China Credit, Commodities Bubble

By John Richardson

China announced last week that its state-owned banks had lent Rmb1.07 trillion ($172m) in January, which was more than double the amount in December.

Financial markets have taken as evidence that the economic recovery has gained momentum.

But when you combine January-February lending for 2012 in order to get rid of the Lunar New Year distortion effect (the Lunar New Year falls later this year and so there are extra working days in January 2013), the number doesn’t look so astounding: In January-February 2012, Rmb1.4 trillion was disbursed.

(It is also important to note that bank lending in China always surges in January as state-owned banks start to fulfill their new quotas and companies dip into new budgets.)

This suggests that while the government might have gone hell-for-leather in boosting lending in May-October 2012 for political purposes, the supply of official new credit was kept at a relatively conservative level last month.

One reason could be that Beijing recognises inflationary pressures are building and so has instructed the state-owned banks to tread fairly cautiously, whilst the government also wants to press ahead with economic rebalancing.

For the time being at least, though, consumer-price inflation appears to be fairly benign as it fell to 2.0% in January from 2.5% in December.

Some economists expect inflation to gather steam during the first quarter, but they think it will stay below 3.5% for the full year 2013 – a figure that they expect the government to announce at its target. If inflation stays below 3.5%, the argument is that there will be no need for increases in bank reserve requirements or interest rate increases.

We think, though, that government concern might well be building over inflation because:

*Food prices were up by 2.9% in January. Food-price inflation matters a lot in China because it remains a poor country.

*Overall consumer prices were by 1.0 percent in January from December, the strongest monthly gain January 2012.

*”Apart from higher state investment as a potential source of inflation, the housing market is showing signs of strength once again as prices climb towards record highs despite curbs to try to cool the market,” wrote Reuters in this article.

*Commodity prices are on a role as the ICIS Petrochemical Index (IPEX) for February indicates (see chart below). Northeast Asian prices rose by 3.2% on a 4.8% increase for olefins, a 3.1% increase for polymers and a 0.8% rise for aromatics. Olefins prices were lifted by a continued strengthening of butadiene.

 

IPEXFeb11.png 

*Overall input prices are at their highest level since mid-2011, when China was last forced to tighten liquidity. Part of the reason is that Chinese manufacturers, which includes, of course, chemicals and polymer buyers, are once again in the midst of a strong restocking phase. They are attempting to hedge against further price rises whilst also preparing for the post-Lunar New Year demand recovery. 

*”As the economy transits into another stage of growth, economic controls need to always emphasize containing inflation risks,” the People’s Bank of China said last week, indicating a change of approach from accommodative to more cautious.

But if state-owned credit growth in January was indeed not that dramatic, where is all the money coming from to fuel increased industrial activity?

The answer lies in January’s “social financing aggregate” which more than doubled from a year earlier, to Rmb2.54 trillion.

Social financing aggregate is a broader measure of liquidity in the economy, including state-owned bank lending, wealth management products, corporate bonds and unofficial lending.

This suggests to us that the small and medium-sized enterprises (SMEs) might have taken a gamble on by borrowing a lot of money from the unofficial lenders, who make up the shadow banking system, at high rates of interest. The SMEs have to borrow from unofficial lenders because the state-owned banks are biased in favour of the state-owned enterprises.

The rise in unofficial lending further supports our main argument: That Beijing is very worried about inflation, and also about the bad-debt implications of a collapse in commodity prices – as it was from April 2011, at the beginning of the last cycle of credit tightening.

Everything will be fine, of course, as long as commodity prices don’t collapse.

But is anyone really convinced that some of the recent dramatic price increases are entirely justified by demand? Iron ore is, for instance, up by 79% since September, even though 33.8% of China’s steel mills are loss-making and excess production was 160 million tonnes in 2012.

Economic problems in the US and Europe, which we will examine later this week, also suggest that China’s recovery in exports of manufactured goods will not be maintained.

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