INSIGHT: China yuan devaluation to exacerbate price pressure on petchems

By Joseph Chang, New York and Nigel Davis, London

NEW YORK (ICIS)–China’s surprise devaluation of its yuan currency versus the US dollar will have broad implications for global commodity prices, including petrochemicals and polymers.

In the near term, the simultaneous strengthening of the US dollar will put even further pressure on commodity prices (denominated in US dollars) across the board which have already been in freefall.

On the flip side, longer term, the marginally improved competitiveness of Chinese exports on the back of a weaker yuan (down by 1.9% initially but weakened further on Wednesday with a 1% fall), coupled with other stimulus measures from the government and central bank, could finally provide a lift for China’s stagnant economy. That is the aim by the government, and the hope for many players in the commodity space.

Everyone is talking about it but few are clear on the immediate implications. But it is the momentum behind the sharp devaluation that is most important, particularly for commodities and chemicals.

The 1.9% devaluation on Tuesday was the largest decline in the value of the yuan in a single day, not in itself huge by comparison to other exchange rate movements, but followed by a further devaluation on Wednesday which shook global markets.

A spokesman for the People’s Bank of China (PBC) on Tuesday described it thus:

“Currently, the international economic and financial conditions are very complex. The US economy is recovering and markets are expecting at least one interest rate hike by the FOMC (Federal Open Markets Committee) this year. As such, the US dollar is strengthening, while the euro and Japanese yen are weakening. Emerging market and commodities currencies are facing downward pressure, and we are seeing increasing volatilities in international capital flow.

“This complex situation is posing new challenges. As China is maintaining a relatively large trade surplus, RMB’s (renminbi’s) real effective exchange rate is relatively strong, which is not entirely consistent with market expectation. Therefore, it is a good time to improve quotation of the RMB central parity to make it more consistent with the needs of market development.”

China’s real, or effective, exchange rate had increased significantly, pushing up the price of exports as China’s manufacturing engine has stalled.

Back in March, China was not expected to respond to the increase with a competitive devaluation because it would undermine economic reform and the shift away from export-led growth. At the same time, there was no appetite for China to join the global currency war which has sucked in the euro, the Russian rouble and the Japanese yen, India’s rupee and other currencies.

Now, rather than defend the currency, China appears to be allowing it to fall in value to help prop up its pressured, still export-led growth model.

“As we first warned in March, and as became abundantly clear over the weekend when weaker than expected export data as well as the steepest decline in factory gate prices in six years underscored the extent to which the engine of global growth and trade has officially stalled, Beijing has no choice but to join the global currency wars, as the yuan’s dollar peg will ultimately prove to be too painful going forward,” was one comment on the Zero Hedge financial blog on Tuesday.

China’s exports were down 8.3% year on year in July and imports down 8.1% (they were down by more than 6% in June). The year-on-year drop on China’s producer price index was 5.4% in the year to July, worse than expected and the most significant fall since October 2009.

The People’s Bank of China said on Tuesday it would give markets more of a say in setting the currency, a move which comes before a decision of the International Monetary Fund which could be pivotal in the possible inclusion of the yuan in the IMF’s Special Drawing Rights (SDR). The SDR is an international reserve asset which is based on basket of currencies currently including the euro, the Japanese yen, the pound sterling and the US dollar.

In its comments on Tuesday, the PBC said that the market would need time to adapt. “The PBC will monitor the market condition closely, stabilising the market expectation and ensuring the improvement of the formation mechanism of the RMB central parity in an orderly manner.”

Some analysts believed further devaluation would be necessary given China’s weakened trade performance. 

The macro backdrop for commodities has been as dire as one could imagine. And it shouldn’t be surprising that the driver of the previous commodity supercycle peak – China – is now driving the way towards the trough.

This is evident in China’s manufacturing sector, which has posted five consecutive months of contraction (reading below 50) through July, according to the now-called Caixin China General Manufacturing Purchasing Managers’ Index (PMI) (used to be the HSBC Market China Manufacturing PMI).

The July PMI reading of 47.8 was down from June’s 49.4, and the weakest since July 2013.

Crude oil prices have renewed their plunge on the back of rising production, US dollar strength and the prospect of Iran coming back into the market.

On 11 August, on the first Chinese yuan devaluation, Brent crude oil fell $1.23, or 2.4%, to $49.18/bbl. US WTI crude fell $1.75, or 3.8%, to $43.91/bbl.

From oil, to copper, steel and aluminium, commodities prices have been on a major downtrend since May.

Oil price weakness has already dragged down petrochemical prices, but there is plenty of room to fall further, given the relatively still-robust margins in products such as polyethylene (PE).

“With margins through naphtha cracking to polymers still running very high currently, there is massive scope for competitive price erosion in the market – you could take $500/tonne off PE prices and still be making money,” said Paul Ray, head of consulting and analytics at ICIS Consulting.

“We are not suggesting that will happen, although we firmly expect some realignment post the chaotic shutdown season. Falling prices will drive de-stocking, so there will be an exaggeration to the downside,” he added.

Underlining the fundamentals, the devaluation move by China points to the level of weakness in its economy. Quantitative easing-like measures by China’s central bank to boost liquidity have so far not had the desired effect of reviving higher growth rates. Other measures to prop up the local equity market have had mixed results so far.

While official estimates and targets for China GDP are 7.0% growth, few if any doing business in the country believe that is being achieved.

“I think everything is pointing to a couple of very hard years for China. We see the devaluation as being very bad news for commodities – it’s very hard now to believe that China’s demand is somehow going to soak up the massive oversupply that now exists in almost all areas,” said Paul Hodges, chairman of consultants International eChem, and author of the ICIS Chemicals and the Economy blog.

“I imagine it therefore won’t be long now before oil falls back below $30/bbl, as the bursting of that bubble reaches its endgame,” he added.

Karl Bartholomew, vice president, Americas at ICIS Consulting, points out that China has finally reached the “dreaded balancing point” where its economy does not need an increasingly greater level of imports.

“Globally we have more exports wanting to go to China than China wants to import. And this is all happening before we really get petrochemical and polymers exports cranked up from the North American market. This definitely does not bode well for the next few years,” said Bartholomew.

That’s going to be a problem for petrochemical companies building world-scale ethane crackers and derivative projects in the US, with much of the production – largely PE – targeted for export, and to Asia in particular.

There are already six crackers under construction in the US – five slated for start-up in 2017, and one in early 2018. If China weakness persists through that period, the absorption of US petrochemicals and polymers exports will be a painful process.

China is displaying weakness across a number of markets. Passenger vehicle sales fell 6.6% in July year on year, after a 3.4% decrease in June.

“China will no longer be able to drive growth in the global auto industry – quite the reverse, as sales are already falling in countries such as Brazil and Russia that were previously dependent for their economic growth on commodity exports to China,” said Hodges.

And prices for a wide range of goods are falling in the country. China’s Producer Price Index (PPI) in July fell 5.4% year on year, following a 4.8% year-on-year decline in June. That deflation can be expected to continue being exported throughout the world.

“And of course prices will be even lower after today. As China is unlikely to throw more people out of work by closing factories, I imagine deflation will therefore soon become entrenched in the advanced economies as a result,” said Hodges.

Commodities equity prices were crushed on 11 August, reflecting the diminished outlook from the yuan devaluation and spotlight on weak China fundamentals. US publicly traded commodity chemicals stock prices were generally down in the range of 2.5-4%, but the sector’s declines were outpaced by those in industrial metals steel, copper and aluminum.

China’s devaluation and prospect for widespread commodities deflation may put pressure on the US Federal Reserve (Fed) to delay a widely expected interest rate hike beyond its September meeting.

A hike in interest rates supports a stronger US dollar versus other currencies and in turn even weaker commodity prices (priced in US dollars). US-based companies with international exposure are already taking earnings hits from currency translation on dollar strength. A stronger dollar still could put the kibosh on the US industrial and manufacturing economy.

And there are global implications for a US rate hike. The International Monetary Fund (IMF) is calling for the Fed to delay any increase through the first half of 2016 for the sake of US and global growth.

Yet the Fed appears determined to get the process of rate hikes started sooner rather than later, so that it can move more gradually towards the normalisation of rates. The China devaluation adds a twist to those plans.