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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 only increase. International suppliers are trying to take advantage of the situation by consolidating. But Chinese buyers are fragmented due to local government protection. Chinese lending surge has made it worse by creating excessive speculative demand.

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.

Borrowing money for asset market speculation is not restricted to private companies. State owned enterprises appear to be lending money to private companies at high interest rate, i.e., loan sharking, with the cheap loans from the state-owned banks. Of course, we can’t estimate the magnitude of such SoE lending. What it has done is to replace the high interest rate financing in the gray market. As the economy weakened in late 2008 private lenders began demanding money back from distressed private companies. The lending from the state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel the 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.

The trend of businessmen becoming de facto fund managers or speculators is a worrisome one. It happened ten years ago in Hong Kong. Its economy has stagnated since. Some may argue that China has state-owned enterprises to lead the economy forward. However, even though state-owned enterprises account for more GDP, private companies account for most employment. The government is spending huge amounts of money to support temporary employment for the college graduates in 2009. If the employment in the private sector 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 solve the employment problem.

We are seeing the dark side of the lending surge in supporting asset speculation. The commodity speculation is doing significant damage to the Chinese economy. More bank lending may lead to higher commodity prices, threatening stagflation for the Chinese economy. This self-inflected damage from China’s lending boom should be a major consideration in China’s lending policy. Cheap loans benefit foreigner commodity suppliers, not necessarily the Chinese economy.

Many analysts argue that GDP growth follows loan growth as money is spent. Inflation becomes a problem only when the economy overheats, which is still not a problem. This sort of thinking is naïve. We see the lent money is not spent in creating demand. It is being channeled into asset market speculation, which leads to inflation without boosting the economy. The long-term damage could be more serious as private businesses withdrawing from the real economy into the virtual one. When private companies don’t expand, China would suffer a lasting employment crisis. The lending surge may be hurting the Chinese economy both short term and long term.

The way that the bank lending has been channeled reflects that China’s economic problems couldn’t be fixed by liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grow, the government channels the income into investment to support export growth. As the global economy has collapsed, China’s exports have too. Unless the global economy comes back, China’s exports wouldn’t rise. There will be no income growth to support investment growth. The investment stimulus now is spending the saved income from past exports. It couldn’t last.

Unless China’s economic model changes, businesses really don’t want to invest. Without exports, who would be their customers? Hence, their response to put money into speculation isn’t totally irrational. It is better than expanding capacity, which would surely lead to losses.

If exports remain weak for years, China could only bring back high growth by shifting demand to household sector from export. It requires significant rebalancing of wealth and income in the Chinese economy. I have written repeatedly that a new growth cycle would start with distribution of the shares of the listed state-owned enterprises to Chinese households. It would lead to a virtuous cycle lasting a decade.

China’s bank lending surge has led to asset appreciation. Buoyant asset markets make many think that the economic problems are fixed. This may be an illusion. The lending surge may have created more problems than it solves. China’s economic problems are structural. They couldn’t be fixed by stimulus.