Boom, Gloom and the New Normal

Investment bankers and development economists like to talk about China being a ‘middle class’ country. Yet Asian Development Bank data shows that 96% of the population earn less than $20/day on a (PPP) Purchasing Power Parity basis.

Similarly, China’s ‘luxury market’ remains very small. Latest data suggests it was just €12.9bn ($16.9bn) in 2011, or <0.3% of China's total GDP. The UK is spending almost as much ($14.9bn) just to host the London Olympics for 2 weeks this summer.

These myths matter, because they help to explain why China's housing market is in such trouble. The official China Daily reports that Beijing new home prices fell 21% in Q1. But they still averaged Rmb 12400/ ($1950) sq metre.

Equally, average house price to income levels were 14:1 in Tier 1 cities such as Beijing in January. By comparison, US ratios at the height of the sub-prime boom were ‘only’ 5:1. These prices are clearly now unaffordable for most people, without stimulus subsidised loan finance.

Equally, low wages mean that food price inflation is vitally important for most people. As the chart from the Wall Street Journal shows, food price inflation (green line) climbed again to 7.5% in March. Vegetable prices surged 21%, whilst meat and egg prices rose 11%.

This makes it very difficult for the government to launch further stimulus efforts, like those seen in 2009-10. Instead, as premier Wen has emphasised, the focus remains on further reducing home prices to bring them back to a “reasonable level”.

It is hard to be very optimistic about the demand outlook for Q2.

Demand in Q1 was lacklustre, even though it should have been the strongest quarter of the year. H1 is seasonally strong, and Q1 also benefited from Easter being in Q2. Equally, the Chinese holidays fell in January, so February and March should have seen a major recovery.

Just as in April 2011, the oil price rally seems to have peaked, so there is little need for buyers to buy forward. More likely, we will see destocking down the value chain instead. CFOs are clearly worried about today’s high levels of working capital, given that bank credit can be difficult to obtain.

The real problem is that the years since the start of the Crisis have not been used to solve the major problems. The banana skins highlighted by the blog in January have become more dangerous, not less:

The USA has not solved the housing crisis, the original cause of the Crisis. Homeowners have suffered a $7tn loss of wealth, and 12m (1 in 5 with a mortgage) now owe more than their house is worth.

Europe is still suffering from its debt crisis. Policymakers continue to mistake sound-bites for action, and their recent move to impose austerity will only increase social tensions, rather than solve the problems.

China, meanwhile, has done little to refocus its economy on domestic consumption. Premier Wen’s speeches are clear about what needs to be done, but he seems unable to carry his senior colleagues with him.

In addition, Western policymakers have allowed oil prices to increase to record levels. They mistakenly believe that stronger financial markets will increase consumer confidence. Instead, high oil prices destroy demand, and make today’s tight credit conditions even more difficult.

The chart shows price changes since the IeC Downturn Monitor launch on 29 April, with ICIS pricing comments:

PTA China (red), down 13%. “Most players were staying at the sidelines during the two trading days of the week because of the unclear outlook for downstream polyester demand in April”
Benzene NWE (green), down 10%. “Traders suffer weak demand, as players take a wait-and-see approach with regard to upstream crude oil”
HDPE USA export (purple), down 6%. “Globally, prices were slightly lower on weak demand”
Naphtha Europe (brown dash), down 2%. “Demand from the petrochemical industry remains subdued”
Brent crude oil (blue dash), down 1%
S&P 500 Index (pink dot), up 3%

Globalisation had a golden age between 1982-2007. Trade barriers fell almost everywhere. Companies focused on achieving a ‘lowest cost’ position, in order to maximise their competitive advantage.

Today, however, the world is starting to look quite different.

The chart above summarises the changes underway. It shows US polyethylene net trade (PE) since 2009, based on GTIS (Global Trade Information Services) data, and updates that shown last November.

It presents a remarkable picture. Over this period, the USA gained major cost advantage, due to the increased extraction of ethane from cheap shale gas. Yet:

• Its net PE exports actually fell 39% from 2.6MT to 1.6MT
• Net exports to China were down 70% from 900KT to 266KT

The blog’s many US friends naturally find this very difficult to understand. They believe China should simply shut down its high cost, naphtha-based production and import cheaper US product.

But China operates on different values. Its petchem industry operates as a utility, providing reliable supplies of raw materials to the factories to keep people employed. If it shutdown plants, then social unrest would increase, threatening the existing Chinese political structure.

Sinopec’s own financial performance proves the point. Between 1998-2010, it invested RMB 166bn ($25bn) in chemicals capital expenditure. Yet its total EBIT (Earnings Before Interest and Taxes) was only half this at Rmb 84bn. No Western company would dream of investing on this basis.

But as the blog noted last week, China is continuing to expand production. And the government is currently expected to raise its stake in Sinopec from 76% to 78% over the next few months. It is paying the bills, not Western-minded investors.

The US thus faces a major dilemma. It has the 2nd cheapest ethylene feedstock in the world (after the Middle East). But its markets for this product are reducing:

• Braskem of Brazil is building new capacity in Mexico (with Grupo Idesa)
• It is also planning to build in Brazil
• Both expansions will reduce US exports still further
• Equally, Asian/ME producers are already expanding sales in Latin America, to compensate for lower import demand in China

The US position on ethane thus provides a good example of the changes underway as we transition to the New Normal. New value structures are emerging that focus on social and political factors, rather than economics.

There are increasing signs that China’s economic growth is slowing. Local gasoline and diesel prices are now (as in Europe) at record levels. Gasoline is Rmb 8.2/litre, the equivalent of $1.20/l, or $4.40/US gal.

Unsurprisingly, this leaves people with very little spare cash, especially with food price inflation still at 6.2%. Equally, with rumours of coups in Beijing following Bo Xilai’s purge, the communist party clearly has other things to worry about than a further economic stimulus package.

Polyethylene has been a good indicator of the slowdown as it has developed over the past year. The above chart, using GTIS trade data (Global Trade Information Services), shows combined January/February volumes (red column) compared to 2011 (green) and 2010 (blue):

• Total demand is up only 12% versus 2010, well below GDP growth
• Local production is up 28%, despite last month’s slowdown
• Overall imports are down 1%, whilst exports are up 160%
• Middle East and South East Asian net imports have grown rapidly
• North East Asian, NAFTA and EU net imports have fallen sharply

Unsurprisingly, as the blog noted on Monday, this slow growth is now causing Asian/Middle East producers to target other markets, particularly Latin America. They have to sell their product, or shutdown plants.

The blog is very pleased to have been invited to contribute to the Financial Times’ new FT Data blog.

Please click here if you would like to see the FT blog itself.

Chemical prices might not be the first forecasting indicator that springs to mind. But over the recent economic crisis, benzene in particular has highlighted economic shifts well before more traditional metrics.

Benzene’s 40 million tonnes of global sales are a key raw material for a very diverse group of end-products, including polystyrene cups, nylon clothing and carpets, pesticides and dyes. Equally, as it is produced from crude oil, benzene provides a highly-sensitive barometer of consumer reactions to changing energy prices.

A key metric is its price premium to naphtha (its oil-based feedstock). The chart above shows this metric since the crisis began in (using ICIS pricing data).

• Typically, the premium has found a floor at $150/tonne
• But it collapsed during October 2008, remaining very weak until February 2009
• The depth of the downturn was also demonstrated by the premium becoming a discount
• It then staged a sharp recovery, which took it back above the $150/t level

Therefore, benzene highlighted, well ahead of other indicators, both the downturn in the wider economy and the equally sudden upturn.

Its recent performance therefore merits close attention.

The major increase in oil prices from November 2010 to April 2011 gave powerful support to benzene’s price premium. Companies down the value chain cannot simply increase their own prices overnight. Instead, they have to protect their margins by buying forward, giving a perception of robust demand.

However, the premium’s subsequent collapse between August to October indicated that higher oil prices were actually reducing end-user demand. Even more worrying is that recent renewed support from rising oil prices has proved short-lived. Instead, the premium has been steadily eroding since January.

The decline cannot be related to developments on shale gas, as this is not a feedstock for benzene. Benzene may therefore be flagging an important message about consumers’ fading resilience to today’s higher crude oil prices.

Benzene is not the only chemical with forecasting ability. Terephthalic acid (PTA) is similarly well-placed as a key raw material for polyester, where China is the dominant player. Its price premium versus naphtha can provide valuable insight into China’s economic health.

As the chart shows, the floor for its premium has typically been $200/tonne. But this has halved in recent weeks, despite the end of China’s holiday period. Equally, as with benzene, reports from end-user markets suggest that consumer demand is weakening.

PTA is thus warning that China’s economy could be slowing faster than generally realised.

The Financial Times has kindly published the letter below from the blog today. It argues that affordability, not luxury, is the key need in China, as income levels are very low by comparison with those in the West.

From Mr Paul Hodges.

Sir, Martin Wolf, in “How to blow away China’s gathering storm clouds” (March 21), provides an excellent summary of the issues now facing China as it seeks to make the transition from an export-led development model to one based more on domestic consumption.

Mr Wolf’s article provides a healthy reminder that China’s transition to a developed economy is by no means assured. All those who wish it to succeed would do well to emulate his realism about the difficulties that lie ahead.”

Paul Hodges, Chairman, International eChem

On 29 June 1987, the blog was in S Korea on a business trip. With its ICI Korea colleagues, it arrived at the company we were due to visit, to find the gate open. The offices were also deserted.

Surprised, we walked into the factory to find 500 people watching a small black and white television. It was a momentous day in the political life of S Korea. President Chun was announcing that, for the first time, the next president would be directly elected under a new constitution.

Since then, Korea’s economy has blossomed. Even the 1997 Asian Crisis proved helpful in hindsight. It further weakened the ‘crony capitalism’ that still existed between the powerful industrial chaebols and the government.

China, of course, still has to go through this process. But the starting gun was fired on Thursday, when it was announced that one of the Communist Party’s top officials, Bo Xilai, was being fired. Premier Wen then went on live television in his annual press conference to warn:

“Without successful political structural reform, it is impossible for us to fully institute economic structural reform and the gains we have made in this area may be lost. New problems that have cropped up in Chinese society will not be fundamentally resolved and such a historical tragedy as the Cultural Revolution may happen again. The mistake of the Cultural Revolution and impact of feudalism are yet to be fully eliminated.”

The background to this intense debate, as in Korea in the 1980s, is the need for political reform to accompany and support economic growth.

The chart above, from chapter 6 of ‘Boom, Gloom and the New Normal‘, highlights the insight of West Indian, Sir Arthur Lewis. He won the Nobel Prize for his work showing how early growth (y-axis), based on the supply of cheap labour, comes to an end after ~20 years (x-axis):

• This ‘free labour’, which kick-starts industrial development, has to be replaced by more labour intensive manufacturing
• In turn, this means people have to be allowed to think for themselves

Since 1987, Korea (red dot) has successfully followed Japan (blue dot), in moving up what has become known as the ‘Lewis Curve’. Now China (green dot) has to try and follow the same path. It will not be easy, and as Wen warned, success is not guaranteed.

Bo’s dismissal shows that China’s leadership is starting to move in the right direction. But it is just a first step. The new Politburo leadership, due to emerge in October, has a major task ahead of it.

Cotton prices are falling again, since Monday’s reversal by the Indian government of its proposed ban on cotton exports. India is the world’s 2nd largest cotton exporter, after the USA, with 20% of the market:

• On 5 March, its Textiles Ministry banned all exports
• Domestic users had applied pressure to divert supplies to local markets
• Domestic prices immediately fell, whilst world prices jumped 5%
• Cotton farmers, and major importers such as China, then protested
• This week, the Agriculture Ministry announced the ban’s partial removal

The chart highlights the extreme volatility that has hit cotton markets since 2009. Demand suddenly jumped as China’s bank lending spree and stimulus programme took effect:

• Prices soared from 46c/lb in March 2009 to 227c/lb on 7 March 2011
• A drought in the USA also helped to reduce supplies
• But recently, prices and demand have weakened
• Last week’s 5% price rise on news of the export ban is already history

This is yet another clear indicator that China’s economy is cooling fast. In turn, this will reduce inflation, and help the government achieve its main policy objective of social stability.

The cotton price now seems headed back towards its traditional 50c-70c/lb range. This has important implications for petchem markets, and the C8 chain into PTA and PET.

Textile companies routinely change the blend mix between polyester and cotton, depending on the relative price between the two. So if oil prices stay high, C8 volumes and pricing will come under further pressure.

If something seems to be too good to be true, then it generally is. That appears to be the learning from China’s auto market in recent months.

February sales jumped, as the Lunar New Year holiday took place in January this year. But total sales in January/February were down 5% versus 2011 at 2.37m versus 2.5m.

This is quite different from the 2008 – 10 period when;

• Sales fell 4% in Q4 2008, as the Crisis hit China’s economy
• Then they jumped 53% in 2009, and 33% in 2010
• But this was only due to the government’s panic reaction
• It doubled bank lending, and added stimulus worth 13% of GDP

The blog has always argued this growth could not be sustained.

The reason is simple. 96% of China’s population earns less than $20/day, according to Asian Development Bank data. This means they would be living below the poverty line in any Western economy.

So cars are a luxury item for many people, and only really affordable when the government helps to pay the bill.

The past few years have seen an increasing number of countries and major companies moving to ban or reduce the use of plastic bags. Now Austin, state capital of Texas, and the 14th largest US city has voted to introduce criminal penalties for any retailer breaking its new law.

ICIS’ Joe Kamalick notes that “the Austin bag ban law also requires that retailers post signs informing customers that they must bring their own multi-use bags, any failure to post such signs could be subject to the misdemeanour criminal penalty”.

The maximum penalty is $2000, although the ban “includes exemptions for plastic bags used by laundries and dry cleaners, newspaper delivery bags and some other single-use plastic bags provided by specific vendors such as pharmacies and for restaurant carry-out foods”.

The blog remains fully supportive of such bans, although it regrets any criminalisation measures. The video above, first posted last May, highlights the enormous environmental damage caused by these single-use bags. They are simply too light, and cannot be properly contained during or after use.

The situation seems to parallel other occasions where products have been withdrawn after it was found they produced unintended, and unwelcome, side effects. Nobody today, for example, would advocate adding lead to gasoline to boost octane, now we know about its health hazards.

The polymer industry would boost its public image, and lose very little in terms of total sales volume, if single-use bag manufacturers were to voluntarily stop production.