Global Deflation At Risk Of Returning On End Of China Commodities Bubble

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By John Richardson

THIS time last year it was deflation that seemed to be the problem for the global economy. Despite many years of US Federal Reserve, European Central Bank (ECB) and Bank of England (BOE) etc. economic stimulus, consumer and producer prices had stubbornly refused to respond in the way that most of the economic experts had expected.

Wind the clock forward 12 months and we are now back in inflationary territory in the West, and crucially also in China where the country’s closely-watched producer price index has swung back into inflation. In February, it reached a nine-year high on higher commodities prices.

Nobody is quite yet panicking about rising prices choking-off global growth in the way that deflation clearly was doing a year ago. But the Fed of course raised interest rates earlier this month and is expected to raise rates at least twice more in 2017. And whilst the ECB and the BOE are keeping rates on hold at the moment, there seems to be rising pressure within both central banks to raise rates.

But I believe that global inflation has only returned because of last year’s renewed credit bubble in China and the effect that this has had on commodity prices. Now, though, China has started to take the air out of the bubble as Xi Jinping, China’s president, presses ahead with economic reforms.

We may have one or two more months of excess credit floating around China’s financial system that will support global commodity prices.  But later this year, I think we will start to see Xi’s reforms exert significant downward pressure on commodities prices, including most importantly of all oil. As I discussed on Friday, Xi’s reforms are likely to result in the growth in China’s crude imports falling to a four-year-low in 2017.

1,200 Empire State Buildings, and now nearly 13,000 Eiffel Towers

Iron ore prices could also fall back to where they were 12 months ago – at around $45/tonne – because stockpiling in China again seems to have moved ahead of demand.

Remember June 2014 when there was enough iron ore stockpiled in China to build 1,200 copies of the Empire State Building? Reuters at that time estimated that some 100m tonnes of iron ore was “off market”, as it was tied-up in collateral or circular trades. Circular trades are where a speculator buys a commodity, any commodity including polyethylene (PE), not for the intrinsic value of that commodity but to instead obtain credit for speculation in other commodities and in real estate.

Reuters now reports that China’s domestic iron ore production jumped 15.3% in January-February as last year’s price rally extended into 2017, causing imported ore to pile up at China’s ports. Inventories of imported iron ore at 46 Chinese ports reached 132.45m tonnes on March 24 – the highest since data started to be tracked in 2004. This would be enough to make 12,960 replicas of the Eiffel Tower. A third of the stocks belonged to traders.

China’s polyolefins commodity markets also continue to exhibit signs of significant inventory overhang, perhaps again as a result of excessive speculation:

  • Net PE imports (imports minus exports) in January-February 2017 rose by 38% to 1.9m tonnes over the same two months of last year, according to ICIS analysis of China Customs department data.
  • Polypropylene imports rose by 39% on the same basis to 840,000 tonnes.
  • Meanwhile, ICIS China estimates that domestic PE production rose by 11% to 2.7m tonnes, with PP production up by 15% at 3.1m tonnes

This could help to explain today’s weak polyolefins markets in China where prices keep on slipping. Prices were again down in the week ending 31 March. Another factor, though, is of course the renewed uncertainty over crude prices.

And in copper, inventories in warehouses monitored by the Shanghai Futures Exchange had by 20 March more than doubled from early January. Stocks in LME-approved warehouses were up by nearly 70% since early February.

The Importance of Housing

This is all heavily linked to the renewed boom in China’s real-estate sector. Investment in real-estate development grew by 8.9% year-on-year in January and February. New home prices in Beijing rose by 22.1% year-on-year in February.

But there was a slowdown in overall credit growth during the first two months of the year. New cooling measures  specific to real estate are also constantly being introduced – for example, the Beijing city government now considers former married couples of who have been divorced for less than a year to be second-time buyers. There has been a surge in divorces in order to get around higher down-payment requirements for couples buying second homes.

Wat happens next? As Simon Daly writes in this Seeking Alpha article:

In the [China commodities} cycles that have defined the growth slowdown since 2013, inventory levels in coal, steel, iron ore, and housing all reach levels of absolute overcapacity before beginning to fall in an apparent cyclical downturn. Eventually, the market reaches equilibrium and a cyclical upturn starts again.

The Global Implications

In 2-3 months’ time – or sooner – as Xi’s economic reforms start to take effect, we could thus see a repeat of events in late 2014 when oil and other commodities prices fell on a slowdown in Chinese economic growth. This would lead to weakening purchasing manager’s indexes across the West as a commodity destocking process began. And global equity markets, which have benefited from the temporary return of inflation, would suffer. People would also again start to fret about deflation

The reason for a return to a deflationary world would be because – as the Fed now belatedly recognises – too much supply continues to chase too little demand in Western economies. This is the result of the retirement of the Babyboomers. Until or unless this demographic challenge is addressed deflation will remain a constant threat.

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