The good, bad and ugly of China’s economic rebalancing

Fears of a significant slowdown in China’s economy, the second largest in the world, have whipped markets into a frenzy this year. As global equity markets opened on August 23, one by one and region by region, key indices flashed red. This, as the after-effects of China’s Black Monday – in which the country’s benchmark Shanghai Composite Index extended its losses to post its steepest one-day decline of 8.5% since the 2007 financial crisis – was ripping through world markets and prompting historic single-day sell-offs across the board.

Since then, continued volatility in Chinese markets, tempered somewhat by state intervention, which Goldman Sachs values at $236 billion over three months, has left investors across the globe uneasy.

Last year, the country’s economic growth slowed to 7.4%, its lowest level in more than 20 years. The extent to which the economy will slow this year remains a mystery – the People’s Bank of China expects the country’s economy to grow by 7%, the World Bank revised its annual growth forecast down to 6.9% from 7.1%, but the International Monetary Fund is sticking to its estimate of 6.8%. As is to be expected, some are less positive while others believe these fears are overdone.

“There is no doubt that growth will slow, but I don’t think there is a collapse in China coming,” said Liang Du, director and co-head of Asset Allocation at Prescient Investment Management, who is billed as the driving force behind the firm’s investments in China. He added that China’s stock market can withstand a long-term growth rate of 3%, a level which his firm would still consider attractive.

These fears have had a ripple effect on commodity markets, prompting widespread sell-offs in a number of precious and industrial metals as well as bulk commodities. Caroline Bain, senior commodities economist at Capital Economics, told Mineweb from London that the extent to which commodity markets are pricing in a collapse are also overdone, particularly as China’s commodity imports are “holding up”.

Still, the rout looks set to deepen, and concerns that the country’s shift from a resource-dependent, investment-led economy to a consumer oriented one may spell even more trouble for commodity demand are heightened. But not all commodities are equal – some are even likely to benefit from China’s economic rebalancing.

In a note, Bain and her colleagues put forward Capital Economics’ view on how the rebalancing will affect individual commodities. Here is some of the good, the bad and the ugly:

The Good

•  Gold

Higher disposable incomes, along with China’s cultural preference for the yellow metal is likely to result in an increase in the amount spent on gold jewellery. According to the firm, gold has been the main driver behind the country’s jewellery demand over the past decade, with consumption increasing 158% in volume terms and 498% in terms of value – that’s compared to an increase in GDP per capita of 161%. Gold’s status as a safe-haven asset is also expected to boost investment demand.

•   Oil

Citing the US Energy Information Administration’s forecast that liquid fuel consumption in China will double by 2040 on the back of increased transportation usage, Capital Economics says car ownership driven by increased consumption and higher incomes is set to accelerate, increasing the demand for oil. But China’s push to limit pollution from vehicles and increasing focus on greater fuel efficiency may somewhat curb consumption.

•   Platinum and Palladium

Increased car ownership should also prove a boon for platinum and palladium demand, particularly as the automotive sector uses PGMs to manufacture catalytic converters, which limit harmful emissions. Capital Economics’ calculations show the average content of catalytic converters in China, of about 2.4 grams, is significantly lower than those used in North America and Europe. As Chinese authorities adopt tighter emissions standards, catalytic converters for use in the country will need higher PGM loadings to better reduce pollution, thus fuelling demand for the metals.

•   White Metals and “High-End” Metals

The proliferation of electronics, technology and white goods is likely to result in increased demand for the likes of tin, zinc, aluminium, cobalt, silver and PGMs.

The Bad

•   Steel and Iron Ore

The end of China’s construction boom as well as moves to replace steel with the more energy efficient aluminium in the country’s transport sector are contributing to the structural decline of the commodities. But given the social and political concerns over economic growth and the scale of job creation by the construction sector, “now is not the time that we’ll see major rationalisation [in steel],” said Bain.

The Ugly

•   Coal

Although China’s electricity usage will increase, health and environmental considerations are set to change the way electricity is generated. Bain said by telephone that the country’s plans to impose a carbon cap-and-trade scheme, to curtail emissions, in 2017 “feels like another nail in the coffin for coal consumption in China”. She added that “phenomenal growth in the roll-out of renewables” together with growing concern over the high levels of pollution in major cities will further impact coal consumption.

Capital Economics stressed that growth in China’s commodities demand is coming off a “much higher base,” which means “slower growth can still be positive for global metals demand.” According to Du, institutions such as the Asian Infrastructure Investment Bank, which can potentially provide $1 trillion worth of firepower for infrastructure development globally, means demand for commodities will continue “just perhaps not at the pace we have previously seen.” In its 2015 Beyond China Report, Citi said while commodities demand will be driven by the “Emerging 5” – India, ASEAN, the Middle East, Latin America and Africa – it will not be able to offset slower growth from China. According to the bank, this will result in “slower demand growth globally for commodities as well as weaker global trade flows.”

Speaking to Mineweb from Cape Town, Du said, “commodities have hit a perfect storm” characterised by a slowdown in demand, a massive supply over-hang all while more production comes on stream with negative investment demand. And he is against investing in commodity stocks in China, as the 50 million strong retail investors in the country’s insular stock market have driven up the prices of local commodities companies rendering them much more expensive than their global counterparts. Instead, he’s buying a “hell of a lot” of blue chip companies, particularly those that are growing at 20-30% while doubling their return on assets and trading at a relatively cheap price-earnings ratio of 10-13.

In terms of China’s economic rebalancing, investment contribution to the country’s $10.47 trillion gross domestic product (GDP) fell from 54.4% to 48.5% last year. Over the same period, data from the National Bureau of Statistics shows consumption ticked up 0.2% to 50.2%. And there is still some way to go. “Chinese people are changing the way they do things. They are no longer saving 100% of their income and they have very little debt compared to the rest of the world so there’s potential for growth there. Consumption will be a big story in China going forward,” said Du.

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