Liquid Paper

In the past few weeks we’ve had renewed stimulus attempts from the Fed, the Europeans and the Japanese — the three big dogs in the central banking world. What has it achieved? Apart from giving stock prices a temporary boost, all it’s done is to act as a counterweight to the extreme deflationary forces weighing on the global economy.

Now the world is looking to the People’s Bank of China (PBoC) and hoping that they can do something too. Yesterday’s announcement that the PBoC had injected nearly US$60 billion into the market gave them some more…errr…hope. But as we’ll explain in a moment, if you’re betting on more China stimulus to boost markets around the world, you are going to be disappointed.

You’re also going to be disappointed if you were expecting a quick rebound in iron ore prices. Based on Fortescue chief Andrew Forrest’s comments at the PGA conference we spoke at the other day, he is one of those whom disappointment awaits.

Reuters reports:

‘China’s steel market, the world’s biggest, is feeling the pinch of a slowing economy that has sapped demand for new ships and construction work. Its largest listed steelmaker has halted output at a 3 million tonnes-a-year plant, and over a third of the country’s iron ore mines stand idle.’

The largest listed steelmaker referred to is Boasteel. The fact that it has bit the bullet and decided to slash production is an ominous sign for the steel industry. Up until now, China’s steelmakers have been content to keep churning out steel, sacrificing profits to maintain employment levels.

But the resulting oversupply of steel pushes prices down, and is no doubt affecting companies’ cash flows. Now, they have little choice but to start mothballing their highest cost production.

Perhaps more ominously for the steel (and iron ore and coal) industry is comments by Liu Xiaoliang, deputy secretary general of the Metallurgical Mines Association of China. At a recent industry conference in Dalian, he said that China’s consumption of crude steel could be around 705 million tonnes by 2015.

According to today’s Financial Review, steel production this year will be around 710 to 720 million tonnes, but consumption is much lower than this. If Liu Xiaoliang is right, growth in demand for steel making raw materials will be flat at best for years.

Of course the 2015 prognostication is just an opinion. But in China, official opinions tend to have some weight. They are an indication of where and how the Party tries to steer thinking on a topic. If this is the case, the message contained is that the infrastructure boom is over.

The silver lining here for Aussie iron ore producers is that the fall in steel prices and demand, and the subsequent fall in iron ore prices, knocks high cost Chinese iron ore producers out of the market. Iron ore from the Pilbara is amongst the highest quality and lowest cost in the world to produce. It will always be in demand.

The question for Rio, BHP and Fortescue investors is at what price will this iron ore sell? With all companies gearing up for production increases in the next few years (the result of boom time investment decisions), along with Brazilian company Vale, the iron ore market is going to see an increase in supply at the same time as static demand for steel.

The bottom line is that low prices are here to stay for a few years to come. We wouldn’t be surprised to see iron ore fall back towards US$80-$90 per tonne as we head into 2013.

The action in the Chinese steel market and the recent actions of the PBoC have a lot in common.

In recent weeks, the PBoC has had a preference for injecting liquidity into the market via a mechanism known as ‘reverse repos’. This is basically a way for the PBoC to inject cash into the system on a short term basis. That’s because the bank ‘reverses’ the cash injection after a certain amount of time. In short, it’s a temporary measure.

It differs from more permanent actions like outright interest rate cuts or reductions in the ‘reserve requirement’. This suggests to us that the authorities are very determined not to reinflate the infrastructure boom. While doing so might produce a short term boost, they know it would only lead to longer term problems.

Our theory is that the point of the PBoC liquidity injections is to stop the financial system from seizing up. When you go from boom to bust (and make no mistake, China is in the bust phase now…look at the performance of its stock market in the chart below) you get liquidity problems.

What do we mean by that? Well, when one company starts to struggle it might hold off on paying its creditors. Those same creditors have their own creditors to deal with and so on down the line. Cash flow problems at one company tend to flow through and impact many companies.

This is the genesis of a credit crunch. Credit within the system ‘freezes up’ and the system grinds to a halt. To offset this risk, the PBoC is now conducting regular ‘liquidity injections’ to ensure the system remains tepid at least.

Shanghai Stock Exchange – A Sign of Poor Profitability and a Credit Crunch

Source: StockCharts


But we see it as no reason to get excited. Overnight, commodities and particularly gold performed well, apparently on the back of China’s liquidity announcement. Funnily enough, the gold market didn’t react at all during the Asian trading session when the PBoC made the announcement.

But when the US markets opened, paper commodities and precious metals benefited. The (more permanent) liquidity provided by the Fed’s open ended QE program loves other liquidity type announcements because it can take advantage of them through the derivatives/futures markets.

Which brings us to an absurd point of QE. When central banks print money, investment banks design products to help you offset the inflationary impacts of the money printing. They tell you to buy ‘real assets’ and then sell you a wheat/copper/gold future…or put you into an Exchange Traded Fund (ETF) that gives you exposure to real assets via the derivative market.

And just like that, you ‘escape’ the invidious effects of monetary inflation by putting your savings into paper based investments which are the very result of the monetary inflation you’re seeking to escape.

So here’s something to think about over the weekend. If the price of ‘real’ assets is largely the product of demand for paper derivatives seeking exposure to real assets, how do you hedge against the risks of increasingly reckless central banking?


Greg Canavan
for Markets and Money

From the Archives…

The Sharks Amongst the School
21-09-2012 – Greg Canavan

Bernankonomics 101
20-09-2012 – Greg Canavan

There’s Going To Be a Fight
19-09-2012 – Dan Denning

The World’s #1 Money Printer
18-09-2012 – Bill Bonner

The Video That Started All the Controversy
17-09-2012 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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3 Comments on "Liquid Paper"

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truth and integrity
Only by precious raw material like metals and gems. All production products are accounted for in GDP = average of income + expenditure + production. By excessive income and expenditure growth we can have a high GDP; ie income +10% and expenditure +5% with production -2% and we have a GDP = 13%. Fantastic. Therefore as Equity = (Assets – Debt) declines drastically we have a high GDP. Politicians and financiers have discovered the perfect self destruct mechanism. Pay myself a high salary and I will put you all out of work. What will they eat? Paper? Gold will buy… Read more »

And on Australian liquidity ….

try re-running the AU numbers since the mid 90’s with out the foreign wholesale funding sugar daddy.

The AUD would be lower and the mining and agriculture would be in better shape on competitiveness, your house and rents would be half the price, government half its size, and only those soulless city vistas would be a little dirtier and Sydney Harbour busier with the citizenry pulling harder in order to make ends meet for themselves, their city, and their nation.


Comment by truth and integrity on 29 September 2012:

“Gold will buy a lot of sustenance because it is real equity and it can be bartered.”

The baker will barter with the wheat farmer and the butcher will barter with the cow and milk farmer and all will barter with the fruit ‘n vegie farmers and the carpenters and candlestick makers because ‘liquid paper’ and gold have no nourishing abilities, except, of course, the ability to nourish greed.

If/when the SH’sTF you will starve to_death holding gold and the ‘liquid paper’ used to acquire it.

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