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Msg  62233 of 65647  at  1/30/2010 3:46:03 PM  by


China Update

The following was published by Na Liu of Scotia Capital yesterday.

China Commodities Weekly for the Week of January 25 - January 29, 2010

Last week, China’s urea and DAP prices were up; coal and oil products prices were flat; and base metals, iron ore, steel, grains, and potash prices were down.

Macro – When China Begins To Tighten

More Tightening News

More monetary tightening news has surfaced so far this week. First, China implemented a planned increase in the required reserve for some banks on Tuesday (50 bp for those banks whose loan growth has been deemed too high). Secondly, the 21st Century Business Herald said that Chinese banks extended a whopping RMB1.45 trillion in new loans during the first 19 days of the year. Now, Chinese banks are required to report loan addition on a daily basis to authorities. Thirdly, according to the Securities Times, commercial banks that had made large amounts of loans this month were being instructed not only to halt new lending but also to recall some already issued loans as soon as possible. The newspaper further said the recall means that the new loan total for January will fall well below market expectations, despite a burst of lending in the first three weeks of the year.

We understand that the impact of the loan restriction has been felt by small business, property developers, private home buyers, and some importers who need to open a Letter of Credit.

Local Investment Vehicles

Separately, the China Securities Journal, an official newspaper, said that local governments, through their investment vehicles, had borrowed RMB3.8 trillion last year, about 40% of all new loans in 2009. This is why central bank governor Zhou Xiaochuan has warned about risks in the buildup of local government debt. We understand that a lot of local infrastructure construction started last year was initiated by investment vehicles established by local governments with land rights as collateral (like the offbalance sheet special-purpose vehicles established by Western banks before the financial crisis). If the commercial banks cut the lending to local investment vehicles, local infrastructure

construction might be delayed.

When China Starts to Tighten…

Many investors have asked us what the impact of the recent tightening efforts by the Chinese government on the raw materials sectors would be. To answer the question, we looked back to the market’s behaviour when China started its last tightening cycle. Back on September 21, 2003, China hiked the reserve ratio for the first time in the last decade (see Exhibit 1 on the first page). The market ignored the signal, and market reaction was very muted. Commodities and stocks continued to rally to new highs, and new loan growth was very strong in the beginning months of 2004. And then in March, the Chinese government began to tell the banks to quantitatively curb loan growth, and on April 25, 2004, the central banks announced the second hike of the reserve ratio. This time, the commodities markets and local Chinese stock markets did not take it lightly and suffered a very severe pullback. But eventually, this severe pullback was proved to be a buying opportunity for the multiple-year bull markets that ensued.

Based on the experience in 2003 and 2004, the question for investors today is whether the recent tightening (and the market reaction towards it) bears more resemblance to tightening in September 2003 or March-April 2004. The experience of China’s last tightening cycles taught us a simple lesson: if the market ignores the initial tightening, it will trigger another tightening that could not be ignored any more; if the market takes the initial tightening seriously, eventually it should prove to be a good buying opportunity.

And this is why we wrote last week: “our near-term investment strategy is: if the pullback last week, triggered by policy fears, continues and becomes more meaningful, and if the Chinese commodities imports moderated in the rest of the winter, we would aggressively buy the dip and load up for a strong spring rally; on the contrary, if the pullback proved to be just a blip and the raw material sectors continue to rally to new highs during the rest of the winter, and if the Chinese imports continue to swell, we will sell some winning positions in early spring to bring raw materials positions to ‘market weight’ from ‘overweight.’”

If the market continues to correct before the Spring Festival, the market reaction to the ongoing tightening will likely bear more resemblance to April 2004 rather than September 2003. This is why we believe it will eventually become a good buying opportunity for a spring rally. Investors have to bear in mind that China is fighting against a “good” problem: its economy is rebounding too quickly and liquidity is too ample. This is in sharp contrast to Western economies, where economic recovery is too sluggish and the velocity of money remains slow. Arguably, China is still the envy of the rest of the world.

At the end of this section, we would like to repeat what we wrote in our thematic piece for 2010, entitled “Focus 2010 – China Outlook, The Three Economic Trends” dated January 11, 2010:

“We note that the raw materials sectors have rallied hard since last March without any serious pullback (and our recommendation has been “overweight” all the way along). If any deep pullback in the raw materials sectors were to happen in the next few months, we believe it would most likely happen sometime in January-February 2010 … If some investors decided to take some profit in early 2010, we believe that this could become a very good buying opportunity for a potentially powerful rally in the spring of 2010, when Chinese construction activities come back.”

Sector Preference – Fertilizer

During a time of policy uncertainties, investors might benefit from the perceived defensiveness of the agricultural and fertilizer sectors. Indeed, these sectors had lagged significantly in the sharp rally in the raw materials sectors last year. Therefore, the downside risks are relatively limited, especially after the recent pullback. As a result, we have decided to upgrade our view on urea and potash to “positive” from “neutral,” and the DAP sector remained our preferred play in the fertilizer sector.

As we wrote last week, we see limited downside risk for urea in the near term as coal and natural gas prices are likely to remain high. This week, urea prices rose again in China after the downtick the week before.

The DAP market is now supported by multiple factors in China: the power outage is curbing capacity utilization in Southwest China; the railway bottleneck in the winter months is reducing DAP transportation to consuming regions; and the higher raw materials cost, with recent sulphur sales to China topping US$140/tonne C&F, is limiting the downside risk for the commodity. Therefore, we believe the Chinese DAP market will remain tight into the spring. The latest statistics showed that China imported 97,793 tonnes of DAP in December, up from 0.48 tonnes in November, while the country’s DAP export dropped 40% MOM to 155,323 tonnes.

This week, the potash port quotation suffered a drop of RMB100-RMB150/tonne to about RMB2,650-RMB2,700/tonne, but still higher than import parity of US$350/tonne. The average retail price in the country was at around RMB2,830/tonne. We note that with the port quotation dropping, transaction volume picked up this week, and port inventory remained at a very low level. In our opinion, potash prices in China will be stable into the planting season, even with new imports arriving in the country. Overall, we expect China’s potash imports to top 4 million tonnes this year, up from 2 million tonnes in 2009.

To maintain our recommendation balance, we have downgraded our view on steel to “neutral” from “positive.” We note that, even though Chinese steel demand is likely to take off in the spring, high iron ore and coking coal costs will likely to squeeze the margins of steel mills, particularly Chinese steel mills, which rely heavily on spot markets.

Recap Of Our Calls

Essentially, we are making four calls in our China Commodities Weekly: economic trends in China, our overall sector call, our individual commodity sector views, and our calls for the contract negotiations for certain commodities. We recap our calls as follows:

Economic trends: There are three intertwined trends for the Chinese economy – seasonal (the current and next few months), cyclical (the current and next few years), and secular (the current and next few decades). We are currently a seasonal bear, a cyclical bull, and a secular bull.

Overall sector call: Our overall sector call is to answer one question: purely from a China perspective, should investors in the Western world be overweight, market weight, or underweight in the global raw materials and energy sectors as a whole? To this question, our current answer is overweight.

Individual commodity sectors: On individual commodity sectors, we are now positive on the copper, iron ore, thermal coal, coking coal, uranium, molybdenum, corn, DAP, urea, potash, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, steel, wheat, soybean, methanol, ethylene, and crude oil. We are cautious on paper products. Please note that our positive, neutral, or cautious views on individual commodity sectors are all on a relative basis from a China perspective.

Views on annual contract negotiations: We are looking for a 25% rise in the 2010 annual iron ore contract. We expect the 2010 benchmark Australian hard coking coal price to settle at US$175/tonne, up from US$129/tonne in 2009. 

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