for commodities, with many policy advisors with whom we spoke concerned that recent production increases had moved ahead of end-demand, resulting in a buildup of inventories along the supply chain.” Concerns were also voiced about industry overcapacity, overconsumption and waste. As a result, “policy objectives have become strongly focused on reducing raw material intensity of growth by reducing waste.”  

Coal will continue to be China’s major source of energy, the policy advisors agree, but gas — with its environmental advantages — will become increasingly important. As for nuclear energy, it will “remain a focus, but likely be scaled back given the events in Japan.”

Other topics of discussion included tax policies, privatization, urbanization and housing.  
One of the most widely discussed topics was the incentive local governments have to invest in the wrong industries and the need to overhaul the tax system.

In China, local governments get the majority of their revenue from land sales and believe that they must sell more land to improve their balance sheet. By contrast, under international tax systems, most revenues stem from income and consumption taxes. This is a problem in China because many workers leave their homes in the countryside or smaller towns and cities to work in the booming metropolises of Beijing and Shanghai, and are taxed where they work, rather than in the city or town where they come from. This means that the taxes workers pay never trickle back to the local governments in their home cities.

Another cause of concern is that investments by local governments in transportation and infrastructure have by and large been debt financed, and are not earning any money. More often than not these projects don’t generate enough income to repay loans, and in some cases the interest on the loans, which is draining the balance sheets of many local governments. In light of these concerns, the policy-makers discussed the feasibility of local governments raising money by privatizing assets.

The urbanization rate is 52%, but advisors suggest the rate could be 62% a decade from now. In housing terms, that 10% increase translates into potential housing demand for 130 million people. On that front, several concerns surfaced. The first is that while per-capita housing on a square-metre basis is still low in China and has room to grow, affordability is an issue. Second, income inequalities are creating many different levels, or tiers of housing. Finally, some participants report that housing that is often not built in appropriate locations. Affordable housing could be built in Shanghai and Beijing, for instance, where migrant workers are moving to find work — and fewer could be built in smaller cities where there is less demand.

The Nomura analysis concludes with a recommendation to avoid copper, aluminum and steel, and buy gold.

Analysts at London-based Barclays Bank argue in an April 30 commodities research note to clients that aluminum, nickel and lead will be three metals that “benefit from the wave of consumption upgrading, consumer-goods spending and increase in car sales over the next five years,” and that of the three, aluminum will benefit the most. Aluminum differs from other base metals, the Barclays’ team argue, because while it is “crucial for use in power networks and construction in early urbanization stages,” it is also widely used in transport and consumer goods, “benefiting as economies mature  and move towards consumer-led demand growth.”

Nickel and lead could also benefit from China’s gradual shift to consumer-led demand growth. Nickel is used in stainless steel that goes into manufacturing higher-grade goods, cookware, food processing and pharmaceutical ­industries, as well as chemical and petro-chemical plant construction, they point out. Using lead in car and electronic bike batteries means that the metal will benefit from increasing car sales and upgrading low-quality lead batteries. Barclays estimates that car sales in China will average 17.6 million units a year between 2011 and 2015, which is up from 11.5 million units from 2008–2011.

Where Barclays and Nomura find common ground is copper. While the red metal is expected to be a beneficiary of upgrades to power transmission in China, “high prices are incentivizing substitution wherever possible,” Barclays says. According to the International Copper Study Group, copper mine production this year will reach 16.9 million tonnes —which is a 5.1% increase. “That’s a huge downward revision from the October 2011 forecast of 17.6 million tonnes and 9.4% growth, and illustrative of the market having once again been too optimistic on mine supply growth for this year.”

As for zinc, Barclays notes that  its biggest use is in bulk-galvanized steel, which it believes is a &
ldquo;slower growth sector, as construction activity slows.”