How Important Is China for Commodities Prices?

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It is widely held that China's economic boom of the past several decades is the chief reason for the big rise in nominal commodity prices since about 2001 (depending on which commodity one picks, the boom began for some in 1998 already, for others as late as 2002). However, this view strikes us as too simplistic. In fact, while China's economic trends undoubtedly influence the demand for commodities, one would then have to ask: why did commodity prices fall in the 1980's and 1990's? Both decades have seen heady growth in China and elsewhere in Asia, albeit interrupted by occasional crises.

It is probably better to ascribe the boom to a few additional factors as well, one of which is probably the by far most important: monetary inflation. It is no coincidence that the boom got going when inflationary policy got into high gear.

In addition, the supply response to the 1970's boom required some time to be worked out of the market's system. After a long grueling bear market, investment in a lot of commodity production had turned into a trickle and given the ever larger lead times and capital intensity of commodity investment projects, it initially only revived sluggishly. When the time had come when it finally looked like commodities were a 'sure thing', they promptly crashed in 2008. Money printing has however not only continued since then, it has accelerated mightily.

China's Economy is Beset with Problems, but Timing a Denouement is Difficult

However, perceptions being what they are, one can not simply ignore China. It seems to us that China may be in bigger economic trouble than generally assumed. For instance, here is yet another recent article on the vast 'shadow banking' system in China and its interconnections with China's banks.

"Shadow finance in China totals about 20 trillion yuan, according to Sanford C. Bernstein & Co., or about a third the current size of the country's bank-lending market. In 2008, such informal lending represented only 5% of total bank lending.

The sector is lightly regulated and opaque, raising concerns about massive loan defaults amid a softening economy, with ancillary effects on the country's banks. Banks often work with private lenders by selling loans to them or marketing investments on their behalf for a fee.

"Regular banking and shadow banking are not isolated from each other. Many activities in the two systems feed into each other, and could influence each other if things start to deteriorate," wrote Xiao Gang, chairman of Bank of China Ltd., in an editorial in the China Daily newspaper.

Although China Credit has the legal responsibility to repay investors, according to Chinese law, "for reputation's sake and potential social stability reasons, a portion of these loans can be banks' contingent liabilities," said David Cui, China strategist with Bank of America Corp.'s Merrill Lynch unit.

Others agree. "Banks might be held liable if bank representatives didn't adequately evaluate the products' risks for their clients," said Peng Junming, a former official at the People's Bank of China who now runs his own investment firm, Empire Capital Management LLP."

Another article detailing the shadow banking risk recently appeared on Bloomberg. It concerns a famous 'ghost town', the new Ordos in inner Mongolia, where construction projects financed by trusts have quietly stopped – without anyone telling investors about it. It seems there is a big time bomb lurking in China's financial system, which shouldn't surprise anyone after the heady credit growth of recent years. Another article relates that corporate debt has grown to alarming proportions. Here we read about local governments 'persuading' companies to prepay taxes as they can no longer rely on juicy development deals to fatten their budgets.

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About Pater Tenebrarum