Stephen Roach on China and the Commodities Cyclical Bear Case

by: Stephen Roach

Excerpt from Morgan Stanley economist Stephen Roach's September 15th essay:

The cyclical bear case for commodities has three legs to its stool -- the Chinese producer, the US housing market, and the asset allocation call. The China factor is, by far, the most important element on the demand side of the commodity equation. Over the 2002-05 period, China’s share of the total growth in global consumption of industrial materials was off the charts: 48% for aluminum, 51% for copper, 110% for lead, 87% for nickel, 54% for steel, 86% for tin, 113% for zinc, and 30% for crude oil (see Chapter 5 of the IMF’s September 2006 World Economic Outlook as well as my 2 June dispatch, “A Commodity-Lite China”). China’s powerful growth dynamic is both rapid in the aggregate and skewed heavily toward exports and fixed investment -- a sectoral mix that favors commodity-intensive activities such as urbanization, infrastructure, industrialization, and residential construction. As long as this growth dynamic remains intact, China’s demand for commodities would appear to be insatiable. That is what is now changing.

The Chinese government has once again sounded the overheating alarm. And like the case in 2004, the authorities have taken action to slow this white-hot economy. Monetary policy has been tightened and a series of administrative edicts have been issued aimed at slowing down investment projects in a number of “hot” sectors -- namely, aluminum, cement, steel, coal, glass and other building materials, autos, and residential ;property. In an economy that is as fragmented as China, the quantity restraints imposed by the central planners are likely to have greater impact than the financing restraints imposed by the central bank. The August data flow just released out of China points to the first signs of the long-awaited cooling off -- meaningful deceleration in the growth rates of both industrial output (+15.7% y-o-y in August versus +18% in June and July) and fixed investment (+21.5% in August versus +30% in the first seven months of 2006). While one month’s data should never be taken all that seriously in any economy -- especially in China with its notorious data problems -- these signs could well be indicative of a legitimate turn to the downside. If that’s the case and Chinese industrial output growth decelerates further into, say, the 12-13% y-o-y zone, then it is almost a mathematical certainty that this slowdown would produce a major downturn in global commodity demand. That follows from China’s dominance in driving world commodity demand described above.

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