Market outlook: China faces a difficult adjustment

17 April 2014 09:37  [Source: ICB]

China’s new economic stimulus package, which was launched on 2 April, is very modest compared with the spending programme launched in late 2008.

The earlier package, introduced to lessen the impact of the global financial crisis, involved much bigger local and central government investments in infrastructure.

Chinese rail Reex Features

Rex Features

China’s new stimulus programme includes investment in railway

And the new package is also aimed at what China’s leaders believe are more sustainable routes to growth.

As a reminder, the main features of the new stimulus programme are:

  • More railway construction. The government will sell $24bn of bonds this year to build railways in the less-developed central and western regions. It also plans a $35bn fund dedicated to rail financing. Eighteen percent more railways will be built this year compared with 2013. Railway capacity remains in short supply in China and better infrastructure, particularly in the less-developed western and central provinces, is seen as vital for raising income levels. China wants to replace overinvestment with domestic consumption as the main driver of economic growth.
  • More investment on slum clearance and affordable housing for low-income earners. This is also all part of government efforts to raise consumption by focusing on the some 80% of people who still earn only $20 or less a day. And, as with railways, while there is a severe oversupply of high-end and mid-range condos in some areas, there is a shortage of affordable housing for low and average income earners.
  • And helpfully for the chemical industry, existing tax breaks for small businesses will be extended until the end of 2016. The tax threshold for small businesses will also be raised. Most of the buyers of chemicals in China are small and medium-sized businesses.

Most importantly of all, this latest stimulus programme did not include any relaxation of the much-tighter credit conditions that have prevailed so far in 2014. A reduction in trade financing has been the main reason for very weak petrochemicals markets, especially since the end of the Lunar New Year.

China’s new leadership team have said that lending conditions will remain tight, and have warned that there can be no return to the credit-fuelled boom of 2008-2013.

Here are some of the reasons why:

  • In 2009, lending via the state-owned banks – which was another element of that first giant economic stimulus package – tripled.
  • This led to overinvestment in new industrial capacity, which added to existing oversupply in industries such as steel and cement, and made environmental problems much worse.
  • And from 2009 until the end of last year, credit creation in the highly speculative shadow, or unofficial, banking system grew out of control.

Now China also confronts a severe bad debt problem. Money, which was borrowed both offshore as well as locally, poured into asset bubbles post-2008.

Quantitative easing by the US Federal Reserve has resulted in lower overseas interest rates than those in China. One can, therefore, argue that the economic problems now confronting China are of the Fed’s making, as well as China’s.

The positive news is that the 2 April stimulus package might well prevent GDP growth from falling to very low single digits, or perhaps even zero – the forecast of extreme China bears.

But the bad news is the great credit drawdown looks set to continue, leading to a difficult adjustment period for the chemical industry.

NEW MESSAGE FOR SPECULATORS

Overseas chemicals cargoes have sometimes been purchased not because of their underlying value, but because of the cheap US dollar-based credit that these shipments have generated. The chemicals have then either been sold immediately or put into storage, and the finance used to speculate on property.

Speculators have also made money on interest-rate arbitrage. This has involved either putting money into higher-yielding local deposit accounts at state-owned banks, or investing in the shadow banking sector, where interest rate-returns have been as high as 20%.

Plus, the yuan until very recently was nearly always appreciating in value against the US dollar. By the time US-dominated debt had to be settled, currency gains had been made.

Along with the tighter lending conditions, which are mainly aimed at the shadow lending sector, the government has also widened the band in which the yuan trades against the US dollar. The message to speculators seems clear: From now on, you can lose as well as make money from yuan speculation.

These investment distortions even extend to investments in plastic processing capacity.

“Speculators have moved into manufacturing semi-finished goods, just to get their hands on the cash flows to service property deals,” said a source with a global polyolefins producer. “This is a big reason for the oversupply we are seeing in the biaxially oriented polypropylene (BOPP) films sector in China.”

It was fairly technically easy to produce low quality BOPP film and the scale of each production line – 10,000-30,000 tonnes/year – guaranteed enough revenues to service property deals, said the source.

“This is less the case in PE where production lines tend to be smaller – for example, 10,000 tonnes for cross-stretch cling-film,” he added.

The BOPP film producers had been losing around yuan1,000 for every tonne they produced, but this didn’t matter because the increasing value of their real estate investments had more than compensated for these losses, he said.

“Investors only got into the films business because of restrictions introduced over the last few years that have made it harder to borrow money directly for property,” he explained.

He warned that the new restrictions on credit supply could force some BOPP film producers out of business.

WORTH 16% of GDP

Many people in the chemicals industry are trying to fathom the impact of all these speculative practices on chemicals demand. The credit explosion in 2009 resulted in an unsustainable rise in polypropylene (PP) consumption.

Another area of great concern is the health of the property sector. This is why: China’s real estate sector was responsible for 16% of the country’s GDP growth, 33% of fixed asset investment, 20% of outstanding loans, 26% of new loans, and 39% of government revenues in 2013, according to investment bank Nomura.

In late March, the property company Zhejiang Xingrun Real Estate, defaulted on $565m of debt.

China PP

When a property company had previously faced default, either a local government or the central government had always come to the rescue, said financial analysts.

The decision to let Zhejiang Xingrun default is, thus, widely viewed as another sign that Beijing wants to get rid of speculative forms of growth.

“We believe more property developers will face similar pressures as transaction volumes slow and cash flow conditions tighten,” said Nomura economist Zhiwei Zhang in a March 2014 research note.

The risk for developers is particularly high in third- and fourth-tier cities, which accounted for 67% of housing under construction in China in 2013, added Zhang.

And while there is a shortage of affordable housing, Nomura estimated that nationwide, residential floor space per registered urban resident reached 37 square metres by 2013, compared with 35 square metres in Japan and 33 square metres in UK. If the current trend it holds it could reach 51 metres in China by 2017, the bank added.

How might all of this end for the chemicals industry? Nobody has a clue.


By: John Richardson
+65 6780 4359



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