China’s changed priorities signal end to stimulus

China’s ‘One Belt, One Road’ project and the need to reduce pollution have replaced “growth at any price” as key government priorities, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

OBOR demographics May17

Companies and investors are assuming it is “business as usual” in China ahead of the important 19th National Communist Party Congress in October. They look back to the 2012 Congress, and imagine the Party’s leaders are again focused on ensuring economic stability. But in reality, 2012 was the exception not the rule, as it featured two potentially very destabilising events for Communist Party rule:

□  The arrest and subsequent trial of Bo Xilai for corruption. Bo was a very senior Party figure (a so-called Princeling whose father was one of the Party’s “Eight Immortals”), and had been expected to join the Politburo Standing Committee at the 2012 Congress. His wife was separately convicted of murdering British businessman Neil Heywood.
□   The intervention of former president Jiang Zemin in the final preparations for the leadership change. This became essential after President Hu’s top aide was involved in a scandal where he endeavoured to cover up the death of his son — who crashed while driving a Ferrari at high speed through Beijing, accompanied by a woman who also died of her injuries.

No such dramas have occurred this year. And as the chart shows, there has been no need to boost the economy via a repeat of the 50 per cent increase in monthly stimulus lending seen in 2012. Instead, growth in total social financing has actually been slowing.

TSF May17

Companies and investors need instead to focus on the two new areas being promoted by President Xi ahead of his nomination for a second five-year term.

The first is his signature “One Belt, One Road” (OBOR) project. Many have assumed this is simply a mechanism for tackling China’s over-capacity in steel and cement. A measure of its real importance can be seen from the fact that the recent OBOR Summit in Beijing was attended by 20 national leaders and more than 100 countries. It connects 64 countries accounting for 62 per cent of global GDP and has two critical elements:

□  It positions China to resume its geopolitical role as the Middle Kingdom, with the One Belt creating a land link from China to Europe, while the One Road creates a maritime link between the South China Sea, the South Pacific Ocean and the Indian Ocean.
□   Economically, as the map shows, it connects China’s ageing population (its median age will be 43 years by 2030) with the much younger countries along the Belt and Road. Most of them have median ages between 17 and 30 years. The OBOR project enables China to benefit from the demographic dividend potentially available to its neighbours.

OBOR is thus critically important for China as it seeks to avoid becoming old before it becomes rich.

The second new policy is Xi’s decision to move away from the “growth at any price” policies of his predecessors. He knows that reducing pollution, rather than maintaining economic growth, has become key to continued Communist Party rule.

As Alan Clark noted in beyondbrics, “environmental sustainability is rapidly moving up the agenda . . . (as) heavy palls of industrial smog have almost become the norm in some Chinese cities”.

The recent rapid elevation of Beijing’s mayor, Cai Qi, to become party chief for the city is further confirmation of the high priority now being given to tackling air pollution and stabilising house prices.

Taken together, these policies represent a paradigm shift from those put in place 40 years ago by Deng Xiaoping after Mao’s death in 1976. This shift has critically important implications, as it means growth is no longer the main priority of China’s leadership. In turn, this means that stimulus programmes of the type unleashed in 2012, and on a more limited basis by Premier Li last year, are a thing of the past.

Xi’s new priorities have already led to renewed weakness in commodity markets. Their full-scale implementation will probably reconfirm Napoleon’s famous warning that “China is a sleeping giant. Let her sleep, for when she wakes she will move the world.” 

Chemical industry downturn challenges stock market optimism

ACC Jun17Stock markets used to be a reliable indicator for the global economy, and for national economies. But that was before the central banks started targeting them as part of their stimulus programmes.  They have increased debt levels by around $30tn since the start of the Crisis in 2008, and much of this money has gone directly into financial markets.  Today, Japan is a great example of the distortions this has produced, as the Financial Times reports:

□  The Bank of Japan (BoJ) has been buying stocks via its purchases of Exchange Traded Funds (ETFs) since 2010
□   Last July, it doubled its purchases to ¥6tn of ETFs($58bn) per year, focused on supporting Abenomics policy
□   Analysis by Japanese bank Nomura suggests its purchases have since boosted the Nikkei Index by 1400 points

Even more importantly, the BoJ is particularly active if the market looks weak.  Between April 2013 – March 2017, it bought on more than half of the days when the market was down.

The distortion ins’t just limited to direct buying by the BoJ, of course.  It is magnified by the fact that everyone else in the market knows that the BoJ is buying.  So going short is a losing proposition.  Equally, investors know that the BoJ is guarding their back – so they are guaranteed to win when they buy.

This manipulation by the BoJ is just an extreme form of the intervention carried out by all the central banks.  It means that the stock market has lost its role as an indicator of the economy.  And so all those models which include stock market prices in their calculations are also over-optimistic.

This is why the global chemical industry has become the best real-time indicator for the real economy.  As I noted back in January, it has an 88% correlation with IMF data for global growth – far better than any other indicator:

The logic behind the correlation is partly because of the industry’s size.  But it also benefits from its global and application reach. Every country in the world uses relatively large volumes of chemicals, and their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.

Latest data on Capacity Utilisation (CU%) from the American Chemistry Council is therefore very worrying, as the chart shows:

□   Since 2009, the CU% has never recovered even to the 1987 – 2008 low of 86.4%
□   It has been in a downward trend since January 2016, when it peaked at 81.4%
□   April’s CU% fell to 79.9% versus 80.7% in April last year
□   This was very close to the all-time low of 77% seen in March 2009

The problem is that central banks have moved from the pragmatism of the 1980s to ideology.  They have become, in Keynes’s famous phrase “slaves to some defunct economist” – in this case, Milton Friedman and Franco Modigliani, as we argued in our evidence earlier this year to the UK House of Commons Treasury Committee:

“Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid.  Modigliani’s “Life Cycle theory of consumption” is similarly out of date. … Friedman and Modigliani’s theories appeared to make sense at the time they were being developed, but they clearly do not fit the facts today.”

Instead of the promised economic growth, the central banks have in fact simply piled up more and more debt – which can never be repaid.  2 years ago, the global total was already $199tn, and 3x global GDP, according to McKinsey. Just in the US, this means net interest payments will cost $270bn this year, and total $1.7tn over the next 5 years, according to the impartial Congressional Budget Office.

Stock markets may continue in their optimistic mode for a while longer.  But in the end, the lack of promised growth will force the central banks to stop printing money.  They will then have to abandon their ideological approach, and instead accept the common sense argument of our Treasury Committee evidence:

Monetary policy should no longer be regarded as the key element of economic policy.   This would then free policymakers to focus on the real demographic issues that will determine growth in the future – namely how to encourage people to retrain in their 50s and 60s to take advantage of the extra 20 years of life expectancy that we can all now hope to enjoy.”

Sinopec’s results confirm China’s focus on employment and self-sufficiency, not profit

Sinopec May17China’s strategies for oil, refining and petrochemical production are very different from those in the West, as analysis of Sinopec’s Annual and 20-F Reports confirms.  As the above chart shows, it doesn’t aim to maximise profit:

□  Since 1998, it has spent $45bn on capex in the refining sector, and $38bn in the chemicals sector
□  Yet it made just $1bn at EBIT level (Earnings Before Interest and Taxes) in refining, and only $21bn in chemicals

As I noted last year:

Clearly no western company would ever dream of spending such large amounts of capital for so little reward. But as a State Owned Enterprise, Sinopec’s original mandate was to be a reliable supplier of raw materials to downstream factories, to maintain employment. More recently, the emphasis has changed to providing direct support to employment, through increased exports of refined products into Asian markets and increased self-sufficiency in petrochemicals”.

Commentary on China’s apparent growth in oil imports confirms the confusion this creates.  Western markets cheered last year as China’s oil imports appeared to increase, hitting a record high. But they were ignoring key factors:

□   China’s crude imports were indeed 14% higher at 7.6 million bpd – nearly a million bpd higher than in 2015
□   But 700 kbpd of these imports were one-off demand as China filled its strategic storage
□   And at the same time, China’s refineries were pumping out record export volume: its fuel exports were up around one-third during the year to over 48 million tonnes

As Reuters noted:

This broadly suggests China’s additional imports of crude oil were simply processed and exported as refined products.”  In reality, ”China’s 2016 oil demand grew at the slowest pace in at least three years at 2.5%, down from 3.1% in 2015 and 3.8% in 2014, led by a sharp drop in diesel consumption and as gasoline usage eased from double-digit growth.”

The issue was simply that Premier Li was aiming to maintain employment in the “rust-belt provinces”, by boosting the so-called “tea-pot refineries”.  He had therefore raised their oil import quotas to 8.7 million tonnes in 2016, more than double their 3.7 million tonne quota in 2016.  As a result, they had more diesel and gasoline to sell in export markets.

China OR May17

The same pattern can be seen in petrochemicals, as the second chart confirms.  It highlights how Operating Rates (OR%) for the two main products, ethylene and propylene, remain remarkably high by global standards.  This confirms that Sinopec’s aim is not to maximise profit by slowing output when margins are low.  Instead, as a State Owned Enterprise, its role is to be a reliable supplier to downstream factories, to keep people employed.

□   Its OR% for the major product, ethylene, hit a low of 94% after the start of the Financial Crisis in 2009, but has averaged 102% since Sinopec first reported the data in 1998
□   Its OR% for propylene has also averaged 102%, but has shown more volatility as it can be sourced from a wider variety of plants. It is currently at 100%

Understanding China’s strategy is particularly important when forecasting demand for the major new petrochemical plants now coming online in N America.  Conventional analysis might suggest that China’s plants might shutdown, if imports could be provided more cheaply from US shale-based production.  But that is not China’s strategy.

Communist Party rule since Deng Xiaoping’s famous Southern Tour in 1992 has always been based on the need to avoid social unrest by maintaining employment.  There would therefore be no benefit to China’s leadership in closing plants.  In fact, China is heading in the opposite direction with the current 5-Year Plan, as I discussed last month.

The Plan aims to increase self-sufficiency in the ethylene chain from 49% in 2015 to 62% in 2020.  Similarly in the propylene chain, self-sufficiency will increase from 67% in 2015 to 93% in 2020.

It is therefore highly likely that China’s imports of petrochemicals and polymers will continue to decline, as I discussed last month.  And if China follows through on its plans to develop a more service-based economy, based on the mobile internet, we could well seen exports of key polymers such as polypropylene start to appear in global markets.