Imagine living in the capital city of a major country, and suffering the level of pollution shown in the above photo on a regular basis. We used the photo in chapter 6 of Boom, Gloom and the New Normal when we highlighted how pollution was inevitably going to move up the political agenda in China. Controversial at the time, it warned:
“Recent growth in China and India has come at a price: Poor air quality, chronic water shortages and deforestation.”
By February 2014, the pressure to act was becoming almost overwhelming as:
“The problems have worsened, to the point where almost everyone now agrees that they are creating a major political problem. The new leadership simply has to solve this, if it wants to remain in office. Beijing and the 6 northern provinces have now been shrouded in smog for 6 days, and on Wednesday the US embassy reported that the levels of PM2.5, the small particles that pose the greatest risk to human health, were “beyond index” at 512.”
Guangdong province, close to Hong Kong, had already moved to clean up. But other provinces did little or nothing, as officials worried about the likely impact on jobs. A major part of the problem was that the economy is the Premier’s responsibility, and Premier Li has been more worried about maintaining growth via stimulus programmes.
This year, however, Xi finally lost patience ahead of next month’s 5-yearly People’s Congress – at which he will be renominated for another 5-year term. Having signed China up to the Paris Agreement on climate change in December 2015, he seized control of the economic agenda, as I noted in the Financial Times:
“Xi knows that reducing pollution, rather than maintaining economic growth, has become key to continued Communist Party rule. 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.”
Since then, the Beijing area, and surrounding provinces such as Hebei and Henan, have become a centre of the battle against pollution. One key development has been the use of thousands of drones to spot, and measure air and water pollution, and then identify and photograph the culprits. As state-controlled Xinhua reported last week:
“A total of 599 companies, mainly construction materials, furniture, chemicals, packaging and printing, were relocated out of the capital, said the Beijing municipal commission of development and reform. Beijing also closed 2,543 firms and ordered 2,315 firms to make changes. About 73% had pollution issues.”
Similarly, a senior chemical industry executive told me last week:
“I was in/near Cangzhou the other day (another city on the list) where the government have created a large National Level Economic Zone including a dedicated chemical “park” to accommodate the companies that are being cleared out of Beijing and surrounds. This was an otherwise nondescript flatland whose only previous claim to fame was a Mao era collaboration with then Czechoslovakia to make tractors.”
The war on pollution has another side to it, of course, as it marks the end of the “growth at any cost” economic model.
As a result, realism is finally returning to discussion about China’s real growth potential. As last month’s IMF Report on China noted, GDP growth had only averaged 7.3% over the 5 years to 2016 because of stimulus: without this, growth would have been just 5.3%. As a result, the IMF also highlighted an increasing risk of “a possible sharp decline in growth in the medium term”, as well as a need to boost domestic consumption by reducing savings.
This is a welcome development. Too many companies and analysts have indulged in wishful thinking, wanting to believe China had suddenly become middle-class by Western standards. In reality, as the second chart shows, the growth surge was due to $20tn of stimulus lending via official and shadow banking channels.
At its peak, between 2009 – 2013, this lending reached 3.2x official GDP. And GDP itself was probably also over-stated for internal political reasons, as Communist Party officials were routinely judged for promotion on their success in generating GDP growth. Now the pendulum has swung the other way, as the Caixin business magazine has reported:
“In a document jointly released by the Ministry of Environmental Protection and nine other ministry-level bodies, if a city does not achieve 60% of the emission reduction target, the city’s vice mayor will be held responsible. If the city achieves less than 30% of its target, the mayor will be held responsible; and if the PM2.5 level ends up increasing instead of falling over the winter, the party secretary of the city will be held responsible.
“Possible punishment includes party disciplinary or administrative punishments, the document says.”
Large economies are like super-tankers, they take a long time to change course. As I noted nearly 2 years ago, China is now attempting to move in a radically new direction, away from export-driven growth and infrastructure spending – and towards a New Normal economy based on the mobile internet:
“The winners are developing services-led businesses focused on China’s New Normal markets – such as those aimed at boosting living standards in the poverty-stricken rural areas, or for environmental clean-up. The losers will be those who cling to the hope that more stimulus is just around the corner, and that China’s Old Normal will somehow return.”
Those who have done well under the old regime, like the Party heads focused on job-creation and the opportunities that it created for large-scale corruption, will inevitably fight hard to preserve their way of life. Next month’s Congress will therefore be critical in assessing just how much power Xi will have to pursue his reform policies in his second term.
As I noted a year ago, this Congress will settle key questions. Will Premier Li gain a second term, and continue to be able to obstruct reform? Will anti-corruption tsar Wang maintain his position on the all-powerful Politburo Standing Committee, despite being over the nominal age limit?
The Congress is therefore likely to the most important meeting since 1997, when Jiang Zemin gained re-appointment for his second term as President and led China out of poverty via membership of the World Trade Organisation. Now, as set out in the China 2030 Report (published when Xi became President), Xi has to led China in a new direction.
Otherwise, he will be unable to achieve his twin goals of
□ Making China a “moderately prosperous society” by 2021 (the centenary of the Chinese Communist Party)
□ Making it a “fully developed, rich and powerful nation” by 2049 (the centenary of the People’s Republic), and returned to its historical status as the Middle Kingdom via his ‘One Belt, One Road’ project.
China’s polyester industry, like many others, is already preparing to shut down ahead of September’s G20 Summit in Hangzhou, to reduce pollution levels. The phenomenon even has its own Wikipedia page, APEC Blue, to describe the moment in November 2014 when Beijing suddenly saw blue sky for the whole of the Asia-Pacific Economic Co-operation (APEC) summit meeting. It is defined as being “something wonderful, but fleeting”.
China’s leaders want blue sky again for the G20 leaders. But you can’t continue to run the world’s second largest economy like this. Hangzhou is China’s 4th largest city, 200km (125 miles) from Shanghai, and is home to 21m people. And yet, as Lloyds Loading List reported in March:
“Exporters and importers from China’s Pearl River Delta brace for supply-chain disruptions as factories prepare for partial and complete closures in advance of September’s G20 Summit in Hangzhou…factories could reduce or cease production starting as early as June. With the Summit not opening until September, importers sourcing from the Shanghai area could face a summer of supply chain disruption.”
You have to deal with the root cause of the problems, not the symptoms.
CHINA’S POST-2008 STIMULUS LED TO CORRUPTION, POLLUTION AND THE INVESTMENT BUBBLE
And pollution is not the only super-critical issue that needs to be tackled. A blog reader has kindly forwarded the attached chart from Woodford, the respected investment fund. Under the heading Bubble Trouble, it shows the volumes traded in China’s Dalian commodity futures markets on just one day last month, 21 April:
- $93bn was traded in steel rebar, $47bn in iron ore, $23bn in copper, $23bn in cotton and $11bn in PTA
- China’s total imports of iron ore were 950MT in 2015: Dalian futures volumes exceeded this on 2 days in April
Readers with long memories will remember we have been here many times before, since China’s stimulus bubble began. In April 2009, the Dalian futures exchange traded 77 million tonnes of LLDPE (Linear Low Density Polyethylene), 3x total world production at the time – highlighting how the bubble was distorting world markets. Most of the speculators probably never even knew what LLDPE was, let along its supply/demand fundamentals.
The underlying cause of both problems – pollution and the lending bubble – is, of course, corruption and graft. Easy money policies make it easy for well-connected people to make vast fortunes very quickly – one, not very senior general in the People’s Liberation Army (PLA), apparently managed to build a $5bn fortune through bribery and corruption. And as Reuters reports, China’s Central Commission on Discipline and Inspection (CCDI) has discovered even the release of commodity statistics is prone to corruption:
“CCDI said last week that hundreds of staff working for the statistics bureau had been using official data for personal gain.”
The key to the problem is the shadow banking system as the Financial Times reports:
Not for the first time since Xi came to power, tough decisions are being made. He has just appointed himself commander-in-chief of the PLA, an essential step to stamping out graft in the army – as Business Insider notes:
“The PLA’s officer corps has gotten deeply involved in enriching themselves. In the past, the PLA was directly involved in PLA-owned enterprises. Those have been reduced, but the PLA leadership is still intertwined with Chinese business, either directly or through relatives. The PLA’s size and influence mean that its officers’ interests are torn between the party and the wealthy now under attack.”
Xi is also moving against the Populist faction, which has been the main supporter of stimulus policies, as I noted in the Financial Times last year. Former President Hu Jintao and current Premier Li Keqiang are both Populists who came to the top via membership of the Young Communist League:
- Wang Quishan, Xi’s corruption tsar, has found evidence of “embezzlement and influence-peddling”
- On Thursday, state media reported the League was soon to publish a “detailed plan for its own reform”
THE COMMODITY BUYING FRENZY HAS PROBABLY PEAKED
Most long-lasting trends in financial markets normally end with a “buying climax” where suddenly everyone jumps in on the action. And it looks very likely that this is what happened in China’s financial futures markets last month. The volumes traded defy rational logic – and can only have been due to financial frenzy. As Woodford warn:
“We know from history that when bubbles burst, they do so in a damaging and unpredictable way. It is impossible to predict when and what will trigger their bursting, but it is inevitable that fundamentals will reassert themselves eventually.”
Evidence from oil markets also suggests the bubble is close to bursting. China’s so-called “teapot refineries” have been a major source of demand this year, due to their new export quotas. They have not been buying for the domestic market, but for exports – and Asian refining margins have halved since January as a result. And now the largest “teapot refinery” says even their storage is full:
“Everybody’s storage is full and it takes time to digest the inventories, maybe 2-3 months.”
Of course, many in the markets think this bubble might continue for another few months. My own view is that this underestimates Xi’s determination to sort out the problems he inherited during 2016, and “take the pain” of restructuring before he comes up for reappointment next year.
The next few weeks will tell which view is right.
$2.83tn is estimated to have left China illegally as a result of corruption between 2005 – 2011. This helps to explain the remarkable poster above, which shows China’s Interpol list of its 100 “most-wanted” corruption suspects. It has just been published by China’s state media, with the following explanation:
“The China National Central Bureau of the International Criminal Police Organization recently released a list of its 100 most-wanted worldwide, all of whom are suspected of economic crimes. The move is part of “Sky Net”, a campaign aimed at repatriating corrupt officials that fled overseas.
“The wanted list is issued by Interpol and its procedures are different from judicial coordination between states. With the release of the wanted list, the police in nations that have not signed repatriation treaties with Beijing can take actions against these Chinese fugitives via coordination with Interpol, thus further helping China. This has sounded an alarm to corrupt officials on the run overseas – even the safe havens will be dangerous for them.
“Browsing the official Interpol site, one finds that more than 400 Chinese are already on its wanted list, most of them for suspected corruption. Interestingly, some of them are not officials, but officials’ family members, such as wives or sons. That has much to do with the unique culture of corruption in China: many corrupt officials tend to seek illicit income by involving their family members in their crimes.”
Every day now seems to bring new arrests. Thus on Monday, the president and vice-chairman of Sinopec, China’s petrochemical giant, were arrested on suspicion of “serious violations of discipline and the law” – a phrase usually used to indicate allegations of corruption.
Last month also saw the trial begin of Jiang Jiemin, the former head of China National Petrochemical Corp (CNPC). Hundreds, probably thousands more, have been detained from lower ranks of CNPC and its subsidiary PetroChina. This follows the detention last year of Zhou Yongkang, the former Politburo member who build his career in PetroChina before becoming head of China’s security services.
As I noted last year, all financial bubbles lead to massive corruption. The major Western banks have been fined over $75bn since the financial crisis began, and new allegations emerge daily. However, nobody seems to go to jail, and shareholders are left to pick up the bill.
China is taking a a different approach, as the wave of arrests confirms. There is even a website that provides more details on day-to day developments. The importance of the campaign to President Xi was signalled as early as November 2012 by the appointment of Wang Qishan to lead the campaign. As I noted at the time:
“Corruption. Countries cannot progress if corruption dominates daily life. Thus it seems critically important that Wang Qishan has been given explicit responsibility for running the anti-graft agency. Equally important may be that previous head, Ma Wen, did not even make the new Politburo’s Standing Committee. Wang is the Party’s ‘Mr Fixit’ and was responsible for resolving the Sars bird flu crisis in 2003 and the success of the Beijing Olympics“.
Wang has a novel approach to gaining the information he needs. His teams settle in at government-owned hotels, and place adverts in the local papers to tell people they have arrived, as well as running online corruption hotlines.
With the launch of the Top 100 list, his anti-corruption probes are now clearly taking a new and even higher profile.
Today is Mid-Autumn Festival day in China, held to celebrate the harvest. Traditionally it features the exchange of moon cakes filled with lotus paste and egg yolks, whilst children go to lantern parades.
But in recent years, it has also become synonymous with corruption. Silver moon cakes, as pictured above, became a common gift for officials, as well as gold-adorned moon cake boxes. And the corruption even extended into schools, as the Financial Times reports:
“For the past decade many Chinese parents have seen nothing wrong with giving teachers gifts to ensure that little extra for their child – maybe a seat at the front of the class, or a position as the Chinese equivalent of milk monitor. In the old days, lucky teachers might have scored a Louis Vuitton handbag or a day at the spa, but now most are lucky to receive grocery coupons or a popular brand of throat lozenges.
“Last year the official China Youth Daily reported that one university student managed to secure a pass in a major exam by plying her teacher with four boxes of top quality milk. But these days even the milk ruse won’t get past the government’s abstemiousness monitors.”
This year, things are indeed different. Luxury goods manufacturers are seeing sales tumble. Fine wine sales for government officials have collapsed by 90%, according to Decanter magazine, which goes on to add:
“We can see a great shift here as the market moves from an era of government-led procurement and opportunistic profiteers to a market driven by genuine consumer consumption.’
Rooting out corruption is the No 1 priority for the new leadership, as highlighted on the official China Daily website, which lists all the leading officials who are now under investigation across the country.
At the same time, the government is collapsing the property bubble, which has become a severe threat to future economic stability. As a result, consumption based on the property ‘wealth effect’ is also collapsing.
Companies and investors need to go rapidly up the learning curve on these new developments. This is why we are holding our second China Transformation webinars tomorrow. The webinar is free, and there are two options to attend – one timed for Asia /Middle East; one for Europe/Americas/Africa.
The main topics are:
- How commodity trade fraud on metals in China could lead to a new global economic crisis
- Problems faced by the polyester industry: Severe oversupply and a collapse of global cotton prices
- The reform drive and what it means for future growth
- The need for companies to reposition themselves as China’s economy changes
Please register here to join the discussion.
WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
Brent crude oil, down 7%
Naphtha Europe, down 6%. “Crude oil futures eased as rising supplies from Libya were matched with tepid demand caused by mediocre refining margins”
Benzene Europe, down 5%. “The key driver was the US market….With demand for benzene derivatives in Asia sluggish, in particular in styrene, this is pushing more material out of the region for export to the US.”
PTA China, down 3%. ”Operating rates were relatively low, as producers were running their plants to meet demand, to avoid a build-up in inventories”
US$: yen, down 1%
S&P 500 stock market index, up 10%
HDPE US export, up 13%. “Buyers are cautious and not willing to buy large volumes of material, waiting to see whether prices will move lower”
We all know that China’s published GDP figures are meaningless. China’s premier, Li Keqiang, has told us so. And common sense tells us that no country, large or small, can possibly produce accurate GDP data within 2 weeks of the end of a quarter. Nor is it possible to believe that this data never needs to be revised, but is always ‘right first time’.
Yet China’s GDP numbers are published just 2 weeks after each quarter, and are never updated.
Of course, one key reason people still use these numbers is simple. There has been little else available. Thus the blog is very enthusiastic about the above chart, from veteran China expert and metals analyst, Simon Hunt:
- It begins in 1991 and focuses on the 2 key variables – nominal GDP (dotted blue line) and GDP deflator (red)
- Nominal GDP is total output before adjusting for inflation, and the GDP deflator then adjusts for inflation
The picture that it gives of real GDP (green) fits very well with the blog’s own personal knowledge of China’s economic development over the period. It shows the major downturn in 1993 and the slowdown at the end of the decade, plus the later downturn in 2008-9.
It also destroys the myth that China’s growth has somehow been in double digits through all the difficulties of the Asian Crisis and more recent crises, until very recently.
It also explains why state media were happy to publish the above map last month, showing large parts of the country coloured dark blue, to “indicate a serious economic cooling-off“.
Noteworthy also is that almost all of the rest of the country was described as being in a “downward trend” (light blue)..
If the new leadership really believed its GDP number, it clearly wouldn’t publish a map like this. Instead, we can simply assume that they inherited a GDP process which they knew to be wrong, but which would cause too many problems to correct. So the best solution was simply to ignore it.
This approach means they can focus on what really matters, getting the future direction right, and implementing the necessary policies. This will be quite different from the previous focus on creating a property ‘wealth effect’ and boosting exports. As China Daily commented on Li’s visit to Central China’s Hunan province:
“Experts said his choice of a destination reveals the answer. The potential resilience of China’s economy lies not on the coastline but more in the central area of the country, where urbanization is just getting started, the infrastructure needs upgrading, and robust growth is expected.”
And it went on to note that “the old industrial bases are finding their restructuring to be a challenging task”.
GDP growth of around 5% a year for the past couple of years is a far more believable level than the published figures. It also relates very well to Li’s suggestion that data such as electricity consumption was a better guide to the reality of economic growth.
In turn, of course, it means it is much more likely that China will now see a period of negative growth, as it bursts the property bubble and tackles widespread corruption.
But at the same time, it will be building for the future, particularly through the development of the new rail and maritime ‘Silk Roads’ that aim to connect Europe and Asia with China.
Even more importantly, it makes it much less likely that China will do the massive stimulus that outside ‘experts’ expect. If China has survived economic downturns before in the past 25 years, rational leaders such as President Xi and Premier Li will assume that it can survive another one today.
But companies and investors who haven’t planned ahead for this Scenario may find life very difficult indeed.
Very large amounts of copper, iron and other commodities are in long-term storage in China as part of the ‘collateral trade’. More recently, it seems large amounts of polyethylene (PE), ethylene glycol (MEG) and probably other chemicals have also started to be used for the trade.
None of this used to matter when the Chinese economy was booming. Why ask too many questions, when the profits are rising? But now China’s economy is slowing fast under the new leadership.
So now people are asking questions about why, for example, polyethylene imports appear to have risen 20% in H1 versus 2013, as the chart above shows, based on Global Trade Information Services data:
- Could total demand in a large, nature market like China’s really have grown 12% in H1?
- It was already nearly 20 million tonnes in 2013, and now it seems to have grown another 1.2MT in 6 months
- We can certainly believe that production has grown 6% as China continues to support its job market
- But can import demand really have grown 20% over the period to 5MT?
The blog, like many others, is left scratching its head about what is happening.
The likely answer comes from the insight of the famous fictional detective, Sherlock Holmes:
“When you have eliminated the impossible, whatever remains, however improbable, must be the truth?”
If we apply this rule, then we must eliminate as impossible the idea that China’s demand could have grown 12%. Instead we must accept that the imports have been used for some other purpose, however improbable this may seem.
Luckily, however, there is good support for this conclusion when we look at what has been happening in other commodity markets such as copper and iron. Vast amounts of these commodities have been stored in warehouses as part of the ‘collateral trade’, as the blog described in its recent China Compass research note.
Fellow-blogger John Richardson has described recently how ethylene glycol also appears to be involved. And in a “must read” post yesterday, he describes how polypropylene also appears to have been used – via the establishment of full-scale BOPP lines – for the same purpose.
The logical conclusion from the import data is that PE has become part of this trade, which appears to work as follows:
- A company buys PE from an overseas supplier on 180 days payment terms
- They immediately sell the volume on the Dalian futures exchange
- Now they have money to invest in the property market at rates of up to 60%
- They can then ‘roll over’ the purchase after 180 days by selling to a Hong Kong-based company
- This company opens a letter of credit and can use the proceeds to ‘roll over’ the previous trade
The risks of a disorderly unwinding of China’s “collateral trade” are now rising day by day, as the leadership tackles the housing bubble. As the Wall Street Journal reports, 17 cities now have inventories of unsold housing that will take at least 5 years to clear at current sales rates.
PE producers and consumers need to urgently develop a strategy to deal with this possibility. Waiting until it happens will be too late.