China and the Commodity Complex

In the old American West, there was a cowboy named Tom Prichard. He was known throughout the state of Texas for driving cattle on his oversized white Percheron horse, Buck. Tom was the quintessential hard-driving, rugged cowboy who characterized the American frontier.

In the summer of 1877, he was approached by Gordon Meriwether of the firm of Russell, Majors, and Waddell (RMW) to drive about 850 cattle on the 1,000-mile-long Chisholm Trail from the Rio Grande to Abilene, Kansas. Normally a trip like that would take about two months, but Meriwether insisted that Tom do it in just 30 days. Sure enough, Tom made it to Abilene in 30 days. He drove the cattle so hard, however, that many of them didn’t survive. The heat of summer, limited water, and poor grazing conditions killed off nearly 300 of his stock, and the 550 or so that survived were so underweight and feeble that they were roundly rejected at auction. After that trip, Tom refused to travel more than 15 miles a day with a live herd, regardless of what management wanted. Tom Prichard learned his lesson the hard way.

I created this story to illustrate an important point: China’s handling of its economy today is just like the challenge Tom Prichard faced. China is pushing its economy hard, hoping for a short-term reward, but is simultaneously saddling the country with enormous long-term costs that it is only now beginning to pay.

Over the past 18 months, prices among virtually all commodities have crashed. In mid 2014, oil was regularly trading for over $100 per barrel. Today, it is trading in the $30s. After peaking near $10,000 per metric ton in 2011, copper traded above or near $7,000 all the way through 2014. Today, copper trades near $5,000 per metric ton. And so it goes with other commodities: Inventories are rising, demand is falling, and prices are cratering. And it’s not just commodities — stock markets the world over have just entered bear market territory.

During the run-up to the commodity bull market in 2005 (and thereafter), every investor learned the lesson that demand from China was now driving commodity markets. But what was driving Chinese demand? The country has long been the most populous nation on the planet, but it has only recently become the largest commodities consumer.

In the 1970s and 1980s, China initiated a profound change of direction by embracing a market-based economy. A key piece of the strategy was to become a global manufacturer and exporter. In order to achieve this, China weakened its currency and then pegged it to the US dollar. Between January 1981 and February 1994, China reduced the value of the yuan (CNY) relative to the US dollar by nearly 82%. As the price of China’s currency fell, the price of Chinese exports to foreign buyers fell as well, helping set the stage for China to become a major global exporter.

But this growth did not come without a cost. As China’s exports rose, its current account surplus exploded. Between 2000 and 2007, China’s current account surplus-to-GDP ratio increased from a modest 1.7% to over 10%. A surplus that large doesn’t happen by accident: China was deliberately pushing its economy hard to juice growth.

As China grew into the new century, it built out massive infrastructure and sprawling cities, creating enormous demand for nearly all forms of commodities. In fact, China’s appetite for commodities was so great, that it singlehandedly pushed up demand worldwide. Between 1970 and 2002, global commodity demand increased at a rate of roughly 2% per year. Then, from 2003 to 2005, China’s demand spiked as its current account surplus ballooned. China quickly became the marginal buyer of internationally traded commodities, comprising around 50% or more of global demand in many commodities. Suddenly, after having been steady for decades, global commodity demand suddenly began growing at roughly 4% to 6% per year — about three times the demand growth over the preceding 30-plus years.

With China’s emerging growth as the backdrop, commodity industries suddenly found themselves overwhelmed trying to meet the new levels of demand. However, new capital projects for commodity producers require massive investments in infrastructure, including ports, railroads, bridges, ships, etc., as well as extraordinarily long lead times (seven to 12 years is not uncommon to develop a project). This combination of markedly higher demand and inflexible supply pushed prices to greater and greater heights across the commodity spectrum.

Of course, during the financial crisis of 2008, commodity demand took a hit while the world struggled through the ensuing recession. Not content with the global recession and its own slowing economy, China doubled down on its aggressive policy, embarking on a $500-billion stimulus plan and cutting its interest rates markedly. China’s demand for commodities once again surged and credit growth accelerated. But some believe that China wasted as much as $6.9 trillion in bad investments since 2009. China’s official growth is faltering, and many speculate that its actual growth rate is falling even more.

Furthermore, fear of a weakening economy and possible devaluation of the yuan is forcing capital to flee the country. The government can’t raise interest rates to entice capital to stay, nor can it print unlimited money for fear of devaluing the yuan. Because a weaker yuan flushes foreign investors out of the country and threatens to spur tariff and trade wars with the United States and other countries, China is using its massive $3.3 trillion in foreign currency reserves to support the yuan. But these currency reserves are being depleted at a rapid pace, losing $108 billion in December 2015 alone.

Now, China is emphasizing “supply-side” reforms. This in part means that China will increasingly embrace consumerism within its own borders. If true, consumption and services are far less commodity-intensive than, say, building ports and other infrastructure. But China hasn’t let the yuan float to correct supply-side imbalances and has continued to push new credit creation and subsidize bad loans throughout the financial system. With respect to commodities, the question is not whether China will return in full force — it can’t. The question is whether India and other countries will grow enough to make up the incremental difference. If not, the commodity complex will struggle with overcapacity for many years to come.

The question for China is ultimately the question that Tom Prichard faced — will it kill the economy in the process of driving growth?

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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