'China Effect' means commodities may take years to recover

Nation's slowdown coincided with major increase in production capacity

China's economic slowdown has led to sharp commodity price falls on an unprecedented scale and it may take many years for global commodities markets to pick up again, experts say.

Although the slowdown of the commodity market began in the last few years, huge growth in China's stock market gave the commodity industry hope of recovery. But tumbling share prices and the yuan's depreciation have made the reality clear, and commodity prices have plunged further.

"We've never seen the scale and speed of consumption growth that China has seen since 2004, so the downturn in commodity prices led by China's slowing down could be unprecedented," says Bjarne Schieldrop, chief analyst of commodities at SEB, the Nordic bank.

"This will be one of the big events in terms of the boom and bust of commodity prices." He adds it will probably take years for the global commodity markets to start picking up again, and that the impact of this commodity downturn will be significant for all commodity-producing countries.

"During the commodity boom, these commodity-producing countries all had trade surpluses that they invested in overseas government bonds, and now many of them have trade deficits, so this will have a significant impact on the global bond market," he says.

The S&P GSCI, an index that tracks a diversified basket of commodities, is down 36 percent over the past year, and fell a further 6.4 percent in June, when the Chinese stock market started to slump.

Shares in even the biggest, most resilient mining companies have also dropped. BHP Billiton Ltd and Rio Tinto PLC have slid back toward their lowest levels since the depths of the global financial crisis six years ago. BHP reported an 86 percent drop in net profit, to $1.9 billion (1.7 billion euros), for its latest financial year.

On Sept 2, the International Monetary Fund issued a note in a report for a Group of 20 finance chiefs meeting in Ankara. It warned that China's slowdown would affect commodity markets and the global economy in a more significant way than originally expected.

"China's transition to a lower growth, while broadly in line with forecasts, appears to have larger-than-previousl envisaged cross-border repercussions, reflected in weakening commodity prices and stock prices," the IMF said.

China's economy has become the backbone of the global commodities markets in recent years and especially since the financial crisis, when consumption in mature Western markets waned.

China now consumes roughly two-thirds of the world's iron ore, and consumes roughly 40 to 50 percent of the other metals, according to statistics provided by CME Group, a Chicago-headquartered commodities options and futures exchange.

John Davies, head of commodities research at BMI Research, says the most significant impact of slowing Chinese demand is on construction materials, particularly steel, iron ore and copper.

"This is for two reasons. First, China's economic slowdown is being driven by a major contraction in fixed asset investment in the country. Second, China plays a particularly large role in global import demand for industrial metals."

"The most exposed countries are small countries that rely on China for a major chunk of their export revenues, such as Mongolia, Myanmar, Sierra Leone and Congo-Brazzaville," Davies says.

Erik Norland, executive director and senior economist at CME Group, says analysis based on prices of iron ore, copper, aluminum and other industrial metals shows China's slowdown became apparent in the last quarter of 2014 and is now attracting more attention as it becomes more acute.

Norland says he believes reasons for China's slowing demand for commodities include the country's highly indebted private sector, which is beginning to de-leverage, and the yuan, which had become overvalued in recent years, restricting export growth and hence commodity demand.

He says the most heavily affected commodities are industrial metals and precious metals that are used for industrial purposes such as copper, iron ore and platinum.

Softer demand in China may have contributed to the decline in crude oil prices but the drop mostly remains a story about supply and inventory rather than one of slowing demand growth in China, Norland says.

"The slowdown in China's demand is impacting a variety of countries. Australia and Brazil are being impacted by slowing demand and much lower prices for iron ore. Chile and Peru are impacted by the decline in copper prices and South Africa by the drop in platinum prices," he says.

A survey of Australian mining companies by Newport Consulting showed that 80 percent of them plan to reduce jobs, and smaller companies are canceling projects and are in danger of failure.

Schieldrop says the slowing of global commodity markets actually started in 2011 but the growth in China's stock market since 2014 gave markets a false optimism, a belief that China's real economy would start to grow fast again and push for another commodity market pickup.

Globally, the commodities market already started to slow in 2008 following the financial crisis, but the Chinese government quickly implemented economic stimulus packages to fuel the real economy's growth, which led to increasing demand for global commodities, Schieldrop says.

But toward 2011 the stimulus packages' impact on the Chinese economy started to lose momentum, and this triggered consequences for global commodities markets.

Another reason for the drop in commodity prices is a big increase in commodity capacity globally.

"The reason for the commodity price decline is twofold. On the one hand the Chinese economy is slowing down, and on the other hand you have massive investment in new capacity coming to the market at the same time," Schieldrop says.

These capacity and supply increases are particularly prominent in exporters like Australia and Brazil.

They started to invest in additional capacity around 2004, when high growth in the Chinese economy exhausted global commodity supply capacity. As many commodity production plans are big greenfield projects that take between five to 10 years to add capacity, the new capacity came to market around 2011 and coincided with China's slowdown.

"The commodity producers did not realize that the rebound of commodity prices in 2009 was not driven by natural growth in the Chinese economy but by stimulus packages that will eventually lose momentum," according to Schieldrop.

Although the global commodity market normally goes through cycles of boom and bust, the current downturn is of a significant scale, he says.

Schieldrop expects commodity producers to increase production efficiency in order to stay competitive in a less favorable environment. This will lead to new cost cutting technologies and processes being introduced, and cheaper commodity supplies across the whole industry.

"This cost efficiency and cost deflation will be good for commodity import countries, and it will be good for China too as it will give them access to cheaper commodities for economic growth," he says.

Norland adds that as long as China's economy does not slow down too dramatically, commodity prices might be hitting the bottom right now. If China continues to slow more than the markets currently anticipate, however, there could be further downside risks for commodities.

"The equity values of metals and mining companies have taken a hit during the past year, as have the values of many energy companies as a result of lower commodity prices. "Those two sectors of the equity market will be key to watch for signs of either a revival or a continued decline in Chinese demand growth," Schieldrop says.

cecily.liu@mail.chinadailyuk.com

(China Daily European Weekly 09/11/2015 page19)