Dark side of the lending boom
China’s lending boom since December 2008 has boosted bank loans by over Rmb 6 trillion. Many analysts think that an economic boom will follow in the second half of 2009. They will be disappointed. Much of the lending has not been invested and has flowed into asset markets. As money flows into speculation in asset markets, many believe that it will lead to spending boom through the wealth effect. First, creating a bubble to support the economy at best brings some short term benefits and more long term pain. Second, some of the speculation is actually hurting Chinese economy. The surge in commodity prices is fueled by China’s demand for speculative inventory. The damage is already significant. If lending doesn’t cool, this force would transfer Chinese income to foreigners and trigger stagflation for a long time to come.
Commodity prices have skyrocketed since March. The CRB index is up about on
Financial demand alone can’t support commodity prices. Financial buyers can’t take physical delivery and must sell the maturing futures contracts. This force would lead to steep price curve against time. In early 2009 the six month futures price for oil was twenty dollars higher than spot price. Unless spot price rises, financial buyers suffer huge losses. The wide gap between spot and futures price increased inventory demand as arbitrageurs sought to profit from the difference between warehousing cost and the price gap between spot and futures price. That demand flattened the price curve and diminished the losses to financial buyers. Without inventory demand financial speculation couldn’t work.
For some commodities the warehousing costs are low, i.e., the net loss for financial buyers is low. They can behave like pure financial products like stocks and bonds. Precious metals, for example, are like that. Copper, though five thousand times less valuable than gold, still has low warehousing cost relative to its value. Some commodities like lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that. They can leverage China’s size to make everything possible for speculation.
There is little doubt by now that China’s bank lending since last December is driving speculative inventory demand for commodities. Chinese banks lend for commodity purchases with the underlying commodities as collaterals. The lending is structured similar to mortgage. Banks usually need to be much more cautious about such lending as commodity prices fluctuate far more than property prices. Chinese banks are more lenient. As China is an industrializing economy, it is understandable that the country should support industrial activities like purchasing raw materials for industrial production. However, when buying commodities is for speculation, the lenders suffer high risk without benefiting the economy. In some cases it hurts banks and the economy at the same time.
The speculative demand for iron ore, for example, is gravely hurting China’s national interest. Rio Tinto was suffering bankruptcy risk due to its overpriced and debt financed takeover of Alcan. When iron ore price dropped by two thirds from the peak, the market became worried about its viability and its share price became very low. Chinalco then negotiated a $19 billion investment in the company to support its finance. However, as its share price has nearly tripled from the bottom, it has decided to cancel the Chinalco investment and issue new shares instead. Chinalco essentially gave Rio Tinto a free call option. It ditched Chinalco when a better option became available. The issue is why its share price has done so well.
International media has been reporting record amounts of China’s commodity imports. The surge is being portrayed as reflecting China’s recovering economy. Indeed, international financial market is portraying China’s perceived recovery at the harbinger for global recovery. It is a major factor in 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 the financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. As the price curves have flattened for most commodities, the imports are for speculating in price increase. As there are so many Chinese speculators, their demand is driving up prices, making the expectation self-fulfilling in the short term.
One obvious cost for China is the failure of Chinalco’s investment in Rio Tinto. When it saw its share price tripling, it could raise money cheaper by issuing new shares to pay down its debt. The potential financial loss to Chinalco isn’t the point. Bigger cost would come from further monopolization of iron ore market. After scrapping the Chinalco deal, Rio entered into an iron ore JV with BHP. Even though the two will keep separate marketing channels, joint production allows them to collude on production levels, which would have significant impact on future ore price.
The iron ore market has been brutal for China, partly due to China’s own inefficient system. For four decades before 2003 fine ore price fluctuated between $20-30/ton. As iron ore was plentiful in the world, its price was driven by production cost. After 2003 Chinese demand drove it out of the range. The contract price quadrupled to nearly $100/ton. The spot price reached nearly $200/ton in 2008. China imports more ore than Europe and Japan combined. The skyrocketing ore price has cost China dearly.
The gradual concentration of major iron ore mines among the big three was a major reason for the price increase. The nature of the Chinese demand was a major reason too. China’s steel production capacity has skyrocketed while the capacity is fragmented. Chinese local governments have been obsessed with promoting the growth of steel industry, which is the reason for the industry’s fragmentation. Huge demand and numerous small players are a perfect setup for the big three to increase prices. They often cite high spot prices as the reason for jagging up the contract prices. But, the spot market is relatively small. They can easily manipulate it by decreasing supply into the market. On the other hand, numerous Chinese steel mills all want to buy ore to sustain production for their governments to report higher GDP, even though the GDP is money losing. China’s steel industry is structured to hurt China’s interest.
As steel demand collapsed in the fourth quarter of 2008 and first quarter of 2009, steel prices fell sharply. It should be led to a collapse in ore demand. The surge in bank lending armed Chinese ore distributors with money to stock up ore for speculation. It has strengthened the hand of the big three enormously. The tie-up of BHP and Rio Tinto has increased their monopoly power further. Even though China is the biggest buyer of ore by far, it has had no power in price setting. When the global recession should have benefited China, the lending surge has made it even worse for China by financing Chinese speculative demand.
China is a resource scarce economy. The need for imports will on
What is happening in the commodity market is a glaring example that China’s lending surge is hurting itself. Even more serious is that it is leading Chinese companies away from real business and further towards asset speculation. The tough economy and easy credit condition have led many companies trying to profit from asset appreciation. They have borrowed money and put it into stock market. As China’s stock market has risen by 70% since last November, many businesses feel vindicated for focusing on asset market rather than real business. The speculation has spread to Hong Kong. Mainland Chinese money may have been the force between HIS moving up to 19,000 from 15,000 and have been driving the luxury property sales. One way or another the money came from China’s lending binge.