On the Brink?

EDITORS’ NOTE: The views expressed in this article are those of the author and not necessarily Recycling Today’s. Some of the statistics cited by the author have not been verified by Recycling Today.

Copper consumption in China has been quite strong throughout the past several years. China consumes more copper than North America and Europe combined. A drop in copper demand in China alone will signify a global crisis in industries pertaining to this raw material.

Despite the high and long-lasting economic growth opportunities for China, the country’s economy develops in economic cycles, including long ones. After the economic boom of China during the past several years, there is the possibility of a deep recession. The financial system of China may prove to be a bubble, and currency reserves, though they appear enormous, could lose their significance against the scale of outstanding credits that were used to finance, among other things, rushed government investments.

Adding to the challenges, Chinese government statistics are raising some red flags. The public debt was shown to be 20 percent of GDP (gross domestic product) at the end of 2010. However, it does not take into consideration the creative accounting of local Chinese governments where the actual debt was delegated to financial vehicles that invested on behalf of local authorities.

According to Chinese authorities, the debt of entities belonging to local governments is about 25 percent of GDP and, according to many independent analysts, the debt is more than 50 percent of GDP. The result is that China’s total public debt can be assessed at between 60 and 70 percent of GDP. A working paper by the Australian Treasury also estimates Chinese government debt to be in this range.
 

An Export-Based Economy
The driving force in China was and is the export market, which is responsible for about 40 percent of the country’s GDP. The drop in global demand because of the recession, as well as increased protectionism, based not only on duties but more frequently on quality standards, certificates, sanitary and ecological requirements, does not favor an optimistic prognosis for Chinese exports.

Looking inward, China’s internal demand may turn out to be an elusive assumption. Exports generate primary capital, including wages. Without a strong export market to drive China’s economy, the country’s economy could fall into a recession. The increase in public expenses in China to improve its market outlook may cause the opposite effect, increasing the investment risk and the withdrawal of foreign investors from the market.

Despite the fact that most of China’s public debt is in the hands of Chinese entities, it does not minimize the risk of a crash of the Chinese economy, it only diminishes the direct negative impact throughout the world. However, the indirect effects of the crash of the Chinese economy will have global repercussions.

While many economists herald the Chinese miracle, the crash of “the Chinese model” is only a matter of time, keeping in mind the dynamics of economic processes. This perspective is shorter rather than longer. Crises come suddenly...and usually right after the first symptoms.
 

Technology Impacts Pricing
The potential drop in copper prices, apart from the global recession, including China’s, also is influenced by technological progress through increased recycling. In addition, earlier models of much of the equipment that is being recycled contain more metal such as copper than its replacements. Industrial technology is sensitive to raw material prices, including copper, which is reflected in the reduction of costs of materials or in the replacement of some raw materials with other, less expensive substitutes.

Copper competes with other conductors of electricity and heat. Meanwhile, technological changes may favor the replacement of copper in some uses. Copper supply from recycling sources also is influenced by the massive exchange of copper wires for data transmission by fiber optic cables.

The increase of economic efficiency (as a result of the recession and of improvements in technology) means that more metal will be obtained through recycling processes. The amount of copper mined at any time is growing. It is the prognosis of the economic market outlook in China that shapes the prices of copper in the spot and future markets.

The price of copper is the marker for the expected outlook in the Chinese economy. Therefore, the price of copper is important for Chinese authorities. It is probable that Chinese authorities may have been interested for some time in influencing the price of copper, in particular after the September 2011 drop from $4 to $3 per pound. Taking long positions in copper may be, in this case, treated not as an investment in a future market but as showing off the power of the Chinese economy—on the basis of the evaluation done by the “invisible hand of the market,” and, thus, as an evaluation somewhat credible (as opposed to statistical data from the Chinese authorities).

The strategy of overstating copper prices performed by one larger player (in this case, China) may bring intended results for some time. However, within the longer perspective, it leads to a sharper price correction.

Accepting the thesis that since October 2011 China has influenced the price of copper, this strategy would have to lead to physical supplies of “speculative” copper. The final destination of the transport of such copper most certainly would be China, where it can be added to the stocks of unreported copper inventory that many people speculate exist throughout China.

I feel China has been increasing its copper stocks in recent months. However, these are not stocks accumulated with economic expansion in mind. Rather, they are designed to provide the illusion of an expansion.

It is difficult to evaluate the operation’s scale. Also, Chinese authorities must be aware that this strategy will last at most for a few months, eventually leading to a deeper price crash in the near future. Higher copper prices will inevitably create new supply, which can be seen with the opening of new copper mines. Additionally, the increased “artificial” demand will eventually turn to lower orders—especially when the plot for the game of increase will be disclosed and weighed.

It is likely that China accepted, to some degree, the concept of influencing the prices of some commodities and have counted on a soft landing of the Chinese economy. One can accept that Chinese copper stocks, declared by China at the end of 2010 to be 2 million metric tons, increased significantly by the end of 2011.

China is providing an alternative justification for the increase in copper stocks. The growth in raw material stocks by China may have been explained as a method of diversifying its financial assets from its reliance on U.S. bonds and treasury bills. With the quantitative easing (printing more U.S. dollars) taking place with the U.S. Federal Reserve, the value of bonds becomes questionable. The question is whether the negative interest rate is a safe haven.

The increase in rare earth metals prices from China may have been compensation for the country maintaining high copper prices. In addition, maintaining mutual price relations in the metal market has a great significance in registering these prices and not registering the real strategy of China, whose determinant is fostering the conviction of the good condition of the Chinese economy, particularly when this fostering is not too costly. For example, 2 million tons of copper at present prices is equivalent to $15 billion and, thus, quite little in relation to the Chinese currency reserves.
 

The Alleged Miracle
The Chinese miracle is framed in the dynamics of its GDP growth. However, when comparing GDP per capita, China places in a distant 90th or 100th place, depending on the ranking. Despite the miracle, we are dealing with a poor country that also is divided socially.

Taking into the consideration China’s dramatically low GDP per capita starting point from the beginning of the 1980s, no one should be surprised by an average of 9 percent annual growth of GDP in the last 30 years, especially when the result of this dynamic is still a very remote position of China in the GDP ranking per capita.

The growth in China’s economy during the last two years is because of public spending. If we assume that the public debt at all Chinese government levels is 60 percent of GDP, one should ask when this debt was created. The majority of public debt was made in the last 10 years and the peak of growth of public debt was in 2010 and 2011. Exact data is unknown because most of the increase came from local governments (with inaccessible records). The public debt may have grown during the past two years by at least 5 percent per year.

If we consider that the public expenses generate a multiplier effect on the economy, then we know what the driver of China’s GDP growth has been. Unfortunately, it is a driver just a moment before the engine seizes up.

A hard landing could await the Chinese miracle. Considering the specific gravity of China, we can expect a worldwide earthquake after its fall. Although, we know the sooner the better and the effects of the crash would be less severe if it is sooner. Still, many interested parties who can influence the events prefer to defer this moment. Unfortunately, tensions are so great at the moment that China’s crash will cause global effects to be calculated in years.

The prognosis of the copper market brought us to where it should have—to the prognosis of the overall situation in China. In both cases, a crash is imminent, but the crash in the copper market does not even need a recession or a crash of the Chinese economy—it is enough on its own to be caused by a weak market of 5 percent GDP growth in China.

And thus the prognosis for copper prices is a deep drop. I would expect that later in 2012 we will see copper prices below $2 per pound.

The author is an analyst with Poland Securities, www.polandsecurities.com and www.changevalue.com.