|
|
Mining and Forestry
|
|
||
China UpdateFrom Scotia Capital today. China Commodities Weekly for
the Week of April 28 - May 2, 2008 Na Liu,
MBA, CFA - 416-945-4235 na_liu@scotiacapital.com ■ Last week, China's base
metals prices were mostly down, but the steel markets remained strong. The
ethylene price continued to rally while the methanol price was unchanged. Grain
markets were largely stable, while fertilizer markets were well supported. Coal
and oil products prices were flat. ■ Last week was China's May 1
holiday and the commodities markets were very quiet. Therefore, we take this
opportunity to discuss our investment themes for 2H/08 in this report. We also
briefly discuss the early ending of the slack season for coal demand in China,
the poor economics for China's copper imports, and China's efforts to block the
export of phosphate rocks. Strategy
– Time to Think Beyond the Spring Revival ■ At the beginning of 2008,
in Scotia Capital’s “Focus on 2008” publication, we introduced our annual China
outlook work titled: “Comfortable for 1H/08; Nervous for 2H/08.” So far, we
have steadfastly stuck with this investment theme by repeatedly stressing our “overweight”
call for the raw materials sectors from a China perspective over the past
several months. ■ Our bullish view on the
global materials sectors is not likely to change in the very near term for two
simple reasons: On the macro side, we expect the ongoing “spring revival,”
i.e., the seasonal strength of the Chinese economy, to last for another two
months or so. On the commodity side, we look for strong re-stocking demands for
oil products and coal to continue before the summer heat waves and the Olympic
months. ■ Now the question would be:
it is already May and what about after the spring revival? The short answer is:
we remain “nervous” for 2H/08. Although it might be too early to talk about the
downside risk for Chinese economy and the global raw materials sectors, the
risk should no longer be totally beyond investors’ radar screen. This is why in
this note we briefly repeat some of the risks we saw for 2H/08 in our “Focus on
2008” piece. The
Normal Seasonality and the Loan Quota Constraints ■ As we repeatedly noted,
there is a normal seasonality of the Chinese economy in recent years. Economic
growth is usually strong in the first quarter, peaks in the second quarter, and
moderates in the second half of a calendar year. It has been this way almost
every year since 2000. The reason for this seasonality is simple: Commercial
banks in China typically lend at a cracking pace in the first and the second
quarters, after they receive the yearly lending quota for the year – partly so
they have more assets that will yield income throughout the year, and partly
because they never know when the next administrative clampdown on credit might
come. Those fears then become almost self-fulfilling as the authorities,
forever worried about credit fuelled investment, usually apply the brakes in
the second half. ■ This year is a little
different. Readers of our reports can easily recall that at the beginning of this
year, the Chinese regulators said that commercial banks in China should not
issue more loans this year than last year’s total of RMB3.63 trillion. In addition,
the regulators set quarterly loan quotas to impose extra discipline. For
instance, lending for the first quarter should not exceed 35% of the total
yearly quota, i.e., RMB1.2705 trillion (35% of RMB3.63 trillion). ■ As we noted in our Weekly
dated April 14, the actual loan addition in Q1/08, at RMB1.3304 trillion,
exceeds the loan quota for the first quarter by only RMB59.9 billion, or 4.7%.
This is a small violation, by Chinese standard. It shows that Chinese
commercial banks have taken he central bank’s quarterly loan quota seriously.
The implication is two-fold: First, Chinese economic growth is likely to
moderate on a year-over-year (YOY) basis, as the total new loan quota is set at
RMB3.63 trillion – the same level as last year without any growth – and Chinese
commercial banks have so far abided by the quota. Second, most of the
moderation of economic growth will take place in the second half of 2008.
This is because the quarterly loan quota is set at max. 35% of the total at the
end of Q1; 65% at the end of Q2; 85% at the end of Q3. Clearly, like last year,
there will be very tight credit availability in 2H/08. The
Impact of Inflation on Fixed Asset Investment ■ If China’s total loan
addition quota is the same as last year, can China build the same numbers of
bridges, highways, and factories? Probably not. For instance, in Q1/08, China’s
fixed asset investment (FAI) in urban areas grew 25.9% YOY, and in Q1/07, the
number was 25.3% YOY. On the surface, China’s FAI growth is stronger in Q1/08
compared to Q1/07. However, in Q1/08, China’s producer price index (PPI) was
8%, while in Q1/07 it was 2.7%. If adjusted for inflation (higher raw material,
labour, and land costs), we estimate that China’s real FAI growth was 17.3% YOY
in Q1/08, as compared to 22% in Q1/07. ■ In other words, with the
same amount of money available, if the raw materials, labour, and land costs
are higher this year, developers will have to build less bridges, highways, apartments,
and factories, which in turn, means less raw materials will be used. The
Lagging Effects of the Ongoing Tightening Program ■ Over the past 18 months,
lending interest rates in China have been hiked by 1.35%, the reserve ratio has
been increased by 7.5%, and the Chinese yuan has appreciated against the U.S.
dollar by some 11%. In our opinion, on a cumulative basis, this is not a
trivial monetary tightening program. In fact, we are probably at the late stage
of the monetary tightening cycle in China. ■ The tricky part of monetary
tightening is that it has a lagging effect. The fact that it fails to slow down
the economy today does not mean that it will fail to slow down the economy forever.
Take the U.S. situation as an example: at the late stage of the Fed’s latest
tightening cycle, the U.S. GDP and IP growth was still robust. It was almost
eight months after the Fed stopped tightening that the sub-prime crisis began
to manifest itself. ■ The Chinese central bank
has been tightening for two years. Our conversations with local traders,
entrepreneurs, and other business contacts indicate to us that people on the
ground are already feeling the pains of tight credit and higher borrowing
costs. In our opinion, we are at the late stage of the Chinese tightening
cycle; and beginning sometime in 2H/08, we may begin to feel the lagging
effects (read: the pain) of the ongoing tightening. The risk for the Chinese economy
today is that the Chinese central bank may overdose the economy with tightening
medicines, as it saw its previous tightening package failed to abate the
inflation pressure. Pollution
Control ■ The Chinese government is
probably as concerned about the air quality in Beijing as foreign athletes. The
government is very keen to bring blue skies back to the country during the Games.
This is why Beijing will start a construction halt beginning in June. If the
pollution control measures are limited in the city of Beijing, we will not be
too concerned. However, the central government said that measures will also be
taken in the six surrounding provinces. Apparently, the six provinces are “negotiating”
with the central government on the scale of the pollution control measures. For
instance, Hebei Province, which surrounds the city of Beijing, is the home for
one-sixth of China’s steel capacity and one-tenth of its steel output. If steel
production had to be partially shut down, then provincial governments would
need details such as: by how much, when to begin, and what would be the compensation
for companies who undertake it? It remains to see how aggressively the central
government wants to implement the pollution control measures. The
Fear of a Post-Olympic Bust ■ Historically, there has
been a so-called “post-Olympic bust” in almost all of the countries that hosted
the Games over the past 40 years, except for the United States and Germany. Even
for the United States, which hosted the Games twice, there were post-Olympic
busts in its respective hosting states, although the country as a whole escaped
the fate owing to the size of the U.S. economy. ■ Observers pay particular
attention to two of the Games – the Tokyo Games in 1964 and the Seoul Games in
1988. In both cases, there was a strong case of post-Olympic slowdown. Japanese
GDP growth collapsed to 5.7% in 1965 from 11.2% in the Olympic year of 1964. South
Korean GDP growth declined to 6.7% in 1989 from 10.6% in the Olympic year of 1988.
Critics say that today’s China is in a similar urbanization era as Japan in the
1960s and South Korea in 1980s. If history repeats itself, a post-Olympic bust
looks inevitable in 2009 for China – so sell everything in 2008, when the Games
are still on. ■ To be clear, we are not believers
of the post-Olympic bust scenario for China. In fact, we believe the U.S.
experience is more applicable to China given the scale of today’s Chinese economy.
As mentioned above, although the hosting states in the United States did not escape
the bust, the country as a whole escaped the fate. ■ Although we discount the
possibility of a post-Olympic bust in the real economy, its psychological
impacts on investors’ behaviour should not be underestimated. Essentially, if everybody
has a fear, even if it is just an illusion, it still prompts selling behaviour
in the market. In the past 40 years for all the hosting countries, on average
their stock markets posted a 24.8% gain in the pre-Olympic year (Y-1), 11.6% in
the Olympic year (Y), and 24.2% in the post-Olympic year (Y+1). A more detailed
look at stock behaviour shows that in the second half of the Olympic year, the
performance of the stock markets in the hosting countries was abated. Although
the Chinese domestic stock market has already retreated partially due to the fear
of an economic slowdown, the global raw materials sectors have not. A temporary
setback of the materials sectors is highly likely to occur sometime in 2H/08,
in our opinion. Only
a Pullback, Not the End of the Game ■ After reviewing all these
risks in 2H/08, we would like to make it clear that we are not bearish at all
at this stage. For the near term, we reiterate our “overweight” recommendation for
the global raw materials sectors, again, due to the ongoing spring revival of
the Chinese economy and the ongoing re-stocking efforts for coal and oil
products. In fact, the latest PMI data for April shows that the spring revival
is stronger than we expect. China’s official PMI climbed to 59.2 in April from
58.4 in March, the highest level on record since the index began 28 months ago.
The sub-index of new orders rose to as high as 65, the highest since April
2007. As we pointed out before, the Chinese PMI survey is very comprehensive
and there is no incentive for purchasing managers to lie to the survey. ■ Even for 2H/08, all we have
been discussing in this report so far, are risks, and risks are not realities.
Even if some of these risks eventually turn into realities – the Chinese
economy slowing down in 2H/08 – we would view it as a temporary pullback in a
secular bull term for global raw materials sectors. For one thing, if there
were indeed a sharp slowdown, the Chinese government could easily ramp up
government spending in rural areas to shore up investment growth, cushioning
the downside. The Chinese government has minimal fiscal deficit and sits on
US$1.6 trillion in foreign exchange reserves. The Chinese commercial banks are
setting aside over 16% of their funds in reserves, a vivid illustration about
the huge size of bank liquidity that is artificially locked up by the 16% bank
reserve ratio. In the meantime, the infrastructure in rural China still needs
major upgrading as it has been lagging badly versus the urban region. Under the
slogan of “Reviving the New Socialist Countryside,” the Chinese government has
both the monetary resources and the political will to significantly boost investment
in rural China. And if this happens, one has to remember that one percentage of
percentage of GDP growth led by either consumption or exports. Copper –
Two Paths ■ If one wants to be bearish
on copper, the most obvious reasoning now is that China’s import economics have
been poor since the Spring Festival. During the festival in early February, when
Chinese traders took vacation, the LME price jumped. Since the festival, the
Chinese copper traders and users have been so far reluctant to chase higher and
higher copper prices on the LME. As a result, local Chinese markets have been
clearly underperforming the LME market. The price ratio between Shanghai and
LME (see the chart on the copper page) has been abated, meaning import
economics have not been good. Therefore, it would not be surprising for us to
see China’s refined copper imports to decline further in April and May, and
even in June. ■ Actually, we have seen this
behaviour before; when copper was traded toward US$4 per pound back in 2006,
Chinese users were similarly reluctant to chase higher prices (in contrast,
when copper dropped towards US$2.50 per pound at the end of 2006, Chinese users
began to import huge volumes of copper to re-stock). In other words, Chinese
copper buyers have been proven very price sensitive in recent years. ■ There are two potential
development paths for the current situation. If the spring revival of the
Chinese economy, which we have been discussing in recent weeks, is strong and
longlasting, eventually Chinese users will run down their existing inventory
and be forced to buy at the spot LME price. If this scenario develops, we
should see the Shanghai/LME price ratio rebound sharply during the next one and
a half months, restoring Chinese users’ import economics. If so, we would
maintain our bullish view on copper. ■ The flipside of this
scenario is, of course, if in the next one and a half months, the Shanghai/LME
price ratio remains at a low level. If so, we would downgrade our view on copper
to neutral from bullish, from a China perspective. This is because if the
import economics do not improve before the mid-June, then China is highly
unlikely to import a significant amount of copper in the ensuing summer months,
which are traditionally the “summer lull” months for China’s base metals
demands. In this case, investors have to wait for the autumn months to see
seasonally strong Chinese copper imports. During the summer months, without
further supply disruptions, it is very likely that LME copper is sold off because
of the persistently sluggish Chinese demands (from spring to summer). Coal –
Slack Season Ends Early ■ China’s domestic spot coal
prices have rebounded toward previous highs, fuelling worries about possible
power shortages during the summer – usually the peak electricity consuming season
in China. Benchmark prices at Qinhuangdao, China’s top coal shipping port, for
the top-grade thermal coal reached RMB650-660 (US$93-94) per tonne on
Wednesday, up from RMB625-635 in early April. They were up 40% from the
year-ago period. ■ Usually, the spring is the
slack season for coal demands in China, as the winter heating season finishes;
but the summer heat waves have yet to come. The recent rebound of coal prices
indicates that the slack season might have ended earlier this year. Last week,
we reported that coal stocks at major power plants around the country had
fallen below the safe bar of 15 days to 12 days. In some provinces, coal stocks
had fallen to alarming levels by late April, enough for less than seven days of
use, according to the State Electricity Regulatory Commission. ■ The National Development
and Reform Commission, China’s top planning body, said on Tuesday that
hotter-than-usual weather and lower-than-average rainfall was expected this summer.
This would strain thermal power plants by boosting the use of energy-intensive
air conditioning and cutting available hydropower resources. ■ Separately, last week,
China and Japan reached an agreement on prices for this year’s bilateral
long-term coal trade, with prices rising 93.52% from 2007 to US$131.40 per
tonne, based on 5,800 kilocalories of steam coal produced in northern China. News in
Brief Copper
– SHFE Stock Dropped for the Third Week ■ Last week, the copper stock
monitored by SHFE dropped 2,944 tonnes to 46,473 tonnes. Aluminum and zinc
inventory also dropped modestly. Grains
– Curbs on Exports Reaffirmed ■ China’s commerce ministry
on Wednesday reaffirmed government curbs on grain exports and urged local
governments to increase reserves of grains, meat, and cooking oils to ensure supplies
and keep food prices in check. The ministry asked local authorities to “take effective
measures to strictly control grain exports,” it said in a notice published on
its website. ■ China’s grain prices are
among the lowest in the world as Beijing constantly releases state reserves to
keep prices in check. If exports are not controlled, traders will ship cheap Chinese
grain to overseas markets. Potash
– Demands Hit by High Commodity Prices ■ After the annual import
price settlement, the local Chinese price spiked higher. Last week, the average
retail sales price for potash hit RMB4,650/tonne (US$664/tonne) in China. This is
some RMB1,100/tonne higher than one month ago. The sharply higher potash has
hit hard on local demands, as both farmers and NPK producers are reluctant to
buy potash at the current price level. Potash inventory in Chinese ports did
not decline during the ongoing planting season. This is because on the one
hand, users are reluctant to buy at the high price level; while on the other
hand, traders are reluctant to sell, as some traders believe the potash price
could go even higher. DAP –
Phosphate Rock Exports Blocked ■ Starting on May 1, 2008, China
will levy a Special Export Tax of 100% on phosphate rock exports. This will
bring the effective export tax to 120%. The Special Export Tax will expire on
September 30, 2008. Recap
of Our Calls ■ The sole purpose of our
China strategy research is to answer one question: purely from a China
perspective, should investors in the Western world overweight, market weight,
or underweight the global raw materials sectors? To this question, effective
August 16, 2007, our answer is “overweight” (upgraded from market weight). ■ On sectors, we are now bullish on coking coal, iron ore, copper, zinc, aluminum, molybdenum, oil, methanol, DAP, urea, soybean, and hardwood pulp. We are neutral on wheat, corn, potash, ethylene, steel, and nickel. We are cautious on paper products on a relative basis from a China perspective. |
return to message board, top of board |