Wednesday, January 13, 2016

The Global China Connection

We’ve watched the “stop trading” trigger – where China’s stock markets experience a drop in a single day over 5% and trending towards 7% - twice already this year. The first “stop-trading” trigger clearly did not stabilize the market form another such event. For those in China who are watching their real estate sit unsold or experiencing layoffs and contractions in manufacturing limits.
Central policy-makers in China also lost their complete control of the valuation of their currency (yuan/renminbi) in participating in a new “reserve currency” blend (replacing the US dollar as the sole international metric of commodity values). “Chinese yuan officially became a world reserve currency on November 30, 2015. Starting in October of 2016, it will account for 10.92% of the IMF total reserve currency. This would make Chinese yuan the fifth reserve currency after US dollar, Euro, British pound sterling and Japanese yen.” Wikipedia. The renminbi’s value fell along with their stock markets. The world’s stock markets reacted in parallel to the Chinese downward adjustment. Oil prices hit a 12-year low. Why is China such a powerful force in the world markets? Why does a cold in China produce a global economic flu? Hang in there; it’s a longish story.
When China’s manufacturing might flooded the earth with just about everything “built” imaginable – from plastic toys growing to clothes to computers to the inner workings of the most sophisticated smart phones to larger industrial machines and soon to be cars – the world became dependent on these inexpensive items. Wal*Mart expanded with a heavy dependence on such manufactures. As China’s economy exploded, there were global pressures to push the yuan to a higher value. China’s discount edge in manufacturing slipped somewhat at this currency rise and a general notion of increasing labor costs as China moved increasingly closer to becoming a developed nation, particularly in major urban areas.
China became a commodities glutton to fuel both its increasing energy consumption but also its need for raw materials to feed its manufacturing sector and the growing demands of a population with rising incomes and increasing appetites for higher-end food products and goods. “For years, China voraciously gobbled up all manner of metals, crops and fuels as its economy rapidly expanded. Countries and companies, fueled by cheap debt, aggressively broadened their operations, betting that China’s appetite would grow unabated.
“Now everything has changed… China’s economy is slumping. American companies, struggling to pay their debts as interest rates rise, must keep producing. All the excess is crushing prices, hurting commodity-dependent economies across emerging markets like Brazil and Venezuela and developed countries like Australia and Canada.” New York Times, January 9th. Those ‘debts’ applied to entire nations and commodity producers/trading companies from all over the world as they borrowed money to expand their capacities to service this prolific Chinese demand for raw materials and foodstuffs.
Indeed, these borrowers expected Chinese demand not only to hold at current levels, but with Chinese workers raising their standard of living as a result of the Chinese economic miracle, to accelerate even faster. The entire world, it seemed, was catering to the expectation of Chinese demand growth. When the Chinese bubble began to burst and Chinese demand for commodities plunged, the lenders who had financed this massive global expansion effort were still owed continuing interest payments even as the companies who borrowed that money faced a sinking demand from the nation they believed could not stop growing: China. This massive loan float had to be serviced. Some companies simply went under, while others struggled with stopgap solutions to paying their lenders as contractually required.
Normally, when there is sinking demand for a commodity, since prices can drop precipitously as we have seen in the oil industry, commodity producers/trading companies simply reduce their output until the market adjusts and moves prices upwards. But without revenues from exporting those commodities to service the interest requirements from all that debt, stopping or reducing production would result in insufficient money to service those loans. Since the producing countries and companies based their ability to carry such debt on prices determined most significantly on Chinese demand projections, that loan burden was a hefty charge, a voracious devourer of interest payments, which required substantial cash flow come hell or high water.
So in what might otherwise seem a counter-intuitive move, the producers of commodities actually were forced to increase their harvesting/extraction output of such raw materials, because it took more sales now at a lower price to meet those interest charges. And as supply increases without offsetting increases in demand, there is further downward pressure on the price of commodities. These borrowers where simply on the wrong side of the supply-demand curve; it was a vicious circle.
The world markets have shuddered with the consequences. “The flood of raw materials is pressuring prices, prompting a painful shakeout. Oil companies have laid off an estimated 250,000 workers worldwide. Alpha Natural Resources and other American coal mining companies have filed for bankruptcy protection.
“Saudi Arabia, a giant energy economy, has had to tap the credit markets as its financial reserves dwindle. Venezuela, an oil-rich nation that went on a spending spree, is struggling to meet $10 billion in debt obligations this year, since 95 percent of export earnings depend on crude…
“[E]conomists worry that the commodity mess reflects a weakening global economy, lowering the value of trade worldwide and perhaps even pushing some countries into the same kind of deflationary spiral that has hampered the Japanese economy for decades. Global turmoil last summer, stemming from China, prompted the United States to delay raising interest rates until the end of last year.
“‘Lower oil prices have not proven to be as stimulative as economic theory once had it,’ said Daniel Yergin, the energy historian and vice chairman of the IHS consultancy. ‘The question is what are weak commodity prices telling us: Is it overinvestment in the past, or signaling a weaker global economy forward? My own feeling is the answer is both.’…
“In 2015, commodity prices had their worst year since the financial crisis and global slowdown. Nickel, iron ore, palladium, platinum and copper all declined by 25 percent or more. Oil prices have declined by more than 60 percent over the last 18 months. Even corn, oat and wheat prices have sunk… And the commodity slide has continued into this year. At just over $30 a barrel, oil has reached levels not seen in over a decade.
“The bust is made all the more pernicious by rising interest rates, as the Federal Reserve changes gears. Companies that took advantage of the cheap debt to increase production are now stuck with a big bill that will be difficult to cover… Although companies are retrenching, they cannot completely retreat. Many new mines, for example, are designed to function at full capacity to keep them operating efficiently. And the sales are necessary to pay the debts incurred to build them.
“At particular risk are coal mines in the United States, Australia, Indonesia and elsewhere. Not only is Chinese demand declining, but rising environmental concerns are also hurting their prospects… ‘Raw material producers invest according to current prices without realizing how those prices might affect future demand,’ said Michael C. Lynch, president of Strategic Energy and Economic Research, a consultancy. ‘Now that the demand is declining because of high prices, they have too much capacity, and once it’s built, you can’t unbuild it.’” NY Times.
For us in the West, we have witnessed a steep fall in our stock markets, although the U.S. decline was not as drastic as some of the smaller stock markets. The problem, of course, is there is no major counter-push to reinvigorate the global markets without a Chinese “recovery,” which experts do not believe is going to happen at a level that matters anytime soon. Instability in the Middle East and the continued deterioration of relations between Russia (which has been slammed by falling oil and gas prices) and the West has not helped matters.
For American commodities businesses, there is no escaping that all commodities are priced globally; there is no real way for a government to hold prices high or low against market conditions as the Venezuelan leadership has discovered… the hard way. But then, we should also remember that China has massive currency reserves (although somewhat less than their recent peak) and a centrally directed planning authority.
There are also serious differences between the Chinese equity markets from such markets in the rest of the world. 80% of Chinese companies wear a “red hat,” meaning some level of government ownership, and PRC publicly-traded corporations are subject to some rather direct control by the government itself (which preempts shareholders). Companies are not valued in accordance with Western standards, and the aggregate of values of publicly-traded Chinese companies makes up a relatively small percentage of the overall PRC economy. And anyway, as one wag said it quite well, “China always has a back-up plan.” The world is waiting for that plan.
I’m Peter Dekom, and the mere thought of too many Americans that we should become more internally independent from global markets is no longer a tenable position, since so much of our economy is simply globally dependent.

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