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China’s “Appetite For Pain” Makes $35/bbl Crude More Likely

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By John Richardson on 07-Jun-2017

The Chinese government is showing great determination in its latest battle against excessive and highly speculative lending. This will carry on as a cushion of strong GDP growth has been created, allowing a slowdown that will surprise many people with its severity. This makes further falls in global commodity prices likely – including a decline in crude to $35/bbl by Q4.


By John Richardson

HOW much longer will what financial analyst Charlene Chu describes as “China’s surprisingly high appetite for pain” continue? The answer to this question will set the direction of the global economy – and with it, of course the global chemicals industry – during the rest of 2017 and into 2018.

Chu, the former Fitch analysts, who is now a senior partner at Autonomous Research, added – in an insightful interview with Bloomberg – that China is in a great position to absorb lots more pain by further reducing leverage because its nominal GDP growth has reached around 10% per annum.

Official GDP growth in Q1 was at 6.9%. China has thus built a cushion of strong growth so far this year that it can use to further decelerate its economy without missing its official growth target for the full-year 2017 of 6.5%.

She added that the reduction in credit growth that has taken place so far this year has now reached the point where in the past China has backed away from economic reforms.

The next few months will therefore prove critical as we gauge whether Beijing continues to reduce the growth in overall credit. It will also be important to monitor the appetite for reducing highly speculative, and so very risky, forms of financing such as wealth management products and negotiable certificates of deposit.

My view is that China will not back down because China’s president, Xi Jinping, is now in a much stronger political position than 12 months ago. More of his supporters are in key government positions, and a greater number of those who want to block economic reforms are being investigated as part of the ongoing anticorruption campaign.

Further, I see the slowdown in lending growth as connected to efforts to improve China’s air quality. Close down uneconomic steel and aluminium plants etc. and Beijing will gain an easy political win by reducing particulate-matter pollution in China’s big cities. Dealing with soil and water pollution is far-more difficult and so will take longer.

Improving air quality has strong public support given that some 1m premature deaths a year in China are caused by air pollution. Many of the middle-class people that China needs to retain if it is going to escape its “middle-income trap” want to leave the country because of this health crisis, especially those that have young children.

China also has the chance to boost its international standing by making big progress in cleaning-up its air. In so doing it would also reduce carbon dioxide emissions. This could help it assume global leadership on climate change mitigation efforts, now that the US has abdicated this position by pulling out of the Paris deal.

“What’s the relevance to chemicals markets?” might still be your question. It really shouldn’t be because very recent history tells us the role that credit cycles in China have played in shaping global economic growth, and the direction of commodities prices – most importantly, of course, the direction of oil prices:

  • China increased lending by $10 trillion in 2009 when its nominal GDP was only $5 trillion. This big increase in credit was an attempt to shield China from the impact of the Global Financial Crisis. In the short term it worked. Many new jobs were created and a great deal of new personal wealth generated as manufacturing capacity increased and a major real-estate bubble developed. China also came to the rescue of the global economy as its consumption of oil, iron ore and other raw materials, including chemicals, soared. This led to a sharp rise in commodities prices.
  • But this also led to overcapacity across many Chinese manufacturing sectors. Debt as a percentage of GDP began to rise, as did bad debts. So, from early 2014 onwards Xi and his fellow economic reformers began to reduce growth in lending. The economy slowed, as did of course growth in chemicals demand. And from September of that year, oil and other commodities prices began to decline as global consensus opinion caught up with the extent of the slowdown underway in China. There were other factors behind weaker crude prices, but China was an important element of the fall in prices.
  • Last year, China once again took the controls off its financial system, resulting in a renewed surge in credit growth. This helped to support oil prices, along with the OPEC and non-OPEC deal to limit production. Other commodities prices, such as iron ore, also recovered. A lot of the improvement in global purchasing managers’ indices (PMIs) can be explained by rising raw-material costs. Purchasing managers have been forced to buy ahead of immediate demand, giving them the false impression that real demand has improved.
  • Another credit slowdown is now taking place. For instance, total social financing – a measure of all the new lending available in China – was down by 34% on a year-on-year basis in April. Interest rates have risen and measures have been introduced to crackdown on speculative financing.

The end-result you can see from the update of my regular chart at the beginning of this post. It shows the Caixin Manufacturing PMI, which monitors mainly small and medium-sized companies in China, and iron-ore prices.

From mid-June last year manufacturing activity picked up as the credit bubble was re-inflated. This led to the Caixin rising above 50, which represents expansion. Iron ore prices also rose as steel production picked up – and as speculative activity in iron ore increased.

But from February of this year, the Caixin PMI began to decline – and in May it fell below 50. This is the first time it has been in contraction territory for 11 months. Iron ore price have also fallen as steel production has been cut back. You can draw the same parallels between the rise and fall of the Caixin and natural rubber and aluminium prices.

What happens next? Quite possibly oil prices falling to $35/bbl by Q4 as the China slowdown combines with rising shale-oil production. OPEC and non-OPEC producers might also back away from their production cutbacks. This is a subject I shall return to in detail in later posts.

And on Friday of this week, I will look at what all of this will likely mean for the Asian polypropylene business during the rest of 2017.