Painful dark side to China's lending surge

Discussion in 'Economics' started by Corelio, Jul 9, 2009.

  1. Corelio


    Some food for thought.

    JUNE 29 — China’s credit boom has increased bank lending by more than six trillion yuan (RM2.88 trillion) since December. Many analysts think an economic boom will follow in the second half of the year. They will be disappointed.

    Much of this lending has not been used to support tangible projects. It has been channelled into asset markets.

    Many boom forecasters think asset market speculation will lead to spending growth via the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is hurting China's economy by driving up asset prices.

    The current surge in commodity prices, for example, is being fuelled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

    Commodity prices have rocketed since March. The Reuters-Jefferies CRB Index has risen by about a third, and several key commodities like oil and copper have doubled in value from this year's lows.

    Demand from financial buyers is driving these prices. The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.

    But financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.

    Early this year, the six-month futures price for oil was US$20 (RM70) higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.

    For some commodities, warehousing costs are low, limiting net losses for financial buyers. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging on China's size. They've made everything open to speculation.

    There's little doubt that China's bank lending since last December has driven speculative inventory demand for commodities. Chinese banks lend for commodity purchases, allowing the underlying commodities to be used as collateral. The loans are structured like mortgages.

    Banks usually have to be extremely cautious about such lending, as commodity prices fluctuate far more than property prices. But Chinese banks are relatively lenient. As an industrialising economy, China's support for industrial activities such as raw material purchases for production is understandable. However, when commodities are bought on speculation, lenders face high risks without benefiting the economy.

    The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

    But China's imports are mostly for speculative inventories.

    The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

    What is happening in the commodity market is glaring proof that China's lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further towards asset speculation.

    The tough economy and easy credit conditions have encouraged many companies to try profiting from asset appreciation. They borrowed money and put it into the stock market. And since China's stock market has risen 70 per cent since last November, many businesses feel vindicated for focusing on the asset market.

    Borrowing money for asset market speculation is not restricted to private companies. State-owned enterprises (SOEs) appear to be lending money to private companies at high interest rates.

    As the economy weakened late last year, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money may have flowed into asset markets.

    Some may argue that China has SOEs to lead the economy. However, private companies account for most employment in China, even though SOEs account for a larger portion of gross domestic product. Now, the government is spending huge amounts of money to provide temporary employment for this year's college graduates. If private sector employment doesn't grow, the government may have to spend even more next year. The government is using fiscal stimulus and bank lending to support economic recovery. But the recovery may be a jobless one.

    We are seeing a dark side to the lending surge as commodity speculation hurts the economy. More lending may lead to higher commodity prices, threatening stagflation. Cheap loans benefit overseas commodity suppliers, not necessarily the Chinese economy.

    Putting money into speculative investments isn't totally irrational. It's better than expanding capacity which, without export customers, would surely lead to losses. But many boom forecasters wrongly assume that recent asset appreciation, fuelled by speculation, signals an end to the economic problems. That's an illusion. The lending surge may have created more problems than it resolved. —
  2. Goldman Sachs says China's GDP growth at 7.8% in Q2

    BEIJING, July 8 (Xinhua)-- China's gross domestic product (GDP) growth in the second quarter this year is forecast to accelerate close to 7.8 percent, Goldman Sachs Asia and the Beijing-based Gaohua Securities Company said in a report Wednesday.

    "The figure is above our previous forecast of 7.0 percent year on year," said Song Yu, one author of the report and Goldman Sachs Asia's economist on China's macro-economy.

    According to the report, economic performance of China in June will show robust improvements, with the industrial output expected to rise about 10 percent in June from 8.9 percent in May.

    Fixed asset investment in June is forecast to grow 42 percent year on year, up from 38.7 percent in May.

    Exports is expected to decline 22 percent in June from a year earlier, smaller from a 26.4 percent dip in May, while imports may post a eased drop at 18.0 percent from a 25.2 percent fall in May.

    The consumer price index is expected to fall 1.5 percent in June from a year ago, compared with a 1.4 percent drop in May. Producer price index would decline 7.6 percent year on year, compared with a slide of 7.2 percent in May.

    Zhou Xiaochun, governor of the country's central bank, said in late June that the second quarter is expected to be better than the first, when the gross domestic product grew 6.1 percent. The National Bureau of Statistics said in June that China's GDP will grow close to eight percent in the second quarter.

    China is due to release its second-quarter GDP data in mid-July.

    Goldman thought about it, too.
  3. Structure commodities like mortgages? Commodities for speculation? What do they do, buy iron and store it in your basement until you expect the price to be higher? Haha, dumbest trade yet. Did they ever hear of the futures markets! The whole chinese population should
    start trading futures, good for the world economy.
  4. And if they trade in all their worthless fiat money for real commodities and get the power to charge whatever they want for those commodities like OPEC?
  5. they dont want cash settled futures, they want the physical commodities to USE and have on hand now for storage. So yes as you put it buy iron to store in basement.

    What is a future contract exactly? a piece of paper promising to deliver the goods from some counterparty. It's fine for traders, but do you think a country will bet their future resource needs on papers and the promise that it will be delivered?

    But I guess you can say try to time the bottom as speculation... China thinks the price is low right now, so they are buying it now for use in the coming years. It's pretty simple, dont know why the "analyst" from malaysia make it so complicated.
  6. moo


    Excellent article, thank you. Andy Xie is always interesting. In fact, we should have an Andy thread here.