Market outlook: China Deflation Threat To Petrochemicals

China’s producer prices have been falling for 34 months in a row because of widespread industrial overcapacity

January could hardly have started on a bleaker note for the petrochemicals business in China as a result of a growing consensus that China’s economy is confronting some major headwinds.

Demand lags far behind supply as a result of capacity expansions from 2008-2013 Copyright: Rex Features

“I am really worried about deflation in China. It is very likely that as the real value of debts increases due to falling prices, we are going to see a substantial number of bankruptcies, especially of smaller, less financially-sound plastic converters,” said a Hong Kong-based senior executive with a global polyolefins producer.

“And the other problem is oil prices. On several occasions over the last few months, when crude stopped falling for a few days, there was a great deal of speculation that the market had finally bottomed-out,” he added.

“This led to some converters in China rebuilding their raw-material inventories to hedge against what they thought would be a recovery in polymer prices.”

But as everyone knows, the reverse has happened as oil prices have continued their remarkable decline. This had led to additional declines, rather than increases, in the cost of polymers in China. The processors that were tempted back into resins markets are, as a result, sitting on raw-material inventory losses.

China’s deflation problem stems from its huge economic stimulus package, which occurred in 2008-2013.

Much of the extra credit made available by the state-owned banks ended up funding capacity expansions that have pushed many industries into oversupply, including petrochemicals.

Take phenol as an example. China’s capacity totalled 870,000 tonnes/year in 2010, but by the end of 2015 will have risen to no less than 3.3m tonnes/year, according to ICIS Consulting . This represents an increase of 279%.

Building New Factories
Meanwhile, demand looks set to be well short of this surge in investment. Real consumption of phenol, which is consumption adjusted for inventory distortions, was 1.3m tonnes in 2010, said ICIS Consulting. This year’s real consumption is expected to reach only 2m tonnes.

Average capacity utilisation of phenol plants in China stood at 91% in 2013, but is expected by ICIS Consulting to have fallen to 65% in 2014. This year, rates are expected to decline to only 52%. The same has happened in polyvinyl chloride (PVC). PVC capacity was 17.9m tonnes/year in 2010 and will have risen to 31m tonnes/year by the end of this year, again according ICIS Consulting. In 2010, real consumption was 12m tonnes, and it will increase only to 16m tonnes in 2015.

Rapid capacity expansions have resulted in a sharp about-turn in petrochemicals trade flows. Taking PVC as an example again, imports fell to 817,000 tonnes in January-
November of last year compared with 931,000 tonnes during the same eleven months of 2013, according to China Customs. Meanwhile, exports surged to 1.1m tonnes from 681,000 tonnes. The scale of the oversupply crisis in some other industries is even more shocking. Take steel as perhaps the most-famous example, where overcapacity is estimated at some 320m tonnes/year.

“During the lending binge of 2008-2013 banks were falling over themselves to lend money to any project, no matter how unviable, because Beijing told the banks that they had to do this to support growth” said a Shanghai-based investment banker.

“The local governments also saw an opportunity to fund their healthcare, education and other spending requirements by selling land to industrial developers – and by gaining tax revenues when new factories came on-stream,” he added.

“I think that it was a bit of an ego thing as well. It was as if every provincial governor wanted a brand-new steel plant or a brand-new PVC plant, for the sake of improving their ‘face’.”

This helps to explain why producer, or factory gate, prices have been falling in China for 34 months in a row.

Last December, producer prices fell by 3.3%, according to China’s National Bureau of Statistics. This was the steepest decline since September 2009.

In the mining sector in December, prices fell by no less than 13.2%.

When China last suffered such serious producer-price deflation, back in the late 1990s, it was six years before prices started to rise again, said the Bank of America (BoA) in a January 2015 report entitled, “Deflation, Devaluation and Default”.

This was despite the economy benefiting from the global information technology bubble and admission to the World Trade Organisation (WTO) in 2001, said BoA. China became the “workshop of the world” for global electronics and other consumer goods, thanks to the lowering of trade barriers that resulted from its WTO membership.

Worse Than Japan In The 1990s
But ahead of this latest bout of deflation, investment as a percentage of GDP had been much higher than during the 1990s, warned the BoA.

“Global growth is also weaker and China has lost a great deal of global competitiveness due to domestic [wage] inflation,” added the bank.

Meanwhile, China is struggling to find new demand drivers, as it has already built too much housing, with further growth in auto ownership constrained by environmental issues, said the BOA.

“We judge the chance of a credit crunch in China – prompted by a sudden surge in corporate debt defaults – as quite high given the excessive capacity and leverage situation,” wrote the bank.

To give you an idea of the scale of 
China’s debt overhang, most estimates point to loans increasing by 100% of GDP over the past five years. This is twice the pace of growth in Japan before the Nikkei bubble burst in the 1990s, and is also more than the increase in US debt ahead of the 2008 Lehman Bros crisis.

The bank worries that as the true scale of China’s debt problems become more apparent, capital flight will be the response, which could result in a devaluation of the yuan.

Further downward momentum could be exerted on China’s currency when the US Federal Reserve finally decides to raise interest rates.

Higher borrowing costs in the States are likely to strengthen the US dollar versus the yuan and other currencies.

China’s central government might welcome a weaker local currency. The reason is that over the last few years, China has seen the yuan appreciate against the currencies of some its Asian rivals.

This has undermined its competitiveness in export markets.

For example, the yuan has fallen in value against the Japanese yen by around 60% during the last two years.

China’s currency is now overvalued by 10-20%, according to Diana Choyleva, head of macroeconomic research at Lombard Street Research – the London-based consultancy.

She warned that China had therefore “lost its competitive edge” because of both a weaker currency and the rise in labour costs that the BoA report also highlighted.

Improvements in productivity had failed to keep pace with the decline in the yuan and more expensive wages, she said.

A fall in the yuan might, thus, allow China to regain its share of export markets, which would serve as some compensation for slowing local growth.

This is a truly scary prospect when you think about the scale of the industrial overcapacity highlighted above.

The end-result could be that China ends up exporting its deflation to the rest of the world – at a time when deflationary pressures elsewhere are also building.

Subscribe to ICIS Chemical Business