China’s PE Cycle Repeats Itself



ChinaPE.pngBy John Richardson

THE above chart shows that China’s polyethylene (PE) demand growth has been well below that of overall GDP for most of the years between 2006 and 2012.

This supports the argument that economic growth has been too heavily focused on investment rather than consumption, given that the majority of PE goes into packaging and agricultural film applications rather than construction.

Another big factor behind the sub-GDP growth performance has been the increasing use of imported scrap, or recycled, plastic during periods of high virgin polymer prices.

This was particularly the case during 2006-2008 when the surge in resin prices, on the back of expensive crude, forced many plastic processors in China to switch to recycled material and/or to increase the use of fillers. Most of China’s plastic processors are small and medium-sized enterprises (SMEs) with limited cash-flows.

In 2009, however, the recycling market dipped on new regulations and reduced availability.

2009-H1 2010 saw a huge increase in apparent PE demand growth (imports plus domestic consumption), partly because of the decline in recycling.

But the main reason for the demand surge was China’s giant late 2008 economic stimulus package, which was designed to mitigate the impact of the Global Financial Crisis.

Polymers in general were being used as collateral for circular trades in other commodities and even property, as a major component of the stimulus package was a jump in bank lending that made speculation easier. 

A trader would, for example, buy PE just to get the credit to trade in, say, copper or to buy a condo in Beijing.

There was also a large build-up in inventories of both resin and of finished goods made from PE, as the easy lending conditions made taking long positions seem like a one-way bet.

But then, from April 2011, credit conditions became a lot tighter as the government grappled with inflation.

The first to suffer were the SMEs because of their poor access to credit and so they began to buy resin on a hand-to-mouth basis.

SMEs have long struggled to access credit because the state-owned banking system is set up to serve the state-owned enterprises.

This became an even greater problem when credit was rationed from April 2011, leaving the SMEs last in the queue for state-owned bank lending. They were forced to either cut production or go to private lenders who charge very high rates of interest.

Big stocks of both PE and finished goods made from PE, thanks to the credit binge, further depressed PE demand growth.

Q1-Q3 of last year was largely the same as the April-December period of 2011: A shortage of credit amongst the SMEs, whilst demand growth continued to be depressed by the lingering inventory problem.

But from May 2012, Beijing launched another stimulus package, albeit on a much smaller scale than the one introduced in late 2008. This latest package was designed to shore up support for China’s new leaders as they prepared to take office.

Up until Q4 last year, commodity and financial markets were full of the notion that China might be heading for a hard landing.

Markets then seized on the idea that China was on a sustainable path to stronger growth – thanks to this new package.

The problem is that the May-October 2012 rise in bank lending and government spending on infrastructure projects is the “same old, same old”.

The extra money has gone into more inefficient infrastructure spending and has re-inflated the property bubble.

Meanwhile, the SMEs, which are still paying interest rates of around 15%, are once again struggling with higher resin and fuel costs because PE and oil prices have risen.

Commodity prices have increased due to greater confidence in both the Chinese and Western economies.

What is different about this current cycle to previous PE cycles in China?

We think the answer is “nothing”, because, as in 2011:

*The new stimulus package has made rebalancing even harder, thus potentially further suppressing the growth of consumption as a driver of economic growth.

*Inflationary pressures are building. For instance, input prices for manufacturers are now at their highest levels since mid-2011. Higher interest rates and a reduction in access to credit seem likely, mainly at the expense of the SMEs – as they also struggle to cope with higher labour costs and reduced labour supply.

*There seems every chance that the current euphoria in China will lead to traders repeating the mistake of taking excessive long positions in PE. Manufacturers of finished goods might also be tempted to overproduce.

*A lot of new PE capacity is on the way, which the market will probably struggle to absorb.

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