China and commodities
0It is very hard to read China’s data and to have a clear understanding of what lies ahead but it is clear that the Chinese economy has performed strongly over recent years, despite the global financial crisis and its aftermath which involved a fall in global GDP in 2009 – the first time output at a global level has contracted in at least 60 years.
China’s relative strength is in part the result of China not having a financial crisis, and also the result of China’s massive policy stimulus. The stimulus achieved its objective of boosting growth, but as it has begun to fade, so it has exposed China’s economy to new challenges, and given the historically unprecedented development path followed by China over the past 30 years, the outlook for the Chinese economy is almost, by definition, uncertain.
Against this backcloth, there are a range of views on the outlook for economic growth and in particular for basic material demand and when assessing the pace of growth in basic material demand in the near term, arguably the best indicator is current momentum, and at a macro level the key indicators of demand are fixed asset investment and industrial production.
In tracking momentum in China, it is important to assess high-frequency movements, reflecting distortions seen in the level of activity as a result of stimulus measures. Meanwhile, as with many economies, fixed asset investment (FAI) flows are highly volatile month to month and quarter to quarter, as by their nature, many large investments are relatively lumpy. Although many analysts have suggested that investment is slowing (some suggest sharply), an analysis of the level of real investment shows that investment growth through February remains very much on trend (no slowdown). Indeed, after dipping in December, as often happens toward year-end, investment rebounded very strongly in the first two months of 2012. Commodity-intensive construction also rebounded in early 2012.
Much of the bear argument about FAI over the remainder of 2012 focuses on the housing sector. Although private housing sales have been weak, seasonal data suggest that they have stabilized and may have even begun to recover. In addition it looks as if a small fall in private housing sales will be offset by robust commercial construction. House prices themselves have fallen, driven lower by policy rather than a result of a deterioration in underlying demand. Macro-prudential policy tightening appears to have come to an end and broader monetary policy has already been eased (normalized), with M2 growth returning to around its average pace.
In contrast to continued robust growth in fixed asset investment, the data for industrial production (IP) for January and February, as well as revisions to earlier data, clearly indicate a gradual slowing, with the pace of growth in Q1 this far this year well below the average of previous years. Looking forward, the new orders component of the PMI looks to have bottomed and this, combined with the gradual recovery in the US, Europe, and Japan, suggests that IP growth is also likely to have troughed.
While we can expect a modest improvement over coming months, we may not see a return to the growth rates seen in recent years, in part because exports look relatively weak and in part because the slowdown has been policy-driven: the government now prefers growth in the 8%-9% range rather than the historical 10%-plus. As for the numbers themselves, the evidence is that IP growth is stabilizing at a weak level. The March data are released in early April and may confirm this trend, with numbers on air-conditioner production and motor cars consistent with this conclusion.
Looking beyond the near-term data, a key issue for China is the outlook for inflation. The rhetoric of the authorities is cautious but stabilisation of global food prices has removed the main risk. Importantly, both the headline CPI and the non-food CPI have actually fallen a little over recent months for the first time since 2009, and the fallback in inflationary pressures provides the authorities with scope to ease policy if they so desire. We can also get some insight on potential GDP growth for China from the nature and scale of inflationary pressures, and the trajectory of inflation over the past year suggests that potential GDP growth remains comfortably above 8%.
Looking further out, there is uncertainty on the structural pace of commodity consumption in China. One objective of China’s 12th 5-Year Plan is to rebalance the Chinese economy away from exports and investment, toward consumption and efficient, value-adding industry and services. That said, we should not expect a step change this year. Premier Wen has stated that the Chinese authorities will target 7½% GDP growth in 2012, down from the 8% target of recent years but the official GDP target for the 10th 5-Year Plan (2001-2005) was 7% and that GDP growth came in at 9.8%, while growth between 2006 and 2010 averaged 11.2% despite the 11th 5-Year Plan targeting 7.5%. Meanwhile, although the rate of investment has been very strong (the flow), the level of the capital stock in China remains very low compared to that of most industrial economies and, more importantly, compared to the needs (recognized in Beijing) of the country’s large and crowded urban and rural populations – suggesting that much remains to be built. The IMF presently expects investment growth of 9.4% in 2012 and 8.9% in 2013, only modestly slower than that in 2011, consistent with very little rebalancing in the near term.
China will remain a very significant contributor to global growth and as it gets bigger so its growth is more important. For example, 10% growth off a base of 100 is the same in terms of absolute increment as 5% growth off a base of 200. In the 1980s, China’s GDP growth averaged 10%, with China contributing less than 10% of global growth. Then in the 1990s, Chinese GDP growth was also 10%, but its contribution stepped up to nearly 20%, and in the 2000s GDP growth again averaged approximately 10%, but the contribution grew to over 25%. Even if Chinese GDP growth slows to 8% per annum in 2012-2014 (substantially slower than in the past decade), its contribution to global growth should continue to increase, to more than a third in the first half of this decade. We can also note that the consensus has almost always underestimated the pace of Chinese growth.
Of course there are risks. A difficult outlook for China’s infrastructure and property sectors, combined with construction-biased Chinese commodity demand, may lead to disappointment in growth expectations for China’s demand for commodities. Also the passing of the baton from one driver of growth to others carries the risk of mismatched timing and can lead to disappointment in demand. Certainly 2012 may be a difficult year for commodity demand and a so-called soft landing could involve commodity demand taking most of the “pain.”
It follows that whilst China’s commodity demand super cycle was driven by China’s extraordinary growth in infrastructure construction, export, and urbanization, China’s commodity demand growth may be significantly below market expectations as the growth rates of these factors fade.
Most economies have undergone transition to consumption-driven growth but what is different about China is its heavy investment/construction-biased growth model. It has made the commodity cycle more powerful in the growth phase and can now work the other way.
We will monitor ongoing developments, especially China’s policies, production, construction and stocking patterns.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
