Commodities: Big, Bad Dragon China Tries Benevolent Stimulus - Again

• China’s Banking Stimulus Round 2 doesn’t look different at all from Round 1
• Estimated freed-up 500 bln yuan nowhere enough for China’s woes - analysts
• But commodities front-run the stimulus, with rally in oil to metals and livestock 

The largest consumer of virtually everything is tempering with banking liquidity for a second time this year to stimulate an economy that hasn’t moved on from the pandemic, even as the rest of the world has raced ahead.

The People’s Bank of China has lowered the reserve requirement ratio for most banks in the country by another 25 basis points, repeating an act from March that brought the weighted average for the so-called RRR of banks to 7.4% this time. 

The move essentially reduces the mandatory cash minimum that banks have to hold in reserve — so that they can do more lending to the private sector, which, in return, the Xi Jinping government hopes will result in trickle-down economics that encourages more spending by regular people. 

The amount of money that will be freed up will be 500 billion yuan, or around $69 billion, according to an estimate by analysts at New York-based Bespoke Investment Group.

China, Economy, and Stimulus

The question almost everyone outside the Chinese Community Party is asking, of course, is whether this will be adequate to shore up the economy from its worst challenge in decades. Take the nation’s Gross Domestic Product, for example. If lucky, Chinese GDP growth will exceed 5% this year versus the record growth of 11.8% in 2020. 

An array of economic gambits pulled out of Beijing’s hat since the start of the year have been perceived as too little and often coming too late to turn into game changers. Thus, the question: How different will this be? 

Before that could be answered, though, commodities have moved at a lightning pace that’s only common for the resource markets. Oil prices surged to new 10-month highs above $90 a barrel, and copper rallied as well, along with almost every commodity mass-consumed by China as bulls in the resource space translated the impact any liquidity enhancement and resultant activity could have on demand.

To be sure, China's industrial output grew 4.5% in August from a year earlier, versus a forecast 3.9%, and retail sales expanded by 4.6%, beating an expected 3% increase. Chinese crude imports rose nearly 31% last month while refinery throughput hit a record 64.69 million metric tons as a function of summer travels. But these short-term upswings only mask China’s structural challenges, from worsening demographics to slowing productivity growth and an economy overly saturated on its property market.

Essentially, what happens with the Chinese economy down the road is far more important than any energy, metals, or grains rally of today. That’s simply because a continuously underperforming GDP will come back to rear-end any commodities rally.

Thus, the short — as well as long — answer to whether the latest banking stimulus will bring a material difference to China's economy is: NO.

This will not do it yet for Xi’s government, say those who’ve benchmarked the CCP’s efforts against hard targets they say need to be met in order to move the needle for an economy the size of China’s. Still, a second nibble at the RRR cake was a bite in the right direction, they said — though what would help, really, are more and larger chomps.

“What they’re looking to do obviously is loosen up more liquidity into their economy so that more money will become available,” said Dennis Unkovic, who has followed China from a legal and socio-economic perspective since 1985 and authored 12 books in all, with three of them on the country.

In an interview with Investing.com, Unkovic said the “Big, Bad Dragon” — as China is sometimes likened to — needs to match action with its tough language on the economy.

The Chinese central bank, for instance, said Round Two of the banking stimulus aspires, among other things, to “create an appropriate monetary and financial environment to promote effective demand in the real economy.” 

Adds Unkovic:

“The assumption is that people given the incentive of a 25 basis point drop will spend more money. I don’t think that’s going to happen. Ultimately, the individual Chinese people will be more concerned about what they see as markets that are unreliable at this point. If it helps, I think this stimulus will only be incremental because the size of the Chinese economy is $17.5 trillion, give and take one or two trillion. The ability to move the market in a more favorable way with a 25 basis point drop just isn’t enough.”

“The bottomline is the Chinese economy is in such a serious state at this point that I think it would require a number of actions by the Chinese government beyond what they’ve been doing. Thirty percent of the Chinese economy, for instance, is dependent upon real estate.” 

Nate DiCamillo, who has authored articles and opinions on China for quartz.com, concurs with that argument, saying the real estate sector was at the forefront of the country’s crisis, with its outsized share of GDP.

He adds:

“Not only did China build too much housing, but Chinese consumers are saddled with large amounts of mortgage debt that they initially took out assuming that the real estate sector wouldn’t stop growing.”

“If China was able to elect a new government, it would have more control over policies that favor real estate, and could instead increase consumption in other areas with more exciting productivity prospects, such as healthcare.”

Instead, China seems stuck with Xi Jinping’s view that avoiding fiscal stimulus will break the country’s habit of investing in real estate. Redistributing wealth in China would also threaten the Chinese Communist Party’s position, as it would empower more Chinese people, potentially leading to more social unrest.”

Thus, Beijing’s approach stood in direct contrast with the way the United States tackled the economic fallout from the pandemic by giving money to Americans, which helped poor people and the unemployed the most. 

The simple act of cash transfers to Chinese investors would allow consumption to play a bigger role in China’s GDP versus investment, wrote GZERO’s Ian Bremmer.

Bespoke Investment Group, which gave the 500 billion yuan estimate for the potential value of or around $69 billion, said it’s unlikely to spur more borrowing while demand for new loans is weak.

Instead of spending its way out of a recession, China aims to lend itself out of a potential future recession, DiCamillo concludes. 

Economists at Bank of America are also predicting that Chinese economic policymakers are only getting started in addressing the country’s economic woes and will ramp up more heavily later in the year.

China and Commodities

So what have the Chinese done so far to try and fix the problem?

Well, the biggest Chinese cities changed the definition of a first-time home buyer, which is allowing some Chinese consumers to obtain lower interest rates on their mortgage debt.

Cities and state-controlled banks have also used a variety of other property easing measures: reducing down payment ratios, removing home purchase restrictions, getting rid of developer pricing controls, and issuing special-purpose bonds for urban renewal.

In capital markets, China halved the taxes it places on transferring assets and loosened the cap on leveraged margin financing, which traders use to trade with borrowed money.

The central government is also considering a bailout of the local government financing vehicles that supported China’s infrastructure buildout, according to media reports. This could mean special purpose refinancing bonds are issued in the range of $1 trillion and $1.5 trillion to subsume the debt of local governments.

The downturns in the Chinese economy could still force policy-makers' hands, and allow the government to ease monetary policy, increase housing support, and deliver fiscal stimulus aimed at consumption, the Bank of America economists noted.

China’s stuttering economy is now the biggest threat to global commodities demand, as economic activity and credit flows in the world’s top buyer deteriorate sharply and put Beijing’s modest growth targets at risk.

Commodities have so far held up better than other assets as the economy has worsened. Freed from the constraints of the pandemic, fuel consumption has risen. Expectations that the government will be forced to amp up stimulus to rescue growth, as well as the onset of a seasonal recovery in demand, have also buoyed some markets.

But the backdrop remains worrisome. Traders are contending with a protracted crisis in the property market, deflation, weak exports, and a falling yuan. Structural challenges include the government’s desire to pivot to an economy led by consumption instead of investment — helpful for fuel and food demand but not for old economy metals driven by construction.

China’s explosive spending on clean energy offers one salve, lifting consumption of materials linked to the green transition, such as copper. But there are always trade-offs, in this case, reduced demand for fossil fuels. 

Now here's a sectoral roundup of market reporting to date:

Crude Oil

Crude oil shipments were a bright spot among China’s commodities imports in the first half, and demand growth this year is expected to account for 40% of the global total. But the recovery may now be running on fumes as refiners throttle back imports and switch to running down inventories.

The need to replenish stockpiles could yet reignite imports, which dropped to a three-month low in July. But a lot of the demand for oil products is showing up in export markets rather than at home. China’s diesel exports in July, for example, more than tripled from the prior month.

Domestically, the picture is bleaker. Diesel consumption is being pegged back by weak industrial activity, while gasoline demand is challenged by the faster adoption of electric vehicles. China’s petrochemicals sector, makers of plastics and rubber, saw a rare decline in sales and profits in the first half and remains heavily dependent on the health of the property market.

• U.K. Brent crude settled Sept. 15 at $93.93 per barrel, up 3.6% on the week, after a 10-month high at $94.62

• U.S. U.S. West Texas Intermediate crude settled Sept. 15 at $90.77, up 3.7% on the week, after a 10-month high at $91.15

Coal and Gas

China’s economic activity is underpinned by coal, its mainstay fuel. Beijing has boosted both output and imports to drive a rebound that has ultimately disappointed, creating a glut that has left prices languishing.

Now that peak summer cooling needs have passed — air-conditioning is a major drain on electricity supplies — power plants could opt to dump inventory if industrial indicators remain gloomy, further pressuring the market.

China’s economic malaise is also likely to rein in the breakneck pace of inbound shipments, which have nearly doubled from last year. Purchases of liquefied natural gas, an alternative fuel, are also likely to slow, given coal’s abundance. The depreciation of the yuan, which makes commodities billed in dollars more expensive, is another headwind for buyers.

• U.S. natural gas settled Sept. 15 at $2.6440 per mmBtu, up 1.5% on the week

Base and Metals

Base metals have retreated from their January high as the economy has lost steam, crushing margins at smelters and fabricators. The drop in profitability in the first half is their worst performance in over a decade. Industrial profits data for July is due on Sunday and is likely to show more pain in the sector.

The plunge in margins at fabricators, especially for aluminum, is “a result of vicious competition, a price war in some segments,” said Wang Rong, an analyst at Guotai Junan Futures Co. 

At the same time, inventories of copper and aluminum, the most widely used base metals, have dropped, with stockpiles of the former near critical levels, according to Goldman Sachs. As traditional drivers of consumption have stalled, “new sources of growth from clean energy sectors have supported metal demand,” ANZ Group Holdings Ltd. said in a note this month.

• U.S. copper settled Sept. 15 at $3.8010 per lb, up 2.3% on the week.

Iron and Steel

Construction accounts for as much as 40% of China’s steel demand, and iron ore, the main input for blast furnaces, is a totem of the old economy. Bets on stimulus have helped keep prices above $100 a ton, although a reluctance to load up local governments with even more debt undermines the case that Beijing will resort to another big splurge on public works.

Seasonal demand is picking up as the summer lull passes into the so-called golden months for building activity, lifting run rates at blast furnaces and shrinking stockpiles of ore. Even so, the state of the property market means steelmakers are probably going to be cautious about tapping more imports to replenish supplies, said Steven Yu, an analyst at Mysteel.

“While this could leave mills highly exposed if there is a sudden recovery in downstream steel demand, this is a relatively moot point given the poor health of China’s industrial economy,” said Atilla Widnell, managing director of Navigate Commodities Ltd.

• iron ore fines settled Sept. 15 at $120.56 a ton, up 3% on the week.

Livestock 

The reopening of the economy after the government’s stringent measures to control the pandemic didn’t quite deliver the celebratory feasting of pork, China’s favorite meat, that many had expected. Instead, households conserved cash as economic uncertainties mounted.

The weaker market for pork has ramifications for the wider economy. Meat has a heavy weighting in the basket of food prices, which was a big contributor to July’s lapse in consumer deflation.

The disappointing recovery has left pig farmers mostly loss-making for the year and the pork market in surplus. Festival season, which begins with the National Day holidays at the start of October and runs through Chinese New Year, will be the next test of the public’s appetite for discretionary spending on pricier foodstuffs. 

• U.S. lean hog settled Sept. 15 at 83.125 cents per lb, up 2% on the week

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Disclaimer: The aim of this article is purely to inform and does not in any way represent an inducement or recommendation to buy or sell any commodity or its related securities. The author Barani Krishnan does not hold a position in the commodities and securities he writes about. He typically uses a range of views outside his own to bring diversity to his analysis of any market. For neutrality, he sometimes presents contrarian views and market variables.