China’s G20 Summit shutdown highlights risks to buying “frenzy” in commodities markets
on May 4, 2016

Dalian Apr16China’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.

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