Chinese inflation, like its bank lending, points to a bubble in investment misallocation...
SO INFLATION in China is running at 5.1% from a year ago, according to official statistics, writes Dan Denning in his Daily Reckoning Australia.
But Zhang Ping of China's National Development and Reform Commission (NDRC) reckons it'll come right. Of course, he didn't put it that way. But we've learned this week that Chinese officials think they can live with a little inflation, as long as it doesn't cause a little revolution.
In fact, despite the fastest rise in consumer prices in 28-years – especially food and fuel – the NDRC raised China's official inflation target (or limit) for 2011 from 3% to 4%. Instead of dialling back the rate of investment and loan growth, in other words...both of which would be bearish for commodity exports from Australia...the Chinese appear to be kicking it up a notch, or at least keeping it at the same notch.
China set a quote of CNY7,500 billion (US$1.1 trillion) in new loans in 2010 after a $1 trillion blow out in 2009. That quota will be met and likely exceeded. But next year's quota is the same size. And it prompts an obvious question: where the heck is all that money going?
Why does the question matter? Because it tells you if China is building too many factories, bridges, roads, and office buildings...or just enough factories, bridges, roads and office buildings. And THAT tells you whether Australia's record terms of trade and booming mineral and metal exports to China are something you can bank on for the next ten years, or something that could smack Aussie minerals investors in the face.
So where is the money going? The most often repeated line about China is the fitting out of the country – its infrastructure – is what's driving metals-intensive demand for Aussie resources. But by definition, fixed assets can include factories and real estate too. So is China building the backbone for its transportation network of the next 100 years? Or is something else going on?
To try and get an answer to this question, you can read a copy of this report at the Reserve Bank of Australia website. It has a refreshingly simple title for a central bank research paper. It's called "Sources of Chinese Demand for Resource Commodities" by Mr. Ivan Roberts. What we'd consider the key points are that China's building more factories, fewer bridges. Infrastructure has declined as a percentage of total fixed asset investment from over 50% at the turn of the century to just over 30% now. Manufacturing – China's export engine – has caught up.
Of course if total fixed asset investment has been climbing, then infrastructure investment's decline could be more in percentage terms than real terms. But let's assume for the moment that China's fixed asset boom is being driven equally by infrastructure and manufacturing, with a growing real estate boom. What does that mean?
Well for starters it means a huge boom in demand for steel making materials, especially iron ore and coking coal. Mr. Roberts explains:
"Iron ore, aluminium ores, base metal ores and coal account for more than half of China's non-oil resource imports. Chinese consumption of imported iron ore and coking coal is driven by steel production in China. China's existing deposits of iron ore have low iron content by international standards, and the majority of iron ore reserves are located inland in the north and west of China, which makes transportation to the steel mills in the more industrialised coastal areas costly.
"In addition, in 2008, more than 90 per cent of China' crude steel was produced using blast furnaces and basic oxygen converters (the highest proportion in the world), which tend to rely on coking coal and iron ore, while comparatively little use was made of electric arc furnaces utilising a mix of steel scrap and other iron inputs. Thus the steel industry depends heavily on imported raw materials, with around half of China's total iron ore supply (adjusted for differences in iron content) sourced from overseas."
Australia is such a big partner because the average iron content in Pilbara ore, according to the US Geological survey, is 60%. By comparison, the average iron content in Chinese ore is just 33%.
You can see why China would like Australia's higher-content iron ore. But the real issue is whether the demand for that ore is driven by a global credit bubble. Why global? China is building factories to export metals-intensive durable goods to the rest of the world. But large parts of the rest of the world (mainly America) have been buying those goods on credit and are now broke.
Has China built an army of factories for an army of customers who are about to lay down their credit cards and surrender to the forces of debt deflation?
Hold that thought. The second aspect of the global credit bubble is the creation of a local real estate boom. To keep its currency cheap, China must essentially match the Fed's policy, printing money which pours into local lending and consumer prices. But aside from food and fuel, the real boom has been in real estate.
If China's booming metals demand is just another aspect of the global credit bubble, Australian investors should be duly warned that what happened in 2008 (a big crash in resource stocks and commodity prices) could happen again. Does Roberts think that could happen...?
"This paper provides evidence that China's manufacturing exports have been a significant driver of its demand for resource commodities. Data on Chinese investment indicate that manufacturing was the strongest driver of growth in Chinese investment prior to the recent global financial crisis.
"Analysis of input/output tables shows that, over the past decade or so, the manufacturing sector (which accounts for most of China's exports) has been more important than construction as a direct consumer of resources and intermediate metal products.
"Accounting for indirect linkages between industries, it is found that manufacturing has been at least as important as construction as a source of demand for metal products...This implies that China's resource demand is influenced by developments in the rest of the world. Consistent with the resource-intensive nature of much investment, the results also indicate – in China and elsewhere – a significant role for investment as a source of resource demand.
"This is in line with previous literature highlighting a dual role for investment and exports as drivers of demand for resource commodities. However, it appears that, over recent decades, a sizeable proportion of China's investment can be traced to the growth of its domestic and export-oriented manufacturing operations. Thus, while much of China's demand for resource commodities over this period has been driven by investment, it appears that this investment has in turn been sensitive to global influences."
Got all that?
To summarise: China's factory build-out has driven its metals' demand. In turn, the factory build-out – and the huge boom in domestic investment – is based on an expectation that the rest of the world will keep on buying what China's making.
Pretty straightforward, isn't it? But if big chunks of the rest of the world are dialling back consumption and entering their own private ages of austerity, who will buy what China makes? "If you build it, he will come," was a line from one of our favourite movies, 'Field of Dreams'. But what if you build it and no one can afford to buy it? Isn't that just another giant misallocation of resources with its roots in a credit bubble? Hmm...
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