What about demand?

September 19, 2012Commoditiesby Michael Pettis

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Could a Commodity Market Crash be Imminent?: Michael Pettis
Could a Commodity Market Crash be Imminent?: Michael Pettis

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China currently is the leading consumer of a wide variety of commodities wholly disproportionate to its share of global GDP. The country represents roughly 11 percent of global GDP if you accept the stated numbers, and substantially less if you believe, as I do, that growth has been overstated because of the difference over many years between reported investment, i.e. its input value, and the actual economic value of output. China nonetheless accounts for between 30 and 40 percent of total global demand for commodities like copper and nearly 60 percent of total global demand for commodities like cement and iron ore.

The only reason China has provided such an extraordinarily disproportionate share of global demand for hard commodities has been the nature of China’s growth model. While China may represent only 11 percent or less of the global economy, it represents a far, far greater share of the world’s building of bridges, railroad lines, subway systems, skyscrapers, port facilities, dams, shipbuilding facilities, highways, and so on.

Over the next decade, two things are going to change. The first is increasingly recognized, and that is that Chinese growth rates will drop sharply. The second is that China will rebalance its economic growth away from its appetite for commodities.

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The consensus on expected economic growth among Chinese and foreign economist living in China has already declined sharply in the past few years. From 8-10 percent just two years ago, the consensus for average growth rates in China over the next decade has dropped to 5-7 percent. But the historical precedents suggest we should be wary even of these lower estimates. Throughout the last 100 years countries that have enjoyed investment-driven growth miracles have always had much more difficult adjustments than even the greatest skeptics had predicted.

After all, there were many Brazilians in the late 1970s who worried that Brazil’s growth miracle was unsustainable and would end badly, but none expected negative growth for a decade, which is what happened during the terrible Lost Decade of the 1980s. Towards the end of the 1980s, to take another example, a few brave skeptics proclaimed that the Japanese miracle was dead and predicted that for the next five or ten years average Japanese growth rates would slow to 3 or 4 percent (in 1994 the IMF belatedly proclaimed that Japan’s long-term growth rate had dropped to 4 percent), but no one, even the most skeptical, predicted twenty years of growth below 1 percent. Finally when the USSR’s economy was hurtling forward in the 1950s and 1960s, and expected to overtake the US within a few decades, even the most die-hard anti-communists did not expect the virtual collapse of the economy in the 1970s and 1980s.

Similarly, the current consensus for Chinese growth over the next decade is almost certainly too high. Even if Beijing is able to keep household income growing at the same pace it has grown during the past decade, when Chinese and global conditions were as good as they ever could be, it will prove almost impossible for the economy to rebalance at average GDP growth rates over the next decade of much above 3 percent.

This 3 percent average will not be distributed evenly, of course, and we should expect higher growth rates at the beginning of the period (perhaps 5-6 percent over the next two years) and lower growth rates towards the end. But as this happens, over the next two years the consensus on China’s long-term growth rate will continue to drop sharply, and this will further affect commodity prices.

But even this underestimates the change in demand for commodities. For thirty years, and especially for the past ten years, China’s extraordinary GDP growth was driven by even higher rates of investment growth – generating for China the highest investment rates and investment growth rates in history. Consumption growth failed to keep pace during this time.

But rebalancing means, by definition, that for the next few years’ consumption growth must outpace GDP growth, and so also by definition investment growth must be less than GDP growth. Even if China is able to achieve 5-7 percent growth rates over the next decade, which I think is almost impossible, this implies that consumption growth will rise to 7-10 percent annually, and so from 25 percent growth in the last few years Beijing will be able to allow investment to grow no more than 2-4 percent annually, and much less if GDP growth rates are as low as I expect.

Which way can prices go?

For these reasons I am very pessimistic about hard commodity prices and expect them to drop substantially further in the next two to three years.

1.       Production capacity for hard commodities is rising much too quickly, in a belated response to the unexpected surge in demand just under a decade ago.

2.       Expected economic growth rates in the country that has been biggest source of new demand – virtually the only source – have fallen sharply and commodity prices have fallen with them. Historical precedents and the arithmetic of rebalancing suggest, however, that the current consensus for medium-term Chinese growth is still too optimistic. Expected growth rates will almost certainly fall further in the next two years.

3.       Beijing has finally become serious about rebalancing China’s economy, and rebalancing means shifting Chinese growth away from being disproportionately commodity intensive. Instead of representing 30-60 percent of global demand for most hard commodities, Chinese demand will shift to a more “normal” level. Remember that even a very limited shift – from 50 percent of global demand, for example, to a still high 40 percent of global demand – represents a sharp drop in global demand.

4.       There has been so much stockpiling of commodities and finished goods with implicit commodity content in China that the country could well become a net seller, and not net a buyer, of a wide variety of commodities in the next few years.

This is going to come as a shock to many people. In my discussions with senior officials in the commodity sectors in Brazil, Australia, Peru, Chile and even Indonesia, it seems to me that many analysts have been insufficiently skeptical about the Chinese growth model and are unaware of how dramatically the consensus has changed in the past two years. They have failed to understand how deep China’s structural problems are and how worried Beijing has become (this worry may be best exemplified by the extraordinary growth in flight capital from China since early 2010).

Under these conditions I don’t see how we can avoid a very nasty two or three years ahead for commodity producers. This isn’t all bad news, of course. What will be a disaster for hard commodity producers will be great news for companies and countries that are commodity users or importers. One way or the other, however, we are going see a big change in the distribution of winners and losers.

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By Michael Pettis

Michael Pettis is a senior associate at the Carnegie Asia Programme and professor of finance with Peking University’s Guanghua School of Management. Pettis previously taught at Tsinghua University and Columbia University, and worked on Wall Street in trading, capital markets and corporate finance.

By 2015 hard commodity prices will have collapsed is republished with permission from China Financial Markets.

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