CommentaryMarket Analysis

China may be the world’s largest producer of coal for power generation, but as the world’s largest consumer, the proportion that it imports is still arguably the single biggest driver of global prices. China often faces power shortages in the middle of winter and middle of summer, respectfully, when heating and cooling demands are at their highest; but this year, power shortages have started two months early and look to be the worse yet, according to a recent Reuters article.

The blame falls largely on the shoulders of Beijing. For years, they have controlled the price at which generators can sell electricity in the market, which worked relatively well when domestic demand could be met by domestic coal supply at a reasonable price, but the cost of coal production has risen, in part because coal mines and coal consumption are geographically some way apart. Imports can make up the difference, and are largely met by Australia and Indonesia. But as imports have risen, this demand has impacted the global coal market, driving up the price such that generators are caught between a capped sales market for power and a rising raw material cost based on global coal prices. Imports have been strong for much of 2009-2010 as this graph from HSBC shows, but the tide could be turning this year:

Source: HSBC

Chinese power generators usually have the option of buying domestically or to import, but domestic prices have been rising fast and even though in January-February of this year coal production rose 12 percent year on year to 516 million tons, imports only dipped slightly, as this graph from HSBC shows:

Source: HSBC

The worst flooding in 50 years in Australia’s Queensland meant coal supplies were tight and prices started the year at the highest since mid-2008 peaks. Chinese coal prices were back to a discount to world prices in February, encouraging buyers to switch to domestic low-grade material, a trend that is likely to continue this year in the bank’s opinion.

While coal supply may not be a problem, prices are, and both domestic and imported prices are higher resulting in power producers losing money. According to Reuters, some privately owned small to medium utilities have already shut down and for larger plants still in business, buyers are switching between domestic and imports to save even a few cents. Power shortages are therefore expected to get worse this summer and metals production is likely to suffer. While larger producers are often shielded by local governments keen to maintain employment and local output, small to medium-sized steel, aluminum, zinc, lead and cement plants will likely not be so fortunate and closures may result. Whether the gradual cooling of the economy coincides with this loss of production, and the extent to which large domestic stocks of non-ferrous metals meet medium-term demand is probably not so much of an issue as is the support this will give to global metals prices. There doesn’t need to be a limitation of metal supply to support prices, merely the expectation that there could be a supply shortage.

Although Beijing has raised power tariffs recently, it is not enough to stem generators’ losses; but with inflation a rising concern, the authorities are unlikely to raise tariffs again soon. For the time being, at least, no end is in sight for power generators’ pain.

–Stuart Burns

Just as we finally began wondering when the commodity bubble would burst, some troubling signs in the precious metals market namely silver and gold are pointing to potentially big selloffs in other industrial metal and non-metal commodities. Reuters reported that silver suffered its biggest one-day drop in 29 months on Monday, down to $42.58 an ounce, and gold also slipped from its high perch. But yesterday, silver tumbled even further. The metal finished down $3.50, or 7.6 percent. That means it lost more than 12 percent over two days, according to the Wall Street Journal. Sell orders began spreading through the Asian market. ETF holdings of silver have also dropped almost 4 million ounces last week, Reuters said. Ultimately, could this isolated drop be a harbinger of a more commodity-wide tumble?

Let’s take silver first, for instance. The drop basically can be attributed to three things: inflation, interest rates, and by extension, the strength of the US dollar. The Wall Street Journal reported that George Soros’ investment firm, which has been buying up silver and gold over the past couple of years, has begun selling more quickly due to less concern over deflation now that the threat seems minimized, those metals are not as valuable to hold. Most of the rest of the crowd buys as a hedge against inflation, which many, including Alan Fournier of Pennant Capital and Keith Anderson, who runs Soros’ firm, seem less afraid of these days. That’s mainly because the US Federal Reserve, they think, will imminently raise their interest rates, making the US dollar pricier and lessening the inflation threat.

Others are not so optimistic as far as the dollar’s concerned. “The U.S. dollar is significant in the price development of the precious metals,” said Quantitative Commodity Research analyst Peter Fertig to Reuters. “With the divergence of monetary policy in the U.S. and the euro zone in particular, I expect the dollar is going to weaken further in the medium term,” he said.

Rhiannon Hoyle, writing in another Journal piece, says that the sell-off has been “largely attributed to a hike in trading deposit requirements, or margins, by CME Group Inc, which operates the New York Mercantile Exchange and took action on speculative trade precisely because of the volatility. Essentially, it’s costing a lot of money in collateral (at least $16,200) to trade silver futures contracts; just one contract runs $212,880, according to the WSJ.

From this, Hoyle also brings up a very important point: the trading of silver is not acting upon the fundamentals. Hoyle writes that there is a surplus of silver, and that speculative activity has singlehandedly accounted for the highest prices we’ve ever seen. With all the drivers out there sovereign debt in Europe and political uncertainty in the Middle East, as just two examples the implicit point could be that we haven’t looked beyond traders making bets on where world economies and their currencies will go.

For industrial silver buyers, of course, the lower prices could be a good thing (even though overall volume of silver usage cannot really compare with other industrial metals); however, the price drop may portend more trouble for those in other metal industries.

Copper, for example, has been suffering a bit as well, but for industrial demand and supply reasons rather than investment demand. China’s PMI has fallen overall in April, according to Reuters, even though the property sector index indicated growth for the seventh straight month. The copper price stood at $9194.75 per ton on Tuesday, its lowest since mid-March, and hit a seven-week low on Wednesday at $9,155 a ton.

Even oil has taken a hit. Light sweet crude futures (June delivery) settled down 2.2 percent, to $111.05 a barrel on the NYMEX, while Brent crude fell 2.1 percent to settle at $122.45 a barrel. Several analysts attributed this drop directly to the fall in silver. “When I saw silver just plummet toward the end of the day, I knew we were going to follow it,” said Raymond Carbone, president of oil brokerage Paramount Options, in a WSJ article. Peter Donovan, vice president at Vantage Trading in New York, agreed. “It’s almost like this silver [market] has turned into a little bit of an indicator for some guys,” he was quoted as saying.

Overall, big banks and analysts (UBS, Barclays, etc.) are generally either neutral or bullish on the precious metal sector, especially silver and gold, because the pressing macro issues like debt imbalances and civil strife are not going away anytime soon. Stepping back to look at the big picture, we also don’t expect overly huge corrections for silver for the rest of 2011 as long as gold keeps rising.

–Taras Berezowsky

(Continued from Part One.)

Chinese domestic production capacity dwarfs any other region of the world, and it is also some of the highest cost — but not across the board. Some smelters rely on the national grid for power deals, others have captive power plants. All of them are influenced by Beijing’s policies on power consumption and on the underlying cost of coal, the fuel source for 80 percent of electricity production in China. Given a free reign and sufficient power supply, smelters would continue to construct new plants and run as close to capacity as they could, but Beijing appears to be finally getting to grips with the smelter building program. National capacity is already significantly higher than actual production and is projected to rise fast to 30 million tons by 2015, from a current 23 million tons unless new capacity is halted, according to the Reuters article.

Source: Reuters

Production soared in the first two months of this year from below an annualized 15 million tons per year to 17 million as power was turned back on.

The country has been largely a closed market for aluminum. Imports have been modest, according to a Reuters article, at just under 70,000 tons in Q1 compared to the same time a year before. But exports have been rising, as the graph below from Reuters shows, suggesting there is no shortage of capacity in the supply chain and domestic demand is not sufficient to keep domestic processors busy.

Source: Reuters

In spite of rules on export taxes intended to limit large-scale exports of semi-finished metals, volumes have surged. These are not yet a problem for western producers, but if the trend continues, Chinese material may begin to undermine western aluminum semis market price levels, even though quality concerns are widespread.

If Alcoa and other western primary mills were to embark on a systematic program of smelter closures like China, such that the country became a net importer again, the ingot price could return to levels last seen in 2007 of over $3000 per ton. While it is a possibility, it is unlikely. Too much money has been sunk into too many smelters for wholesale closure of large swathes of the industry. On the downside, a flattening of the forward price curve could see new finance deals fail to roll over later this year and next, releasing part of the huge stocks held by banks and hedge funds, both in China but more ominously in western markets.

Unlike copper or zinc, where mine supply-side limitations loom later in the decade, aluminum is at risk more from excess refining (smelting) capacity on the one hand and rising electricity costs on the other, with the continued viability of the forward finance deals an ever-present and underlying threat. Volatility will be the order of the day and HSBC’s forward price predictions should be taken as averages for the year with large margins on either side possible on the price. What that means for buyers is keep a close eye on the drivers outlined above and judge forward buys on a perception of where the price is relative to the longer-term trend.

–Stuart Burns

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Speculators, regional unrest and sovereign debt are driving up prices higher than ever in all commodity classes food, oil, cotton, metals and the global markets are once again beginning to heave and cast about, what inflation rising in emerging markets and shortages threatening to deplete all sorts of raw material resources. The question, as always, is not if the bubble will burst, but when?

Cycles come and go, as we know, and prices always have a way of returning to historical averages, but analysts are increasingly concerned that prices will never return to where they used to be. The finite quantities of natural resources simply cannot sustain an exploding human population and rapidly advancing standards of living in emerging economies. A couple recent articles gave an their takes on when the commodity bubble’s point of critical mass will cause it to explode.

Over at MarketWatch, Brett Arends mainly gives credence to GMO chairman Jeremy Grantham’s views, outlining a world of resource scarcity in his quarterly letter. Grantham predicted that if the agricultural sector has record-breaking crop yield next year (effectively producing a glut in supply), and if China’s own breakneck pace of growth backfires, there’s an 80 percent chance of “a commodities slump next year. The copper price, for one, is up 50 percent in just under a year. Interestingly, Arends also points out that investors should keep an eye on more than just the metal (or oil, or cotton, or¦) “Anyone who still wants to bet that commodities will rise further might take a look at the equities of commodity-related companies, he writes. “Miner Freeport-McMoran trades on a modest nine times forecast earnings (recently down 0.26 percent), Chevron is just eight and a half times. And big gold mining companies look pretty cheap compared to gold itself. Barrick Gold (down 0.10 percent)  is just eleven times forecast earnings.

Meanwhile, writing on the Wall Street Journal’s The Source blog, Alen Mattich poke a little hole in Grantham’s (and Arends’) arguments. He posits that ingenuity is increasingly being translated into efficiency, especially in China and India, and that somehow ingenuity/efficiency will help global populations deal with the scarcity that’s looming. While certain degrees of innovation are positioning us to deal with the next century, the relative speed with which we’re mining copper, gold, zinc, and other metals to meet demand is alarming. Does ingenuity override absolute scarcity?

Perhaps speculators do account for the majority of a price increases, but no one can deny that the last decade has seen sustained rises that make it seem like there’s no turning back. The Barricks and Vales and Rio Tintos of the world are not letting up on acquisitions because they know that existing mines are drying up, and new mines must be secured and operations put on-stream. There is always a danger of excess metal lurking in the system, and recycled scrap can account for ever-greater percentages of finished product, but as for the current metal prices, one thing’s for sure: the escalator to the top floor reaches its destination sooner or later then the belt goes back to the bottom.

–Taras Berezowsky

The aluminum price has remained strong this year, even as the price of other metals such as copper have fallen. The steady if unspectacular rise in the price may lead one to believe the fundamentals for the metal are sound. In fact, nothing could be further from the truth, and the next two years could be a particularly volatile period for a number of reasons.

Global production has been rising strongly. HSBC estimates output will rise 8 percent this year, mainly driven by China at 10.8 percent and the Middle East at 24.6 percent. Chinese domestic output has returned to near record levels of 17 million tons per year in February this year, as smelters ( idled in the 4th quarter due to power constraints) have been brought back on stream; even so, capacity is still only running at about 80 percent and with the cost of production well under the market price, the main constraint holding idled capacity from coming back on stream is power supply. A combination of high coal prices and low water levels are severely hindering generators from producing as much electricity as the power-hungry economy requires. According to a Reuters article, China has warned that power shortages this summer could be the worst for years, with power generation and transmission systems unable to cope with the train crash of rising demand meeting coal shortages and low water levels.

Source: Reuters

Meanwhile in the rest of the world, output has been rising, as this graph from Reuters shows, particularly in the Middle East where output in March 2011 was running over 30 percent higher than in March last year. That’s down to the simultaneous commissioning of two new smelters, the 585,000-ton per year Qatalum plant in Qatar and the 700,000-ton per year EMAL plant in Abu Dhabi.

Global aluminum demand appears to be steadily returning, forecast to rise by 9.0 percent in 2011 on top of 12.6 percent last year, according to HSBC. Events in Japan will dent demand there this year, but stimulate demand next year as reconstruction gathers pace.

Amazingly, with some 4.6 million tons of headline inventory plus even larger stocks held off-market, we can still talk positively about falling stocks weeks, with the bank predicting cover falling from 9.1 weeks last year to 8.6 this year, 8.1 next and 7.3 by 2014. The result in the bank’s estimate will be a gradually rising price out to at least 2013 with an average of US $2,535 per metric ton ($1.15/lb) for this year, US$2,600 ($1.18/lb) next year and US$2,645 ($1.20/lb) in 2012.

There are risks to these numbers both on the upside and the down, and in large part the swingo-meter is driven by China.

(Continued in Part Two.)

–Stuart Burns

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This is the first part in a multi-part series. Keep an eye out for the next installment.

The opening “crawl of Return of the Jedi references the Galactic Empire secretly building a new “armored space station even more powerful than the first dreaded death star, thought to “spell certain doom for the small band of rebels struggling to restore freedom to the galaxy. We’ll let readers draw their own conclusions in terms of which metal represents the Death Star and which represents the rebels. But make no mistake about it; metal product substitution appears live and well within the automotive industry. One need only visit a few websites — for example, Alcoa’s — to see how it describes the aluminum value proposition, or this slick video from Novelis on the Jaguar XJ aluminum body or the Aluminum Association’s website articulating the virtues of aluminum over other materials.

But the steel industry has not taken this threat lying down; in fact, it has conducted considerable product innovation to address some of the specific benefits the aluminum industry has touted. What we find intriguing about the specific debate between steel and aluminum for the automotive industry is where it has played out and what arguments each side makes.

The automotive industry, guided by recent changes to CAFE standards impacting passenger cars and light trucks, will need to “meet an estimated combined average mile per gallon (mpg) level of 34.1 by MY 2016, and that has driven the industry to lighten up vehicles as one means of achieving the targets. According to a recent Wall Street Journal article, automakers seek to remove anywhere from 250-700 pounds of weight from each car.

Metal makes for an easy target.

The arguments made by both sides of the debate, however, differ in some key respects. This series will examine the arguments made by proponents of both sides as well as offer up some arguments that have received less media attention. The aluminum industry has built a compelling case centered on the following (and borrowed from the Aluminum Association):

  1. Increased payloads aluminum allows a hauler to carry more tonnage than it otherwise could with an alternative material
  2. Lower fuel consumption (see weight argument above)
  3. Reduced GHG emissions (again, see weight argument above)
  4. Lower maintenance costs fewer trips reduces wear and tear
  5. Corrosion resistance aluminum serves as a better material from a corrosion standpoint
  6. Higher resale value this rests on the notion that aluminum retains its value more than steel
  7. High recycling rates aluminum is “infinitely recyclable

Alcoa makes several additional arguments including: crash protection without compromise and enhanced driving performance, along with, “All other factors equal, lighter cars accelerate faster, stop faster, and have better handling that’s why many top performance cars are all-aluminium.

But don’t count the steel industry out. Though CAFE standards may serve as the impetus and momentum behind aluminum, they have also driven innovation within the steel industry. The steel industry has also built a compelling case centered on the following:

  1. CSR/Lifecycle Costs Steel emits fewer emissions during the production process than aluminum, thus it has a lower carbon footprint
  2. Safety/Energy Management – The main body – the undercarriage and beams are made out of steel. Steel’s versatility from a welding/stamping processing standpoint also has advantages over aluminum (we will dive into this in greater detail in a subsequent post)
  3. AHSS Advanced High Strength Steels these materials are recyclable, take less energy to produce and aid in the “light-weighting of traditional steel parts

Several additional considerations make the debate between the two materials all the more fascinating. For example, consider the aluminum shortages that have already started to appear in the European automotive industry. With a significant ramp-up in aluminum usage in the automotive industry, how will the industry effectively meet demand? That question leads us to another key issue: carbon cap and trade legislation, strongly supported by the aluminum industry and largely opposed by the steel industry. Why?

Aluminum, as a global industry, has a strategic advantage over the [largely] domestic steel industry currently supporting the auto sector. Any climate change legislation would handicap the steel industry while allowing the aluminum industry to leverage global supply options not subject to such legislation. Obviously this has implications from a trade perspective, but provides a real-world example of how policymakers will need to consider climate change legislation as well as regulation (as the case may be) moving forward.

No debate would be complete without an analysis of costs. We will continue to cover this topic; check back in with us for Episode 2.

–Lisa Reisman

Reading the runes for the zinc market has become quite a challenging exercise. The price has been one of the success stories (if you are a producer) of the global recovery, rising steadily along with copper, with which it has been showing a strong correlation. Like copper, part of the story is the probability of dwindling supply towards the middle of the decade as major mines such as Perseverence (with about 130 kt of production), Brunswick (with about 200 kt), Lisheen (with 170 kt) and Century (with about 500 kt) close down from 2012 to 2014, taking 1 million tons of supply out of the market that is currently in deficit to only about 340 kt this year, according to HSBC.

On the flip side, the cost of production at about US $1500 per ton is way below the current market price, today at over US $2300 per ton, so every mine with potential to expand is seeing investment and many smaller projects are being rushed into production even if projects the size of Century are not in evidence.

Demand is forecast to rise by about 5.5 percent this year according to the bank, while supply is set to rise by about 2.2 percent; yet even so, the market is in surplus and inventory levels have continued to rise.

Source: Reuters

Stockpiles of zinc held in LME warehouses surged past the 800,000-ton mark for the first time since 1995, climbing by 26,550 tons to 812,100 tons, this month. Zinc is the only other metal with aluminum that can benefit from stock and finance games due to its strong forward curve.


Source: LME

Traders and banks can buy spot metal and sell forward at a premium, yielding a small premium to cover finance and storage costs. The premium is not as good as aluminum, but could be contributing to growing stock levels.

Of more concern than the rise in LME inventories is the rise in Chinese stocks. As Beijing attempts to curb property speculation, construction activity has cooled and market demand has softened. Construction accounts for half of all demand for galvanized steel and galvanized steel accounts for 56 percent of all zinc demand, so although machinery and automotive are doing OK, the combination of slowing Chinese construction demand and near-stagnant western world demand is contributing to growing stocks. According to Reuters, China, the world’s top producer and consumer of the metal, may be holding 1.3 million to 1.5 million tons of refined zinc in private and public warehouses (including SHFE and bonded warehouses) — about three times its production in March. Normally, April to June are peak restocking months for consumers, but demand ramp-up in the first quarter has been weaker than last year.

Rising stocks, softening demand and continued strong production, at least in the short term, suggest prices are set to ease further this year, but the closure of major mines from 2012 onwards coupled with an expected recovery in the western housing market suggests the market could be better balanced from 2012/13 into the future. In the meantime, there is not much to support current prices and we would not be surprised to see them continue to drift lower. Like copper, the long-term fundamentals are sound, but like copper, recent zinc price rises are proving too much too soon and a reduction to saner levels is in the cards.

–Stuart Burns

Earlier this week we mentioned that platinum is again on the rise, and prospects for the metal are looking good. However, in the wake of the supply chain nightmare the Japan tsunami caused the effects of which are still shaking markets should we be concerned that platinum demand will drastically decrease?

After all, platinum’s place in the auto industry is central to the metal’s industrial activity. Johnson Matthey, for example, supplies one in three auto catalysts globally, according to recent Bloomberg BusinessWeek report, and each one contains approximately 4 grams (0.13 troy ounces) of a PGM. But Japan’s big auto companies, accounting for a good chunk of global production, are in dire straits. Toyota reported that its March output in Japan dropped 62.7 percent year-on-year; Nissan’s fell 52.4 percent domestically, and Honda Motor’s fell 62.9 percent, according to Industry Week. These numbers caused S&P to drop its rating for these companies, as well as for three big suppliers, Aisin Seiki, Denso, and Toyota Industries. Toyota doesn’t expect for things to turn around until December at the earliest, potentially clouding the global auto market’s outlook.

But the situation for the three big Japanese auto companies may not cut into platinum demand as far as we think. Barclays estimated that the Toyota, Honda, Nissan plant closures cut demand for platinum-group metals by about 90,000 ounces so far, equal to about 0.5 percent of combined annual usage, according to Bloomberg. Other car makers should take up the slack — J.D. Power Automotive Forecasting predicted global car and truck sales to be up 6.1 percent this year, to 76.7 million units. Besides, “consumption [of platinum] will be deferred rather than lost, the bank said in a report April 15. Leon Esterhuizen of RBC Capital Markets echoed this sentiment. “Impala [Platinum] said recently that all of its Japanese clients continue to take metal even though they offered them the opportunity not to take metal right now, he said in a recent podcast. “That sort of tells you that the people who are fundamentally involved in this market understand that there is probably going to be a shortage of metal – even if you’re not using it right now, you better take it and you better start building stockpiles.”

On the supply side, then, fears of shortages for the rest of the year remain. Platinum miners are digging deeper than ever to reach the reserves; GFMS Ltd. estimates companies are able to extract 3.83 grams of the metal from every ton of rock. Production in South Africa is slated to decrease 8.4 percent since 2006, and catalytic converter demand will increase 64 percent this year over 2009, Barclays says. Finally, ETF asset flows are red-hot for platinum. As of April 26, ETF Securities’ physical holdings of platinum, for example, increased 5.6 percent since the beginning of the month, up to 487,168 ounces (right around 15 tons), according to their daily flow data.

With bullish analysts calling for platinum to increase to $2100 per ounce by year’s end, and Bloomberg’s survey predicting a 14-percent rally to a three-year high of $2,050 an ounce by Dec. 31 (it hovers at around $1835 these days), the fundamentals appear sound enough for us to say the $2,000 benchmark sounds about right. The only thing that could pull the price back from that benchmark enough might be the hit that inflation could put on Chinese consumers, forcing Chinese auto sales to be a bit less robust in the second half of this year. Otherwise, look for platinum to keep its high profile for a bit longer.

–Taras Berezowsky

The second issue is both a short- and long-term problem, and relates to China’s demographics and changing attitudes. An article by Malcolm Moore in Shanghai explains how each year, fewer young workers are coming into the workforce as China’s population ages. According to his calculations, only 154 million people under 30 were part of China’s 550 million-strong industrial workforce. It had been expected that the agricultural center would migrate to the industrial coastal regions for another 10 to 20 years providing an ongoing pool of cheap labor, but the reality seems to be that as a) the number of youngsters falls and b) those left after earlier moves are less willing to migrate, the pool is dwindling faster than expected. Add to this the ambition of young and increasingly better-informed Chinese youngsters to pursue higher education and aspire to better-paid office jobs. The net effect is rising wages — anecdotal evidence we have seen firsthand in our own Chinese office. Zhang Zheng, an economist at Peking University, estimates wages have risen by 15-40 percent in some areas, pricing China out of low-cost, manually intensive markets. For a while, massive investment in mechanization and automation will counter this trend, but widespread reports of rising real wages are testament to the pressure building in the economy.

As a result of the above, plus possibly a contribution from a gradually strengthening currency, China’s annual surplus is expected to narrow over the coming year. UBS estimates the surplus will be about $150 billion, down a fifth on last year and the third straight year of decline. If that was not enough, the potential long-term savior of the Chinese — guiding the economy towards more domestic consumption and relying less on exports — seems if anything further away. The percentage of the economy accounted for by consumer spending has fallen to about 35 percent, only half that of the US. The WSJ reported on Sunday that China registered its first quarterly trade deficit in seven years, underlining the impact multiple dynamics are having on the economy.

The result could be a difficult couple of years for China as some parts of the economy continue to grow strongly and others, notably exporters, are hit harder. Beijing’s reaction to continuing inflation and rest assured it isn’t going away soon will have ripples far beyond the South China Sea as the measures they bring in impact perceptions of future demand for metals from the world’s biggest consumer.

–Stuart Burns

At MM we try to avoid giving undue attention to extreme viewpoints, because there are always those for whom the world is about to end and likewise those for whom the garden is always in full bloom even when it’s patently obvious it’s winter outside. The reality is human beings are remarkably inventive and generally manage to muddle through between extremes of “boom or bust” most of the time. So while we have reported opinions on the Chinese economy and market conditions that suggest bubbles are developing in the property market and inflation could be a problem in the future, we have also reported on the robustness of the automotive sector and continued strong investment climate. So it takes several data points to align before we report on a number of negative trends that have us concerned. Some are shorter term, some are longer, but all are pointing towards a slowing in the Chinese economy that may be good for metals buyers, but bad for global growth.

The first is a report by Legal & General Investment Management reported in the Telegraph newspaper late last week. LGIM believes the threat of inflation is underestimated in China and warns that rising prices there are set to export inflation to the world. March inflation came in at 5.4 percent according to the National Bureau of Statistics, and annual growth at 9.7 percent in the 1st quarter, only fractionally down on the 9.8 percent recorded for the 4th quarter of 2010, suggesting the economy is still powering ahead despite attempts to cool the pace. While food inflation risks bringing the population out into the streets, wage inflation is what will put them out of work as Chinese products are priced out of world markets. While papers often report increases to reserve ratios as credit tightening, Brian Coulton, an emerging markets strategist at LGIM, argues that China’s 3 percent increase in banks’ reserve ratio requirements over recent months upping the amount of money they must sit on in proportion to deposits should not be viewed as monetary tightening. He believes the strategy is only just managing to offset the impact of China’s interventions to keep its currency weak to support its exporters. The PBC recycles the RMB funds released from imports by the use of sterilization bonds, with interest rates so low there is no appetite for these bonds unless banks are forced by Beijing to buy them which they do by raising reserve requirements. The central bank has been relying on reserve ratios to mop up this excess liquidity for much of the last year.

(Continued tomorrow in Part Two.)

–Stuart Burns

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