10 Reasons to Short China – Part Two

A few days ago we took an alternative viewpoint on prospects for long-term growth within China. Some notable analysts have written concurring bearish notes on the subject, from Nouriel Roubini to George Soros. And as the comments on our post noted, opinions vary wildly with regard to China’s overall prospects.

Though I personally believe China has some extremely serious and (perhaps to some observers) intractable problems, the next set of leaders likely to lead the 9-man Standing Committee of the country’s Politburo offer quite a different perspective than previous committees. Of particular note, the latest passing of the baton from the fourth generation to the fifth provides some new clues on the incoming class of leaders via this extremely insightful (though very lengthy) post.

What we find most intriguing involves the shift in backgrounds from earlier generations of military generals who fought in the revolution, to the next set of leaders, primarily engineers (the new president, also an engineer) to a younger set with a background in law, economics and history. Whether the background of the new leaders will encourage additional reform remains to be see,n but we can certainly count on a different perspective.

The Energy Problem

That aside, today we’ll examine the markets to which we pay close attention and for which China has become the global juggernaut. Despite our comments that we might “short China if we could, the ramifications of a China slow-down do not necessarily equate to a similar drop-off for the commodities we most closely track.

In fact, the energy crisis alone might suggest rising commodity prices, not falling ones. Paul Adkins, founder of aluminum consultancy AZ China, shared some insight with MetalMiner in an email exchange in response to a recent report available for sale from his firm: “The current situation of energy shortages has been caused by inefficiency in the partially-regulated market. With some prices fixed but others floating, and with generating companies losing money, it can be said that the current crisis is entirely man-made.

The result, he suggests, will force the government to raise electricity prices “with little or no impact on inflation, though he goes on to say that may cause some de-stocking as well as a softer landing. But what happens next year may prove far more controversial. Specifically, Adkins believes a failure to heavily invest in thermal power may lead to a supply/demand power gap. Therefore, he suggests the following will likely occur:

  1. Coal prices will rise by Q4
  2. Power increases could lead to additional aluminum shortages and price increases

How all of this will impact copper markets remains to be seen, but my colleague Stuart recently penned a piece stating, “The seasonally strong period is Q2, which we have largely passed through with nary a flicker of demand; Q3 and Q4 tend to be quieter, and with industrial demand possibly impacted by widely expected power rationing in the summer, copper buying may be delayed until stocks are considerably lower, probably later in the year — though he suggested when China re-enters the market, it will create a bullish effect on prices.

And What About the Steel Market?

Gerdau Market Update in their weekly report suggests China demand for scrap remains robust. (This chart illustrates that point.) Current iron ore pricing ( of $174.20/dmt for 62% Fe fines and $152.20/dmt for 58% Fe fines) has served to drive scrap demand, according to the Bureau of International Recycling, as reported this week in Gerdau Market Update. US scrap exports based on current dollar values remain attractive, further supporting scrap prices. Of course we admit this still represents a short-term view of China demand.

The Commodity Upshot

Only slower demand from China as a result of economic policies (e.g. soft landing) could dampen commodity prices, but forced closures by industry due to power shortages will create capacity constraints amongst all heavy industries. That in and of itself will tend to support prices.

–Lisa Reisman

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