China's Perfect Storm Affects Copper

 |  Includes: FXI, JJC, PGJ
by: Erik Bethel

Due to the Global Economic Crisis as well as a relatively strong rise in the yuan last year, China saw a large drop in exports. This hurt the country’s export-focused business model and created a sharp rise in unemployment. In order to mitigate social unrest, Beijing responded quickly (and wisely) with a 4 trillion yuan (US$586 billion) stimulus package.

But it also did something else—it flooded the system with massive amounts of credit (i.e. money), using policy tools (like raising the bank lending quotas, lowering risk assessments, etc.), and “strongly encouraging” commercial banks to lend money. As a result, loan growth has been so high that China overshot the entire year’s lending quota of 5 trillion yuan (US$732 billion) in the first quarter of 2009. And loan growth is continuing. As of June, China’s bank loans had surged to more than 7 trillion yuan (around US$1 trillion).

The amount of bank credit that has been created in 2009 alone is equivalent to one-third of China’s GDP. And with the market awash in liquidity, we see bubbles forming in certain asset classes. The Shanghai stock market is up 85% this year, and real estate and commodity prices are rising sharply as well. It shouldn’t be a big surprise. When money supply in China shoots up 30% in June alone, we shouldn’t be shocked to encounter a whole lot of speculation.

There is no better example of this speculative activity than what is being seen in the copper market. A perfect storm of events is affecting this metal:

  1. China’s stimulus package is heavily focused on the power/utility sector and on putting up transmission lines (53% of China’s copper goes to the cable and wire industries).
  2. China historically has suffered from a copper deficiency (i.e. 2008 domestic production = 3.7 million tons while 2008 domestic consumption = 4.9 million tons).
  3. Rampant concern about a US dollar collapse creates a mentality that seeks to buy hard assets (like copper and other base metals) that will hold their value.
  4. Huge amounts of credit and liquidity in the system fueled by massive bank lending means that the money has to find a home.
  5. Fear that prices may go back up to last year’s pre-crisis nosebleed-level highs of around US$9,000 per ton has led Beijing to go on a stockpiling spree (i.e. buy now before prices go back up).

Bolstered by stockpiling, China’s imports in the first half of 2009 are up almost 70% from last year. And taking advantage of last year’s price drops, China’s State Reserve Bureau now holds roughly 235,000 metric tons of copper valued at US$1.3 billion—almost as much as the London Metal Exchange warehouses hold to back futures trading (Wall Street Journal). In addition to the SRB, traders, hedge funds and individuals are also buying and holding copper. Why? The response we’ve heard is that “prices will continue to go up” and that “copper is a better store of value than the dollar.” Imports of refined copper jumped 400% this year alone, much of which is used in manufacturing. But Deutsche Bank estimates that there is still roughly 1 million tons of copper sitting in Chinese warehouses “outside of the reporting system.”

So what’s next? Is copper rising or falling? If you ask Sumitomo, Japan’s 2nd largest copper smelter, they think that the 80% copper rally in 2009 is over as China will cut back its purchases (Bloomberg). Excessive imports and warehousing could lead to traders selling the metal, thereby reducing prices. In a panic, what would happen if 1 million tons of copper flooded the market? It could be a disaster. Copper bulls, on the other hand, point to a strong real estate and construction industry, power lines being strung up, and strong automotive sales. Analysts are “all over the map “on copper, and price forecasts range from US$3,000/ton to US$7,000.

A lack of clear information doesn’t help. According to the Wall Street Journal, China’s National Development and Reform Commission (NDRC) said stockpiling had ceased as of June. “But not everyone’s convinced. After all, with copper still well below last year’s peak of nearly $9,000 a metric ton, China might want to keep building its position.”