Are Fears Over Chinese Growth Overdone?

Commodity prices have taken a beating in recent days over fears that China’s growth is slowing and demand for copper and iron ore are set to fall; worse that metal held in inventory in China could come flooding back out into the market, depressing prices further.

Investors have as a result sold heavily, resulting in copper and iron ore prices hitting trade limits as prices have collapsed. But is this purely a question of Chinese growth, or are other factors at play – and how bad is this for demand going forward?

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February’s import, export and industrial growth numbers were badly hit by the Chinese lunar new year holidays, which fell at the beginning of the month, so headline comparisons between February and January are understandably severe.

Thomson Reuters Oil Analytics assessments for February crude oil imports into China at 22.96 million metric tons (mt), are down nearly 19% from the previous month’s record high of 28.16 million mt, and were taken as evidence that a slowing Chinese economy is starting to put a dent into the country’s oil demand.

China’s annual economic growth dipped to 7.7% in the fourth quarter of 2013, down from 7.8% in the previous quarter, and a Reuters poll of economists expects growth to further slow to 7.6% in the first quarter of 2014.

Meanwhile, inventory of copper and iron ore are at near-record levels with inventories at the SHFE rising for eight consecutive weeks, to 207,320 tons by two Fridays ago, while stocks in bonded warehouses in China had grown to 745,000 tons by the end of February, close to the historical high of 825,000 tons in late 2012.

Likewise, iron ore imports grew 21% in January and February, even though steel production is declining at present. If this metal was being consumed by industry, such apparent demand would be well received by the market, but in reality at least 30%, maybe more, is part of a financial interest rate arbitrage play, which, if it unwinds, could result in the bonded metal being re-exported.

Interest Rate Arbitrage? Tell Me More

Broadly, the play works by a trader importing copper or iron ore and using it as collateral to take out a US dollar loan at a modest interest rate. The funds are then invested in a higher-yielding asset in China, or lent to the shadow banking sector at higher rates.

Continued in Part Two.

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