By Andy Xie
(Caijing.com.cn) China's credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.
Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China's economy by driving asset prices higher.
The current surge in commodity prices, for example, is being fueled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.
Commodity prices have skyrocketed since March. The Reuters-Jefferies CRB Index has risen by about one-third. Several important commodities such as oil and copper have doubled in value from this year's lows. As I have argued before, demand from financial buyers is driving commodity prices. The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.
Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.
Financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.
Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.
For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China's size. They've made everything open to speculation.
There's little doubt that China's bank lending since last December has driven speculative inventory demand for commodities. Chinese banks lend for commodity purchases, allowing the underlying commodities to be used as collateral. These loans are structured like mortgages.
Banks usually have to be extremely cautious about such lending, as commodity prices fluctuate far more than property prices. But Chinese banks are relatively lenient. As an industrializing economy, China's support for industrial activities such as raw material purchases for production is understandable. However, when commodities are bought on speculation, lenders face high risks without benefiting the economy. In some cases, this practice hurts banks and the economy at the same time.
Speculative demand for iron ore, for example, is seriously hurting China's national interests. Rio Tinto risked bankruptcy following its overpriced, debt-financed takeover of Alcan. When iron ore prices fell by two-thirds from the peak, the market started getting worried about Rio Tinto's viability, and its share price sank.
Chinalco then negotiated a US$ 19 billion investment in Rio Tinto. After that, Rio Tinto's share price nearly tripled. Rio Tinto then decided to issue new shares and cancel the Chinalco investment. Chinalco essentially gave Rio Tinto a free call option, and was ditched when a better option became available. The issue is why its share price has done so well.
The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.
But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.
The failure of Chinalco's investment in Rio Tinto has been costly for China. After watching its share price triple, Rio Tinto saw it could raise money more cheaply by issuing new shares to pay down debt. The potential financial loss to Chinalco isn't the point. Rather, higher costs will stem from a further monopolization of the iron ore market because Rio Tinto, after scrapping the Chinalco deal, entered into an iron ore joint venture with BHP Billiton. Even though these two mining giants will keep separate marketing channels, joint production will allow them to collude on production levels, significantly impacting future ore prices.
The iron ore market has been brutal for China, partly due to China's own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly.
For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008.
The gradual concentration of major iron ore mines by the world's three largest suppliers was a major reason for this price increase. The nature of Chinese demand was another major reason. China's steel production capacity has skyrocketed, even though capacity is fragmented.
China's local governments have been obsessed with promoting steel industry growth, which is the reason for fragmentation. Huge demand and numerous small players are a perfect setup for price increases by the Big Three miners, which often cite high spot prices as the reason for jagging up contract prices. But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China's steel industry is structured to hurt China's best interests.
As steel demand collapsed in the fourth quarter 2008 and first quarter 2009, steel prices fell sharply. That should have led to a collapse in ore demand. But the bank lending surge armed Chinese ore distributors, giving them money for speculating and stocking up. That significantly strengthened the hand of the Big Three. The tie-up of BHP and Rio Tinto further increased their monopoly power. Even though China is the biggest buyer of ore by far, it has had no power in price setting. The global recession should have benefited China. Instead, the lending surge worsened China's position by financing Chinese speculative demand.
China is a resource scarce economy. Its import needs will only increase. International suppliers are trying to take advantage of the situation by consolidating. But Chinese buyers are fragmented due to local government protection. China's lending surge made matters worse by creating excessive speculative demand.
What is happening in the commodity market is glaring proof that China's lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.
The tough economy and easy credit conditions encouraged many companies to try profiting from asset appreciation. They borrowed money and put it into the stock market. And since China's stock market has risen 70 percent since last November, many businesses feel vindicated for focusing on the asset market. This speculation spread to Hong Kong. Mainland money may have been behind a recent rise in the Hang Seng Index to 19,000 from 15,000, as well as Hong Kong luxury property sales. One way or another, it seems the money source was China's lending binge.
Borrowing money for asset market speculation is not restricted to private companies. State-owned enterprises (SOEs) appear to be lending money to private companies at high interest rates, i.e. loan sharking, using money borrowed at low rates from state-owned banks. Of course, we can't estimate the magnitude of such SOE lending. But it has replaced high interest rate financing in the gray economy.
As the economy weakened in late 2008, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money may have flowed into asset markets. It is part of the phenomenon of the private sector withdrawing from the real economy into the virtual one.
It's worrisome that businessmen have become de facto fund managers and speculators. This happened 10 years ago in Hong Kong, and since then the city's economy has stagnated. Some may argue that China has SOEs to lead the economy. However, private companies account for most employment in China, even though SOEs account for a larger portion of GDP. Now, the government is spending huge amounts of money to provide temporary employment for 2009 college graduates. If private sector employment doesn't grow, the government may have to spend even more next year. The government is using fiscal stimulus and bank lending to support economic recovery. But the recovery may be a jobless one. China needs a dynamic private sector to resolve the employment problem.
We are seeing a dark side to the
lending surge as commodity speculation hurts the economy. More lending may lead
to higher commodity prices, threatening stagflation. Cheap loans benefit
overseas commodity suppliers, not necessarily the Chinese economy. Lending
policy should consider this self-inflicted damage.
Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don't expand.
This lending surge proves China's economic problems can't be resolved with liquidity. China's growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China's exports have collapsed, there will be no income growth to support investment growth. The government's current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.
If exports remain weak for several years, China's only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.
Putting money into speculative
investments isn't totally irrational. It's better than expanding capacity which,
without export customers, would surely lead to losses. Businesses currently lack
incentive to invest. But many boom forecasters wrongly assume that recent asset
appreciation, fueled by speculation, signaled an end to economic problems.
That's an illusion. The lending surge may have created more problems than it