Is the massive Ponzi scheme that is China’s credit bubble starting to crack? Recent action out of the Middle Kingdom hasn’t exactly been bullish. In the past few days you’ve seen sharp falls in copper and iron ore prices, two crucial inputs into China’s economic growth machine. Despite this, the level of complacency that persists is astounding.
Just to recap, China’s recent credit expansion is the largest in modern economic history. Since the post GFC boom got underway in 2009, its credit system has expanded by around US$15 trillion. To put that into perspective, the expansion is about the same size as the entire US banking system…which took a couple hundred years to develop into its current size.
Now any rational person, on giving that stat a few minutes thought, would start to think about the practical limits to this whole thing working out well for China. At the very least, they might think the last five years represented somewhat of an anomaly in terms of China’s growth trajectory, and that the next five years might prove to be a little more subdued.
Is that not a fair assessment, dear reader?
We think so. But others clearly don’t. The Sydney Morning Herald reports today on comments made by both BHP and Rio at a nicely timed iron ore conference in Perth yesterday:
‘Big miners believe the recent slump in the iron ore price is due to a mix of credit tightness in China and opportunism from traders, with executives from BHP Billiton and Rio Tinto expressing faith in China’s long-term demand for Australia’s most lucrative export.
‘With analysts predicting the 16 per cent fall in the iron ore price over the past three weeks will continue for at least several more days, the nation’s top iron ore executives sought to calm market jitters at an iron ore conference in Perth.
‘Both BHP’s iron ore president Jimmy Wilson and Rio Tinto’s Andrew Harding kept to long-held forecasts that Chinese demand for steel would top 1 billion tonnes by 2025 or 2030, and would therefore ensure demand for iron ore remained strong for more than a decade.’
BHP iron ore President Jimmy Wilson reckons everyone should just chill out. Don’t worry about these short term credit issues, look to the long term:
‘"Our view to the long term is still very robust. We shouldn’t let today’s price influence our long-term thinking,”
”’You’ve got this credit issue in China … and traders have a view that the price is going to go down so they do everything they can do to hold back, so these fluctuations always tend to amplify.
”’I do think it will come down, but then also come back up.”’
This is not quite in the same league as Rio buying Alcan at the top of the market in 2007, but the complacency is pretty impressive. But when you’ve just spent tens of billions expanding your output, and you’re amongst the lowest cost producers in the world, you can afford to be complacent.
Rio will nearly always make a profit from iron ore…but profitability matters more to investors, and its profitability that will decline.
Mr Wilson is right in one respect. The recent price turmoil is related to ‘this credit issue’ in China. (He makes it sound like such a trifling event, doesn’t he.) Both copper and iron ore have been popular amongst traders in China as a short term financing tool.
That is, you obtain a short term letter of credit from a bank to buy iron ore or copper (because the bank won’t lend it to you unsecured). You then ‘sell’ the raw material to someone else to raise cash for a few months and probably buy some futures to cover your ‘short’ position.
You then use the cash to speculate on interest rate differentials (remember all those juicy high yielding trust products in China?) for a few months, before returning the cash and getting your iron ore or copper stockpile back.
In the good old days (a few months ago) you could sell the stockpile quite easily as there was always an unprofitable steel mill waiting to take in iron ore for any price. This commodity collateral financing scheme became quite popular. According to Reuters, ‘about 25-30 percent of iron ore stockpiled at major Chinese ports is tied to financing deals.‘
But now prices are falling, leading to traders dumping the stockpiles and pushing prices sharply lower. The catalyst for the panic seems to be China’s first corporate bond default, which occurred on Friday (we mentioned it in yesterday’s Daily Reckoning) in addition to a slowing credit growth in February.
Credit data reveals that China’s infamous ‘shadow banking sector’ barely grew in February. With the Ponzi tap suddenly turned off in the riskiest and most opaque part of China’s credit system, you’re bound to get some problems. And those problems surfaced in the commodity financing arena.
The big question is whether this is just a brief speculative unwind or the start of something bigger. We think in the short term, the ‘brief speculative unwind’ argument will win out. This will give the iron ore bulls, like the guys at BHP and Rio, just enough time to pat themselves on the back before the next hit, which will send prices falling again.
This will probably take a few more months to play out. While February credit data was weak, the same thing happened last year before a big bounce back took place in March. When the government is the one pulling the credit strings, you need to be prepared for anything.
But it’s also quite clear the government is trying to rid the system of the speculation that has built up recently…speculation that resulted from the government’s efforts to boost economic growth in the first place. China, quite obviously, is trying to come to grips with controlling a western style credit boom.
The bottom line is that if you’re a bull, you think China’s authorities can bring the out-of-control credit system to heel. If you’re a bear, like us, you think something bad will happen to a system that has expanded as fast as China’s credit system since 2009.
But we also think this will be a good thing for China. A sharp credit crunch and a renewed focus on efficient allocation of capital will be enormously beneficial for China’s long term growth. It will be good for Australia too. But there will be some pain to endure first.
And most of that pain will occur on the iron ore front. BHP for example suffers a US$120 million hit to net profit with every dollar per tonne decline in the iron ore price. If prices eventually settle somewhere between US$80 and US$90 per tonne, as we think they will, the miners will be much less profitable then they have been over the past five years.
That’s why the iron ore miners are nearly all trading on single digit price earnings ratios. They are not value plays, they are value traps.
Copper is probably a better contrarian play than iron ore right now. In a recent report, we wrote that problems in China would send commodity prices to new lows in 2014. We highlighted one copper play as a stock to watch and buy on weakness. You can access the report here.
Iron ore, on the other hand, has been a major beneficiary of China’s unprecedented credit pump. It makes sense that it won’t do as well when the pump reverses and drains the excess from the system.
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