Inventory overhang threatens China's prospects for 2013

16 November 2012 16:36  [Source: ICB]

Excessively easy bank lending at first created an oversupply of real estate, and now high manufacturing inventories are casting a cloud over projections for 2013

Petrochemicals demand growth has been underperforming the expansion in China's overall GDP growth during most of 2011 and throughout this year.


Stockpiles have been building across China

Copyright: RexFeatures

For example, as we have discussed before in this column, in a June 2012 report, HSBC estimated that polyethylene (PE), polypropylene (PP), polyvinyl chloride (PVC), polyethylene terephthate (PET) and acrylontrile butadiene styrene (ABS) demand growth had averaged just 2.7% from the first quarter of last year until the 2012 second quarter. This compared with a 9.1% increase in GDP. And in January-September this year, data supplier Global Trade Information Services estimated that China's PE demand growth was only 4%.

"One reason is inventories. Stocks have been persistently high because of the hangover from the huge economic stimulus package of 2008-2010, when everyone piled into every commodity they could get their hands on to make money," said a Singapore-based polyolefins trader, who spends a great deal of time in China. "A further problem has been the decline in industrial activity resulting from a slowdown in export trade."

However, in September, China's exports grew by 9.9%, much stronger than the 2.7% increase registered in August, according to the country's National Bureau of Statistics (NBS). Overall industrial production also increased in September to 9.2% compared with 8.9% in August, and industrial profitability improved, added the NBS.

As this article was going to press, confidence had also been boosted by the imminent 18th Party Congress, which began on 8 November, during which China's new senior political leadership was due to be announced.

"Once all the political uncertainty is out of the way, I think we will see a recovery in petrochemicals demand growth, but perhaps this won't be until Q2 next year," the trader added.There are numerous reasons to challenge this assumption, including continued political uncertainty.

Outsiders admit that they have little knowledge of China's prospective new leaders and, therefore, what their policies will be as the country attempts major economic reforms. "I would define outsiders as everybody outside the senior leadership circle - in other words, 99.99999% of us," admitted the trader. And, as just about everyone in the chemicals industry seems to concede, even if the September recovery in exports is sustained in October, it is under threat next year from further economic problems in the West.

Here, though, we are going to focus on just one of the challenges to the belief that in a few months' time we will see a strong recovery in China's petrochemicals demand growth: overall industrial inventories.

"What is clear is that the economy has been highly speculatively-driven in recent years. Negative real returns on savings encouraged speculation in most assets. Now this speculation is starting to come out of the woodwork," wrote Simon Hunt of UK-based Simon Hunt Associates, a macroeconomic and copper consultancy, in a September 2012 report.

Inflation of around 6% over the last two years has compared with domestic savings rates of just 2-3%. This has encouraged speculators to seek higher returns elsewhere, first in real estate. This has led to claims that there is an oversupply of as many as 70m apartments in China.

Hunt, in the same report, warned that the oversupply problem has extended to surplus manufacturing and industrial capacity.

"This includes basic goods like steel. For instance, we wrote last month that steel traders would default on some yuan 200bn [$32bn, €25bn] of loans," he said.

"As an example of the need to put the bad news into a back drawer for the new leadership to deal with, banks have been ordered to roll over these loans until sometime next year." Companies had used every trick available to them to take inventories off balance sheets, thus masking to the untrained eye the true extent of the problem, he continued.

"For instance, air-con makers shifted their surplus inventory into the distribution channels by offering extended credit terms, like 180-360 days, probably to be rolled over should the inventory remain within the distribution systems."

But he added that not all companies had the flexibility to remove the problem from their balance sheets. In the case of power cables, for example, he estimated that $5bn worth of stocks was sitting with the cable producers."The consequences of high inventories across nearly all sectors of heavy industry and manufacturing are that many, many companies have very tight cash flows because an inordinate amount is financing inventory," he added. "In turn, this means that companies are using their bank credit lines to finance inventory rather than day-to-day working capital.

"Whatever real financial ratios are used, under any other circumstance many companies would be failing - as in many other countries - and many have, which local governments are just not reporting."

Banks were also constrained in their ability to make fresh loans because they had been forced to roll-over existing lending, he said.

Another consequence of over-investment in industrial capacity is low capacity utilisation. Average industrial operating rates had fallen to just 60% in 2011 compared with 80% before the global financial crisis, according to a July 2012 International Monetary Fund (IMF) report.

It would take "months and in some cases years" for China to work-off its excessive inventories, warned Hunt.

Profit margins would remain squeezed, and as long as oversupply lingered, he said that the temptation to overproduce would persist.

"Official data is misleading because the NBS does not capture inventories within the distribution channels," he said.

Local governments were also overstating production and sales, and failing to report many bankruptcies, because this was a year of political transition, he said. In such a year, "government officials are more concerned with their promotion prospects and not their daily business," he added.

The hope is that China's new political leaders will focus more on domestic consumption and less on investments in manufacturing and exports. Private consumption is now just 35% of GDP compared with 45% a decade ago as a result of the surge in investment, according to the IMF. In the US, in contrast, the consumer is responsible for around 70% of economic activity.

Low domestic savings rates have not only encouraged more speculation in real estate and industrial capacity among the middle-class elite; they have also compelled lower-income earners to save as much money as possible, thus suppressing consumption, said several economists.

Savings rates and the cost of borrowing should therefore be increased, accompanied by a greater focus on the quality rather than the quantity of industrial investment, the economists added.

But data released by the People's Bank of China in late October revealed that lending to the real-estate sector had risen by 29% in Q3 2012 over the second quarter of this year.

"The central government has approved up to Yuan7 trillion for infrastructure investments since May to spur growth," added the China Daily, the official government newspaper, in a 29 October article.

This was widely interpreted as "more of the same": the government pumping additional cheap finance into the economy, at the expense of rebalancing, as it attempted to shore up support ahead of the leadership transition. Inventories of everything from unsold condominiums to plastic pellets to power cables might, as a result, have increased even further.

By: John Richardson
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