INSIGHT: Weaker China economy could hit US cracker investments

21 October 2013 15:59  [Source: ICIS news]

By John Richardson

PERTH (ICIS)--The case for lots of cracker and derivatives investments in the US seems overwhelmingly strong because of the shale-gas boom.

ut some industry observers continue to worry that project proponents are not focusing enough on the demand side of the equation.

“Most people assume that the last few years are an aberration and that global growth will soon get back to normal and so there will be plenty of room for all the US projects,” said a mid-ranking executive with a global polyolefins producer.

“But what if growth doesn’t return to normal, whatever normal is? Or what if a new economic crisis is just around the corner?”

One of the biggest areas is China’s economic future. The country will be an important destination for surplus US ethylene derivatives.

A strong case can be made for lower long-term GDP growth in China, as the economy is adjusted-away from its investment-led growth model towards one that is much-more dependent on domestic consumption. It has become almost conventional wisdom over the last six months that China will have to undergo such a slowdown because:

**The economy is burdened by overcapacity across many industrial sectors – including, for example, in polyvinyl chloride (PVC). In the steel sector, there is so much overcapacity that profitability was just 0.04% in 2012, according to Yu Yongding of the Chinese Academy of Social Sciences. Plus there has been huge over-investment in infrastructure.

**High pension and healthcare costs mean that China’s consumers might take a long while to pick up the slack from lower investment-driven growth. The suppression of domestic deposit rates – the reason why capital has been so cheap for industrial and infrastructure investments – is cited as another reason why consumer spending may take several years to fill the GDP growth gap.

**The November plenum meeting could unlock some of this latent consumer demand. However,  there is an argument to be made that China’s leaders will only be able to introduce gradual economic reforms because of strong resistance from “vested interests” who want to maintain the current economic model.

But what if the strength of China’s domestic consumption has been underestimated?

“Jun Zhang and Tian Zhu, respectively of Fudan University and China Europe International Business School argue that consumption has been consistently under-reported,” wrote David Pilling of the UK's Financial Times in a 17 October article

“In a recent paper they find three important areas of under-counting.

“One is housing. China, they argue, does not properly account for ‘imputed rent’, an estimate of how much owner-occupiers would need to pay if they were renting.

“Second, they say, a lot of private consumption shows up in statistics as corporate expenses. For example, many executives pay for their private car on the company account. Although this appears in official data as investment, it is really consumption.

“Third, and most important, they argue, GDP surveys under-represent high earners, who may not relish the idea of officials with clipboards noting down their every expenditure.

“If high-income households are missing from the survey, so is their consumption. Taking these three factors together, the two academics calculate that China underestimates consumption by 10-12 percentage points.”

Michael Pettis, a finance professor at Peking University, has also argued that whilst overall GDP growth might fall to as low as 3-4% per annum over the next decade, the rise in real household disposable incomes might be much higher.  Thus, chemicals and polymers demand growth could be in well in excess of GDP.

Economic doubts do not just apply to China. A flood of cheap credit, thanks to Federal Reserve quantitative easing, is said to have created economic bubbles in emerging markets in general. Eventual Fed tapering might lead to the bursting of these bubbles – and the full exposure of the failure by many governments to pursue long-tem reforms necessary for sustainable growth.

The future wellbeing of the US economy – and of course the rest of the west – is also hardly guaranteed, argue many other economists.

And no matter how well the US economy grows, there seems no escaping from the fact that the petrochemicals projects being planned in the US will have to be heavily dependent on exports.

Demand for the products finally made from ethylene is expected to grow at only about 2% in North America, maybe more if North America’s re-industrialisation continues, says Accenture’s Paul Bjacek in a 10 October chemicals sector study.

This would be way below the 64% increase in ethylene capacity (an additional 11m tonnes/year of ethylene) if all the announced cracker projects come on-stream, he added.

At least, though, the feedstock side of the equation in the US is proven.

Or maybe it isn’t. Some gas-industry experts are warning of a rise in ethane costs over the long term to the point where competitiveness might be significantly eroded.

By: John Richardson
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