By John Richardson
PRODUCT by product you need to build alternative scenarios for demand growth in the key China market.
The future might end up being the same as the past up and down all the petrochemicals value chains. But if this is your only scenario and it goes wrong you are going to end up in an awful lot of trouble.
During the Economic Supercycle it was actually possible to get away with minimal, or even no, scenario planning.
If your growth forecasts for China were a little optimistic over say a two-year period this didn’t matter at all because over the longer term, the economy was so robust that you would quickly recover lost ground.
And quite often the reverse happened with growth being more than you anticipated. As every mid-level petrochemicals company executive knows, it is better to under-promise and over-deliver to your board of directors rather than the other way round.
But I cannot emphasise enough that the post-Supercycle world is incredibly different. This requires, as I said, a product by product shake-up in your thinking on demand. This is also the case on supply, as my case study on paraxylene detailed last month.
Today, though, due to all of the complexities and uncertainties involved I will focus on demand and on one particular product – high-density polyethylene (HDPE).
China’s Giant Credit-Driven Consumption Leap
It is obvious from our base case Supply & Demand data, which is detailed in the above slide, that something quite exceptional happened to China’s HDPE market in the five years from 2008 until 2013.
In 2008, consumption was around 5.5m tonnes, but by the end of 2013 it had grown to approximately 10m tonnes – an increase when you look at the exact numbers of no less than 81%.
This was almost double the 41% increase that occurred in the five years from 2003 until 2008.
What was exceptional was the growth in credit. China increased lending by $10trn in 2009 alone when its nominal GDP was only $5trn, with the lending binge continuing until the end of 2013.
Since then there has been a sharp fall in credit growth. This has resulted in a slower expansion In GDP and with it, of course, growth in demand for HDPE.
As you can also see from today’s slide, we thus expect HDPE demand to rise by a comparatively modest 21% in the five years between 2013 and 2017 – and again by 21% in the five years from 2017 until 2021. This would leave demand at 12m tonnes in 2017 and 14.5m tonnes in 2021.
But a lot more deleveraging could lie ahead when you consider the extent of the remaining economic imbalances. According to a Fitch report, which was released in late September, bad debts in China’s banking system are ten times higher than official numbers and could reach one-third of GDP in two years. The ratings agency adds it would cost $2.1trn to clean up these bad debts.
Sure, you can argue that the Chinese government might kick the can further down the road. It could decide to delay further deleveraging through spending even more money on infrastructure, whilst holding back on restructuring of oversupplied industrial capacity.
This school of thought is based on the fact that Xi and other senior Chinese leaders face a five-year review of their leadership in either October or November 2017. The Politburo will by then be half-way through its ten-year term. Some commentators believe that the senior leadership team will thus want some positive economic news to report during this review process.
I think the opposite. Because Xi and his pro-reformers have recently cemented their political position, they are now in a place where they can play the long game of painful and difficult reforms.
You thus have to build a scenario where deleveraging gathers pace, resulting in a sharper contraction of GDP growth and with it weaker growth in HDPE than we expect in our base-case scenario.
What if I am wrong? What if the government decides to delay reforms for the sake of shoring-up short term growth?
There is also the danger that China loses control of events.
A financial crisis could happen in China warns both the Fitch reported I quoted above and a recent study by the Bank of International Settlements (BIS). The BIS estimates that debt now stands at 253% of GDP.
I think there will be a global trade war in 2017 because of both the end of the Economic Supercycle and the failure of Western mainstream politicians to address this challenge. A trade war would obviously be bad for global and Chinese economic growth.
The Case against a Smooth Transition
You can argue that China will avoid a financial crisis because of its high level of national savings, and lack of exposure to currency risk: Most of its debts are in local currency.
Equally, you might want to contend that what populist politicians in the West say during election campaigns is very different from what they will do if they win office. For instance, pledges to scrap free-trade deals that have been made during this year’s US presidential election campaign may come to nought.
The third big hope is that China will make a smooth transition from growth led by investment in manufacturing to growth that’s driven by consumption and service industries.
But this transition hinges on China’s ability to meet its rising pension and healthcare costs that are the result of a rapid ageing of its population. As we discuss on our Study, Demand: The New Direction for Profit, quoting OECD data:
- China’s basic pension pays just 1% of average individual/province earnings for each year of coverage, subject to a minimum 15 years of contributions.
- 30 years’ employment provides a pension of just 30% of this average wage.
- Some employees also pay 8% of their wages into a retirement fund and receive top-up annuities based on individual savings – but this only covers 210m urban employees.
Until or unless the government can close this gap Chinese families will want to save rather than spend money in order to cover their own retirement and healthcare costs.
Here’s a dilemma: As the economy continues to decelerate due to economic reforms, tax revenues will decline. This will make it harder to plug the revenue gap.
What about China’s attempt to escape its middle-income trap through building a higher-value services-based economy in its more developed western provinces?
Service sectors identified as strong drivers of future growth include private healthcare, telecommunications and the media. But in a slowing economy, how will they increase their revenues? In Q3 of this year growth in all of these sectors declined, according to the China Beige Book.
From plastic bags to natural gas transmission pipes
HDPE’s myriad of end-use applications range from the humble supermarket shopping bag – where the value addition is very low – all the way to extremely high value plastic pipes that transport natural gas.
Whilst supermarket carrier bags often end up in the bin after one use, natural gas pipes have to last 80 or even 100 years (PE 80 is the commonest-sold grade of HDPE pipe grade pellets, although the PE 100 market is also being developed).
And since January 2008, China has banned the free distribution of plastic supermarket shopping bags less than 0.25 millimetres thick. In the first year of the ban being effective, the government estimates it reduced their consumption by 66%.
What happens next to HDPE and plastics in general as environmental pressures increase? China faces nothing short of an existential crisis of chronically polluted water, soil and air and so in this wider context there could well be more restrictions designed to reduce plastic rubbish.
At the other end of the value-addition scale, it seems likely that China’s vast appetite for more infrastructure spending promises a bright future for HDPE gas-pipe demand. This will be in both China itself and across the huge One Belt, One Road region which comprises 65 countries and 40% of global GDP.
But affordability is the key issue for HDPE and all other chemicals and polymers in China. In a December 2015 survey, which we again quote in our Study, China’s Academy of Social Sciences concluded the following:
- China’s middle class comprises just 100m people with average incomes of $30,000 per annum.
- Even this income is towards the bottom end of the $25,000-$75,000 range that typically defines middle-income in the West.
- China 70m rural residents who live below the country’s own poverty line of Rmb 2,300/year ($350).
And now that the economy is slowing down because of economic reforms, affordability will become even more important.
In the case of HDPE injection grades this might result in more substitution by polypropylene (PP)), given just how relatively cheap PP might become in response to the fall in propylene costs. Propylene in Asia last year moved to a historically high discount to ethylene as a result China-driven oversupply in propylene.
Conclusion
This has just scratched the surface as there are surely many more aspects to this story because of the increasing complexity of today’s new economic environment.
A lot of hard work lies ahead of the petrochemicals industry in modelling and then responding to this complexity. This is where our team at ICIS Consulting can help.