For the past two years, as regular readers know, I have been bearish on hard commodities. Prices may have dropped substantially from their peaks during this time, but I don’t think the bear market is over. I think we still have a very long way to go.
There are four reasons why I expect prices to drop a lot more. First, during the last decade commodity producers were caught by surprise by the surge in demand. Their belated response was to ramp up production dramatically, but since there is a long lead-time between intention and supply, for the next several years we will continue to experience rapid growth in supply. As an aside, in my many talks to different groups of investors and boards of directors it has been my impression that commodity producers have been the slowest at understanding the full implications of a Chinese rebalancing, and I would suggest that in many cases they still have not caught on.
Second, almost all the increase in demand in the past twenty years, which in practice occurred mostly in the past decade, can be explained as the consequence of the incredibly unbalanced growth process in China. But as even the most exuberant of China bulls now recognize, China’s economic growth is slowing and I expect it to decline a lot more in the next few years.
Third, and more importantly, as China’s economy rebalances towards a much more sustainable form of growth, this will automatically make Chinese growth much less commodity intensive. It doesn’t matter whether you agree or disagree with my expectations of further economic slowing. Even if China is miraculously able to regain growth rates of 10-11% annually, a rebalancing economy will demand much less in the way of hard commodities.
And fourth, surging Chinese hard commodity purchases in the past few years supplied not just growing domestic needs but also rapidly growing inventory. The result is that inventory levels in China are much too high to support what growth in demand there will be over the next few years, and I expect Chinese in some cases to be net sellers, not net buyers, of a number of commodities.
This combination of factors – rising supply, dropping demand, and lots of inventory to work off – all but guarantee that the prices of hard commodities will collapse. I expect that certain commodities, like copper, will drop by 50% or more in the next two to three years.
Not everyone agrees. In the July 17 blog entry I made a reference to a book by Dambisa Moyo, a former investment banker turned economic writer, called Winner Take All, in which the author argues that the world is facing a crisis in the form of a commodity shortage, and she expects prices to surge. Unlike her, however, I expect the price of hard commodities and certain industry-related soft commodities (like rubber) to drop sharply in the next three years, and to stay low for many years thereafter.
To address the first of the four reasons I expect hard commodity prices to drop, excess growth in supply, one month ago I spoke at a conference in Sydney, after which Gerard Minack, chief economist at Morgan Stanley Australia, gave a presentation on the world economy and, more specifically, on commodities. His presentation was an eye-opener for me.
Based on my many trips in recent years to places like Australia, Peru and Brazil, I had plenty of anecdotal reasons to believe that commodity producers had significantly overestimated the sustainability of the Chinese growth model (or, perhaps more accurately, had not really thought about whether or not it was sustainable). I was worried that they were expanding production very quickly. Everywhere I went I heard stories of large-scale investments to expand production.
Many producers have acknowledged recent price declines, but they seem to believe that these are likely to be short-lived and that prices will soon rebound when Chinese demand returns. For example the Financial Times’ Alphaville quotes Nev Power, chief executive of Fortescue Metals, discussing iron ore at a recent meeting:
Iron ore prices have slumped to $US104 a tonne in recent days, yet Mr Power said it could soon rebound as high as $US150. ”As soon as restocking and production returns to normal we expect to see prices back in the $US120 to $US150 per tonne range,” he said.
Production capacity has grown
He will almost certainly be wrong. But whereas my evidence for claiming continued high growth rates in production was conceptual and anecdotal, Minack has actually gone out and tried to measure the potential increase in supply. Minacks’ argument is that because of twenty years of stable or falling prices, until the early part of the last decade there had been a minimal amount of investment globally into commodity producing facilities. Commodities seemed to be in a permanent slump and no one was interested in expanding supply.
The surge in Chinese demand at the beginning of the last decade consequently caught everyone by surprise. Minack shows, for example, that in the past twenty years, global demand for steel grew by roughly 6% a year, with most of that coming in the past decade. If you exclude China, however, global demand for steel grew by only 2% a year in the past twenty years, implying that China accounted for almost all the increase in global demand in the last twenty years – and almost all of that occurred in the past decade. In the past ten years Chinese demand for iron ore has grown by 16% a year on average.
The initial surge in demand caught commodity producers off-guard. Because they were unable to ramp up production quickly enough, prices surged. After a few years of high prices, however, commodity producers responded to the huge new increase in demand by planning major expansions in production facilities.
Changing production requires years of exploration, investment, and upgrading, however, so the decision to increase production could only result in higher production many years later. This is shown by a set of cost curves, which are at the heart of Minack’s presentations, and these curves graph the short-term relationship between price and volume. For any given amount of demand, in other words, the graph showed the corresponding price.
The supply curves, of course, are positively sloped – the higher the price of copper, for example, the more copper will be produced and sold. The slopes of the curves, furthermore, are very sensitive to existing production capacity, and Minack lists curves for several points in time as production capacity changes. As one would expect, when demand for copper is less than production capacity the curves slope gently upwards, implying that small increases in copper prices correspond to very large increases in copper supply.
But this curve slopes gently upwards only up to a point, representing the limits of normal production capacity, after which the slope of the curve is almost vertical. Beyond this point – of maximum capacity – no matter how high the price of copper, in the short term supply cannot be substantially increased. Or to put it another way, beyond that point small increases in demand translate into large increases in price.
In 2001, according to Minack’s numbers, this transition point for copper was roughly 12 million tons, above which it would be extremely difficult for copper producers to supply demand except at extremely high prices. There was some improvement in capacity during this time but not much. By 2004 this same inflection point had increased only slightly, to roughly 13 million tons. This, as Minack pointed out, reinforces the argument that copper producers were not expecting any significant increase in demand and so had not prepared for it.
But by 2004-5 it was increasingly evident that demand was rising quickly. Copper producers responded, and thanks to increased investment in countries like Peru and Chile, among others, production capacity surged. By 2018 the inflection point is projected to be at roughly 21 million tons, suggesting that between 2004 and 2018 an enormous amount of additional copper production has become or is going to become available. In his July 17 “Down Under” note, Minack goes on to say:
What’s notable, in my view, is the forecast increase in supply versus the actual supply increases seen over the past decade. For copper, the increase in global supply in each of the next seven years will be roughly equal to the increase in supply over the decade to 2011. Consequently, it would require a material acceleration in demand to keep prices at current levels in the face of this supply increase.
The same story is more or less true for iron ore, although the expansion is supply has been more dramatic. In 2006, according to Minack’s numbers, the inflection point was at roughly 900 million tons, above which iron ore producers would have difficulty supplying demand. By 2011 it was at 1,300 million tons and by 2014 and 2020 it is expected to be1,900 million and 2,600 million tons respectively. In just over ten years, in other words, production capacity will have nearly tripled. This is a lot of iron that has to be absorbed by someone.
The supply considerations are exacerbated by the amount of stockpiling taking place in China. I won’t rehash all my arguments from earlier newsletters about stockpiling but it is enough, I think, simply to list some of the articles I found in my daily readings last week.
Stockpiling
The first article came on Tuesday from Bloomberg:
Cotton consumption in China, the world’s largest user, may shrink 11 percent this year as a deteriorating economy hurts demand and causes a buildup in commodities, according to Weiqiao Textile Co.
…Coal inventories at Qinhuangdao port rose to 9.33 million tons on June 17, the highest since 2008, data from the China Coal Transport and Distribution Association showed. Stockpiles were at 6.69 million tons as of Aug. 19. While steel-product stockpiles at the nation’s 26 major markets have dropped for five months as the end of July, they’re still 19 percent higher this year, according to the China Iron & Steel Association.
Commodity-related companies have flagged their concern. Noble Group Ltd. (NOBL), Asia’s biggest listed commodity supplier, expects a tough environment for the next 12 to 24 months, Chief Executive Officer Yusuf Alireza said yesterday. Vale SA (VALE5), the world’s largest iron-ore producer, said this month that China’s so-called golden years are gone as economic growth slows.
The article in Tuesday’s Financial Times talks about excess inventory of a wide variety of products and refers to an earlier article, from July, that claims that China’s coal inventory is up 50% from last year:
Memories of the London Olympics are already beginning to fade. Li Ning, a Chinese sportswear maker, had better hope that they last a while longer. Like thousands of Chinese companies from property developers to car manufacturers, Li Ning is sitting on a mountain of unsold products. Whether they can whittle down these bulging inventories is the single most important question facing corporate China and arguably the economy as a whole.
…The problems of Li Ning and the sportswear industry are just the tip of the iceberg in China. Across virtually all corporate sectors, inventories are excessive. The stock of unsold homes is the most worrying, because property plays such a dominant role in the economy. Vanke, the country’s biggest developer, estimates that it would take about 10 months to absorb all the unsold homes in China, which is reasonably quick. The snag is that this figure doesn’t count the millions of homes that have been sold but are sitting empty.
Then there is the auto sector. Car sales have been remarkably resilient despite the economic slowdown. But manufacturers have been more bullish than consumers. The inventory index (inventories divided by sales) was 1.98 at the end of June, according to industry data. More than 1.5 is seen as critically high.
The unsold mountains of electronics and white goods are also looking Himalayan in scale. Over the past week, the country’s main retailers descended into a price war. It began when online retailer 360buy.com vowed that it would sell home appliances at a zero profit margin.
The commodities sector is also dealing with a huge inventory overhang, most graphically in the piles of coal that have built up at ports across the country.
In an article one day later from the South China Morning Post, the concern is about copper:
At first glance, China’s copper demand is soaring. According to Ross Strachan, commodities analyst at independent research house Capital Economics, if you add domestic production of refined copper to China’s imports and changes to official stockpiles, then it appears that copper consumption leapt 22 per cent in the first seven months of 2012 compared with the same period last year.
But if you look at the volume of copper products actually turned out by China’s factories – pipes for air conditioners, windings for electrical transformers, foil for circuit boards and the like – then output was flat in July compared with a year earlier (see the second chart). Weak output makes sense. Together, manufacturing industries, home appliances and the construction sector accounted for half of China’s copper consumption last year.
With economic growth now slowing and property investment weak, demand is bound to be soft. Analysts at Credit Suisse expect China’s copper usage to grow by just 2 per cent this year and 1 per cent in 2013, in contrast to the 26 per cent growth seen at the height of China’s stimulus effort in 2009.
This gaping discrepancy between apparent demand and actual consumption implies there has been a massive build-up in unreported stocks of refined copper held in bonded warehouses and elsewhere.
Strachan at Capital economics believes these stockpiles have climbed by 900,000 tonnes since the middle of last year. Standard Chartered puts the total amount held in bonded warehouses at 600,000 tonnes, together with another 400,000 held elsewhere.
To put these figures into perspective, the LME’s worldwide network of warehouses reports copper stocks of just 231,000 tonnes. In other words, China is sitting on a huge overhang of refined copper.
This partly reflects state corporations’ efforts to build strategic reserves of the metal. But it is also the result of massive speculation in copper. The details of the trade are complex. But in a nutshell, companies buy copper on margin, then use the metal as collateral to obtain low-cost loans, using the proceeds to bet on higher-yielding assets.
Not just the raw stuff
And just one day later I saw this article in Bloomberg:
Rubber is poised to drop as sustained supplies from Southeast Asia and falling demand from China’s tiremakers push stockpiles to match their record at Qingdao port, the main shipment hub, an industry executive said. Futures fell for the first time in four days.
Inventories in the bonded zone, where traders store deliveries before paying duties, will probably climb to 250,000 metric tons by end-August from 240,000 tons last week, Li Xiangou, chairman at the Qingdao International Rubber Exchange Market, said in an Aug. 17 interview. China accounts for 33 percent of global demand and tires represent 70 percent of natural-rubber consumption in the country. Reserves last reached 250,000 tons in mid-January, he said.
The article goes on to quote one Chinese rubber trader as saying “Many Chinese tire makers are mired in high inventories of end-products right now.”
I can easily cite many more articles, but as this short roundup suggests, finding articles about huge stockpiles in China is a pretty easy game to play. This shouldn’t come as a surprise and indeed I have been discussing this for the past three or four years. When financing costs are low or even negative in any economy, there is a tendency to accumulate inventory since it is not only easy to finance but, thanks to low or negative financing costs, it can also be extremely profitable. If prices just keep up with inflation, inventory earns a profit, and the greater the pile, the greater the profit.
In addition in the past decade as China’s trade relationship with the rest of the world has expanded and as China’s economy has grown, most Chinese businesses have only experienced rising prices – both for commodities and many kinds of goods. As a result firms that tended to hold high inventory have outperformed firms that haven’t.
This has created a selection process that favors accumulation. Companies that prefer to hold more, rather than less, inventory of commodities and goods in which commodities are a high cost component have outperformed their rivals, and so the whole market has moved towards a preference for stockpiling, much in the same way that, according to Hyman Minsky, periods of stable or rising asset prices force the financial system into taking on excessive risk. Since overstocking has always been a winning strategy until very recently, it is a pretty safe bet to assume that Chinese traders, speculators, end-users and investors have a built-in prejudice towards being long or longer inventory.
The overstocking problem in part has also had to do with financing constraints. In late 2010 and early 2011 in this newsletter I wrote often about commodity inventory financing as a popular tactic among Chinese businesses and banks aimed at getting around regulatory constraints on lending.
By importing commodities that were funded through trade financing and then using inventory receipts to borrow domestically, banks and borrowers could get around lending restrictions. We have never been able to figure out exactly how much of this was going on, but there was plenty of anecdotal evidence to suggest that this was a pretty wide-spread scheme and it involved a variety of commodities – copper, most famously, but also soy, magnesium, cotton, rubber and several others.
Finally, I should add that in China there is, more than in any other country I know, a sense that physical ownership of commodities or of commodity producing facilities creates substantial intangible benefits. This may be a legacy of Maoist perceptions of self-sufficiency, or it may have to do with a history of unstable political and monetary arrangements, but whatever the reason Chinese are often obsessed with the need for physical control of commodities.
The result has been a tendency to hold much larger commodity inventories than can be justified by business needs and risk management concerns. By the way when economists try to calculate the amount of unsold inventory of commodities they typically focus on the raw commodity, but it is important to remember that inventories of finished goods are also forms of raw inventory.
An empty apartment, for example, contains lots of copper wiring, and although it is extremely unlikely that the copper will ever be melted down and sold, it nonetheless has the same price effect as unsold copper inventory. Why? Because an empty apartment today is one less apartment that will be built tomorrow to fill real demand, and so it represents a reduction in the future amount of copper that will be purchased to make copper wire. The same is true of other finished goods.
What about demand?
China currently is the leading consumer of a wide variety of commodities wholly disproportionate to its share of global GDP. The country represents roughly 11% of global GDP if you accept the stated numbers, and substantially less if you believe, as I do, that growth has been overstated because of the difference over many years between reported investment, i.e. its input value, and the actual economic value of output. China nonetheless accounts for between 30% and 40% of total global demand for commodities like copper and nearly 60% of total global demand for commodities like cement and iron ore.
The only reason China has provided such an extraordinarily disproportionate share of global demand for hard commodities has been the nature of China’s growth model. While China may represent only 11% or less of the global economy, it represents a far, far greater share of the world’s building of bridges, railroad lines, subway systems, skyscrapers, port facilities, dams, shipbuilding facilities, highways, and so on.
Over the next decade, two things are going to change. The first is increasingly recognized, and that is that Chinese growth rates will drop sharply. The second is that China will rebalance its economic growth away from its appetite for commodities.
The consensus on expected economic growth among Chinese and foreign economist living in China has already declined sharply in the past few years. From 8-10% just two years ago, the consensus for average growth rates in China over the next decade has dropped to 5-7%. But the historical precedents suggest we should be wary even of these lower estimates. Throughout the last 100 years countries that have enjoyed investment-driven growth miracles have always had much more difficult adjustments than even the greatest skeptics had predicted.
After all, there were many Brazilians in the late 1970s who worried that Brazil’s growth miracle was unsustainable and would end badly, but none expected negative growth for a decade, which is what happened during the terrible Lost Decade of the 1980s. Towards the end of the 1980s, to take another example, a few brave skeptics proclaimed that the Japanese miracle was dead and predicted that for the next five or ten years average Japanese growth rates would slow to 3 or 4% (in 1994 the IMF belatedly proclaimed that Japan’s long-term growth rate had dropped to 4%), but no one, even the most skeptical, predicted twenty years of growth below 1 percent. Finally when the USSR’s economy was hurtling forward in the 1950s and 1960s, and expected to overtake the US within a few decades, even the most die-hard anti-communists did not expect the virtual collapse of the economy in the 1970s and 1980s.
Similarly, the current consensus for Chinese growth over the next decade is almost certainly too high. Even if Beijing is able to keep household income growing at the same pace it has grown during the past decade, when Chinese and global conditions were as good as they ever could be, it will prove almost impossible for the economy to rebalance at average GDP growth rates over the next decade of much above 3 percent.
This 3% average will not be distributed evenly, of course, and we should expect higher growth rates at the beginning of the period (perhaps 5-6 percent over the next two years) and lower growth rates towards the end. But as this happens, over the next two years the consensus on China’s long-term growth rate will continue to drop sharply, and this will further affect commodity prices.
But even this underestimates the change in demand for commodities. For thirty years, and especially for the past ten years, China’s extraordinary GDP growth was driven by even higher rates of investment growth – generating for China the highest investment rates and investment growth rates in history. Consumption growth failed to keep pace during this time.
But rebalancing means, by definition, that for the next few years consumption growth must outpace GDP growth, and so also by definition investment growth must be less than GDP growth. Even if China is able to achieve 5-7% growth rates over the next decade, which I think is almost impossible, this implies that consumption growth will rise to 7-10% annually, and so from 25% growth in the last few years Beijing will be able to allow investment to grow no more than 2-4% annually, and much less if GDP growth rates are as low as I expect.
Which way can prices go?
For these reasons I am very pessimistic about hard commodity prices and expect them to drop substantially further in the next two to three years.
- Production capacity for hard commodities is rising much too quickly, in a belated response to the unexpected surge in demand just under a decade ago.
- Expected economic growth rates in the country that has been biggest source of new demand – virtually the only source – have fallen sharply and commodity prices have fallen with them. Historical precedents and the arithmetic of rebalancing suggest, however, that the current consensus for medium-term Chinese growth is still too optimistic. Expected growth rates will almost certainly fall further in the next two years.
- Beijing has finally become serious about rebalancing China’s economy, and rebalancing means shifting Chinese growth away from being disproportionately commodity intensive. Instead of representing 30-60% of global demand for most hard commodities, Chinese demand will shift to a more “normal” level. Remember that even a very limited shift – from 50% of global demand, for example, to a still high 40% of global demand – represents a sharp drop in global demand.
- There has been so much stockpiling of commodities and finished goods with implicit commodity content in China that the country could well become a net seller, and not net a buyer, of a wide variety of commodities in the next few years.
This is going to come as a shock to many people. In my discussions with senior officials in the commodity sectors in Brazil, Australia, Peru, Chile and even Indonesia, it seems to me that many analysts have been insufficiently skeptical about the Chinese growth model and are unaware of how dramatically the consensus has changed in the past two years. They have failed to understand how deep China’s structural problems are and how worried Beijing has become (this worry may be best exemplified by the extraordinary growth in flight capital from China since early 2010).
Under these conditions I don’t see how we can avoid a very nasty two or three years ahead for commodity producers. This isn’t all bad news, of course. What will be a disaster for hard commodity producers will be great news for companies and countries that are commodity users or importers. One way or the other, however, we are going see a big change in the distribution of winners and losers.
This is an abbreviated version of the newsletter that went out three weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
Time and again, you come up with an article that it pretty hitting. How coupled are some of the global economies with China? As a percentage of their individual GDP? Would it be possible to have a list of the countries that are most dependent on China for exports, and for which commodity?
How much of this supply & demand-driven price drop will be offset by Bernanke’s money-printing? Is it possible that the supply of new dollars will put a “nominal” floor under commodity prices?
Good Article. A 200 year inflation adjusted chart of commodities tells the big picture of this analysis. Many runs up, but mostly down. It’s just to easy to get that stuff out of the ground.
“A 200 year inflation adjusted chart of commodities tells the big picture of this analysis.” sounds interesting do you have a url for this chart?
It was in The Economist years ago. I’m sorry not to have saved it. It was jagged, with many run ups in pricing over the past 200 years. I’m sure each run up represented a highly rationalized “new paradigm”. But in the end, supply over powered demand, and the price went lower than where is was in the past.
The Economist graph is here:
http://bigpicture.typepad.com/comments/2005/02/the_economists_.html
that’s the point, commodities prices have been declining for 200 years, why should it last forever? that’s why many are betting that the year 2000 was the end of the 200 years long commodities bear market.
200 years is not a bear market, it is a structural reality (due to the advance of technology)… bull and bear markets involve sentiment shifts within largely the same group of investors. That being said, the structural reality of the tendency towards deflation (again due to the advance of technology, and synonymous with the 200 year decline in commodity prices) is likely what has changed. Recent decades have seen almost all currency become unbacked, and the game of governments has been to under-report inflation. Continued rising of nominal commodity prices will likely be due to under-reported inflation… i.e. the real price may or may not keep up with inflation.
That’s an interesting chart (obviously depicted in real terms), showing the effect in the progress in technology to get commodities farmed or out of the ground. What’s also interesting is that all the upward phases correspond with Fed inflationary actions, except for the Civil War period, when there was no Fed – but there was printing of ‘greenbacks’ to finance the war – greenbacks which did end up at about zero value, the second time the US currency went to zero. We’re on the third one now, and it’s lost 98% of its value!
If the chart were taken to 2012, we’d see another big zoom.
Commodities bull market will kill the entire economy.. the middle class and the poor are the ones severely hit
I’d prefer a commodity bear market.
I don’t believe Chinese numbers. I believe the Chinese are faking the numbers. China is dependent on foreign economies to buy it’s products and invest in China to drive it’s economy. Chinese statistics from the recession don’t match the reality of it’s role. I think foreigners are very naive to believe East Asian numbers. The culture of “face” is everpresent. It’s something foreigners need to know before dealing with East Asians because East Asian psychology is different. I think creating cooked up numbers can go on as long as the people are ok with it or ignore it and foreigners continue to buy. I don’t see a collapse or realignment of the Chinese economy anytime soon.
It would be interesting to debate this view against Jeremy Grantham’s commodity analysis during the past year or so. His analysis shows that we’ve reached an inflection point in the long-term history of commodity prices with extraction costs rising sharply.
Extraction costs certainly rise sharply as alongside prices. Miners will mine lower grade ores, they will go to more remote areas and dig deeper, workers demand higher wages, and the entire supply chain is stretched. Inflation in the mining industry has been averaging 15-25% p.a. in recent years.
However all of this is reversible if supply starts to outpace demand and prices fall. There is no longer any need to mine lower grade ores, or sink large amounts into new exploration and development. Eventually with profits and jobs under threat even worker’s demands will become less strident.
Much as I admire Jeremy Grantham I believe he is wrong about this. Commodity needs will not continue to grow exponentially. Oil consumption is exactly where it was 6 years ago, while its price has doubled, mostly on speculation that Chinese and developing world demand would boom. It hasn’t.
In addition to the supply vs demand and costs of extraction and labor, is the varying value (recently inflation) of the fiat currency for which price is equated to said commodities. I think price jumps of recent in commodity prices have more to do with Quantitative easing in the US and by other counties (often within weeks of each other as they have recently, Euro, then US then Japan 9-19-2012). I see commodities tracking similar to gold in that when there is rapid inflation, their price rises as their value hasn’t changed, with the price differences being pass on to the end user or consumer of the products which contain the commodities.
I think a graph which lumps all commodities together and tracks them for 200 years is downright silly. I’m surprised that the economist would print such a graph. Aluminum wasn’t even discovered 200 years ago with the graph starts tracking. My point being, that during 200 years, the number of commodities has grown significantly. Sure, adjusting for inflation is mandatory for drawing a graph that has meaning, but so is defining what is being tracked and what is being tracked shouldn’t radically change over large parts of the graph much less over very small fractions of the timeline as presented in this graph.
If you want to make very general observations on a whole lump of commodities which are changing over time, I suppose this graph and method may be useful, but I think anyone making blanket statements from this type of data and drawing conclusions that suggest how you should invest your money is down right silly.
Also, the suggestion that the graph will always go lower because it has for 200 years is also silly. Although this may be true for all commodities lumped together, there are still concepts like Peak Oil and such which can’t be ignored. At some point, all has been mined. We should graph world population or world middle class population for the last 200 years along side of the commodity graph to maybe gain more understanding.
Economics is complex, I don’t think I’ll get arguments for say this, and with globalization, and the crazy politics of late coming from developed countries and highly populated developing countries, things are only getting more complex (i would argue by orders of magnitude) when it comes to understanding how the gears of global economics play in concert…
I have been thinking about how all of this translates to the global economy and growth. Mark Spiegel raises a good question. Could U.S. (and European) monetary expansion provide support for commodity prices? I think its possible once the recovery is more firmly entrenched in the U.S. and has spread to Europe this could very well be possible. Of course, this will still represent a price reduction in “real” or cheap Dollars and Euros for the industrial economies. My fear has always been chronic deflation in the U.S. However, a “real” reduction in hard commodity prices will benefit industrial economies as less money will be exported to pay for imported commodities. The losers are obviously countries with economies with large reliance on natural resources like Australia, Brazil and Canada. As an optimist, I believe global growth will eventually (maybe in 2 or 3 years) enter a period of more balance and sustainability. With commodities more available and slackness in the labor market, inflation will not be a problem for many years. You can throw Gold and Oil out of Mr. Pettis’ thesis. Gold is a stored value play on global uncertainty with little industrial value and Oil has much geo-political risk built into its price.
“You can throw Gold and Oil out of Mr. Pettis’ thesis. Gold is a stored value play on global uncertainty with little industrial value and Oil has much geo-political risk built into its price”
But do the facts support this?
If you compare the rising price of Gold from its late-nineties bottom, it seems to track the rising prices of most of the commodities that Michael mentions, even as those commondities seem to track China’s increasing GDP growth rates (7%, 8%, 9%….12%, 14%) during the last decade.
So if China rebalances by going the othey way with falling GDP growth rates (12%, 10%, 9%..6%,5%) over the next decade, won’t gold track all the other commodities on the way down?
In other words: Could the rising of commodities prices from 2000-2010 have signalled a sense of alarm over the loss of currency value and triggered the gold bull run? Would this not then reverse if commodities began to fall vis-a-vis the US Dollar?
Same for oil. Oil & Gold were both at rock bottom in the late nineties and began to rise with most of the commodities that Michael mentions, even as those commondities seem to track China’s increasing GDP growth rates during the last decade.
Surely, miners, transporters all over the world etcetera would have demanded a lot of oil to fuel China’s boom. China’s energy imports rose dramatically during the investment-boom, so what if China reverses that situation? Would there be an oil glut? Would the Russians & Canadians (expensive to produce than Saudi oil) close their oil pumping operations? What would happen then to oil spot prices?
In summary, is the argument against GOLD & OIL following commondities on the way down really all that sound?
Michael? Anyone?
Vinezi Karim,
Fantastic insight!
I know Mr Pettis has already replied to this, but it is an interesting topic.
In my studies of commodity economics (hard not soft) I came away with the “overall” concept that commodity prices are broadly dependant on three characteristics:
- the supply side curve;
- the demand side curve; and
- speculation.
I guess this is pretty obvious, but if you get in to the detail, you learn that each commodity has its own individual supply side and demand side curves, due to the nature of its use and the nature of its geological occurrence (as well as recycling and extraction technology). It is also important to understand that the “duration” of the resulting price curve (ie commodity cycles) is fairly long, ranging from around 6-8 years to the super cycles of the 20 year duration – due mainly to the supply side response time. Commodity price movements and predictions with shorter timeframes than this are probably closer in style (and accuracy?) to predicting share market movements than actual price modeling (and given the duration of real commodity investments are of a similar timeframe this is what should matter most to real commodity investors. Everything else being trading aka speculation).
These individual supply and demand curves can change shape and gradient over time due to structural changes in both utilisation and in supply technology as well as the nature of each cycle. But generally speaking commodity prices revert to the mean, which results in a gently grading real price decrease towards the lowest marginal production costs (commodities by their nature are unable to sustain a price premium for the long term). Of course this is interrupted by imbalances in supply and demand (reinforced by the fact that supply responses have a reasonably significant lag due to the inherent nature of supply and supply investment), which Mr Pettis and many other people have pointed out over the past few years was the obvious cause of the recent dramatic commodities price spike. But these patterns are fairly well established and well known, and anyone with sufficient interest would be able to research this and understand the concepts to see where we are in the cycle in at the moment and where we are heading. With the important caveat of course that this type of analysis won’t necessarily tell you the timing nor the magnitudes of the peaks and troughs, but it will give you a model showing shape and direction which is of some use.
Speculation is speculation of course and the influence of speculation on prices changes over time dependent on economic cycles plus of course the investment mood and the dramatics of bubbles and crashes. This simply adds to volatility causing “overshooting” and “undershooting” what the systemic prices would probably be without speculation (and if prolonged can contribute to over- and under-investing which can impact the actual commodity cycle). Some commodities also have extreme short term volatility due to geopolitical constraints (eg cobalt was notorious for outrageous volatility during periods of unrest in the Congo, and nickel prices would respond dramatically to miner’s strikes in Canada when they dominated supply – but both of those situations are different now as the nature of supply has shifted in time and location). Professional speculators generally know of these constraints and add significantly to price swings when relevant events occur. I remember vaguely seeing a chart somewhere with a measure of trading levels in commodities which was separate from actual physical traders, ie it indicated the level of speculation and you could see changes over time. Can’t recall the details. Maybe someone can point out something. It is worth seeing just to get a grasp of the level of speculation which can be supporting prices (and therefore how dramatically and quickly they can fall when the speculators exit).
Stockpiling is an aspect of pricing, but many many times in the history of mankind people (and countries) have failed dramatically and miserably to control pricing through stockpiling. So there can be some periods in the cycle where stockpiling is influencing pricing (eg China and copper at the moment), but it is never really controlling it, and certainly not for the medium term. Take your pick from the many disastrous case studies of attempts use stockpiling to manipulate prices (copper is always a good one).
What is interesting is that most commodity price analysis is undertaken against the US dollar. In fact, probably all of it (I saw some graphing of commodity prices against SDR and even against each other eg oil vs gold, but it starts getting seriously confusing to really figure out what you are seeing). So this brings another element into the pricing model … what influence does the USD movement have on commodities prices. Basic inflation effects can (and should be) removed easily. But what of structural changes in the value of the USD? This is something I can’t answer, and it would be fascinating to look at this kind of analysis. ** If anyone knows of one, please share.
Certainly there is some influence in *this* cycle on the value of the USD on commodities … ?? We only need to look at price behaviour in 2008. Despite how some people say that we are enjoying a “second” boom in commodities (the first being from 2004-2008, the second from 2009 to current), it is not two separate “booms” but just one continuous cycle. The demand increase (surge from China) was continuous and the supply response was obviously continuing. It seems we had an unusual financial event (the rush to USD) which saw speculation in commodities completely withdraw and rush to USD cash (a dramatic reinforcing effect of decrease in commodity price and increase in USD value). Of course there was also some significant concern over global growth, but china saved us all by rolling out the mother of all stimulus focused entirely on *HAARD STUFF* [yeah! thanks for the cash! nice V8 I've got myself and my mrs now said random vox populi of WA] and so the commodities demand continued with its matching slow supply response.
So this was an unusual opportunity to consider the influence of USD value and speculation on commodity prices during a period of high demand for commodities. Of course it was an extreme event, so an extreme reaction. Interesting nonetheless. But even still, I can’t tell whether it is a change in the real value of the USD or a shift in popularity from investment away from the USD into commodities (which was dramatically reversed in 2008 and then switched back on again the following year). I understand very little about currency pricing and currency values. In fact nothing really. The only thing I know is that there is a lot of *stuff* happening with currencies at the moment. And that speculation in currencies is even greater than that in commodities (and all other trade able products combined I suspect). The AUD has always tracked commodity prices, but since 2011 clearly broke away, with general consensus being that it is related to the global shift in currency investment (and therefore speculation) and continued devaluation of the USD. This USD devaluation might see commodity price increases, but as Mr Pettis points out so well and so consistently, the demand surge is nearing its (un)natural end. With negative reinforcements of course from the delayed excessive supply response. So regardless of the influence of USD value and speculation on commodity prices, the demand and supply curves will determine the price movements. I agree with Mr Pettis, it is difficult to predict the pattern of price movements in the next 12-24 months, but there is a lot of confident reasoning in expecting the prices in real terms to be significantly below current levels.
—–
Now. Our two special cases: gold and oil.
As I mentioned at the beginning, each commodity has its own supply and demand curves, and its cycle will be slightly different as well. And so of course speculation and stockpiling is matched to each commodity for the same reason. This is particularly true of Oil and Gold, which are just that extra bit special, as Mr Pettis and others have already stated.
Oil is not just about oil, it is about energy. Energy runs our world. And for all intents and purposes it cannot be recycled. Oil (and other forms of energy) have very significant political constraints on supply (and politics often means volatility). Energy utilisation is strongly influenced by the effect of substitution, both in the shorter term and very significantly in the longer term. Structural changes of utilisation and substitution in history and in the future have and will continue to have dramatic impacts on energy pricing. Strategic stockpiling of oil and gas has and continues to be undertaken around the world to try and manage short term price spikes (and therefore minimise negative impacts on economics and social unrest). I understand it is also a favourite commodity for the speculators. I know nothing about oil. Except that it is different, and it matters.
Gold is curious for probably all the opposite reasons to oil. It has no significant industrial utility. It’s pretty and moldable. Not much good for anything really. Practically speaking it is perfectly recyclable and most of the gold produced in the whole of history is still in circulation (est 85%). Supply of gold is completely dominated by stockpiling and it is highly liquid (monetarily speaking of course). Annual production of gold adds approximately 2% to existing gold storage (in banks and jewellery). So if you analyse it as an industrial commodity which is not consumed and consider stockpiled volumes your price would be pretty close to nothing, okay not nothing but similar to something like Jade maybe. Not as much as diamonds and slightly more than shells. But of course it has been used for significant periods of history as a store of wealth (as Mr Pettis says, it is Fiat). The “general feeling” of the value of wealth it represents has changed and will continue to change over time. As an investment you do not earn interest from holdings, but you must pay to store it. Crazy hey. Speculation in gold ranges dramatically between “lots” and “nothing”. Price modeling of gold might involve complex schizophrenic modeling of low utility shell-like demand and supply with wildly fluctuating emotional estimations of fiat value. At the moment it seems to be considered a good form of wealth storage, which may be considered logical as the value of other fiat currencies are coming under question. I know nothing about currencies, and very little about gold. Except that there is some crazy stuff going on at the moment with regards to all fiat, and it matters.
Lots of people have lots of things to say about oil and gold. It can be interesting but it’s pretty complicated. Yes there are aspects of pricing which are related to other commodity pricing models techniques (particular in relation to supply), but they really are very different commodities. It may be hard to separate the inherent emotive attributes of these commodities from the more technical aspects of their use, which in a way hints a little about pricing movements. Dramatic changes in the energy pricing and in the value of stored wealth have been known to cause civil unrest and a few international wars over the years. They have also contributed to industrial revolutions, significant technological advances, increases in living standards and spouts of globalisation. Not so many people have stuff to say about other hard commodities, but there are professionals who can tell you a lot about them with reasonable confidence and it’s not really very complicated. I think a few economies have been temporarily devastated by poor management of industrial commodities, but not sure of any prolonged and epic civil unrest and wars started over copper or zinc, and despite what some people wish we aren’t really having a lithium revolution.
—
If you really do want to understand better the price movements of commodities, you need to understand each individual commodity. Then analyse *separately for each commodity* the drivers (supply, demand, speculation), have a rough idea of what stockpiling is happening, and understand the current cycle. And then you need to go find some mystery person who knows what is happening with fiat (currencies). When you find them, please tell me where they live.
The pricing of Oil and Gold and recent relationships between them and currencies are on a whole different level of complexity which I can only attempt to make bad jokes about.
Mr Pettis my apologies for tarnishing your excellent website with my crude and trite commentary on hard commodities economics. But I have read a lot of rubbishy and hysterical comments in recent years and some intelligent people here seemed like they were interested, so I took the liberty of having a turn …
[lmoconnor]
The price of gold is aligned nearly perfectly with the Fed’s balance sheet. That will grow, and gold right along with it.
This drop in iron ore, and the rate at which it has dropped, which has clearly taken everyone inside and outside of the industry by surprise is worrying. Are we looking at a symptom of a deeper sickness within China? Is this the canary in the mine, and has it just dropped off it’s Perch?
I wonder whether there is something more to this. Growth has slipped back in China a bit, but not to this extent. Up until now, we are sent the picture that China is slowing because they want to slow.
Mr. Pettis.
How does US FED policy play in your forecast?
Thanks
Hmm … sell iron futures and buy wool, sounds like a safe play to me.
Reuters had an interesting story on the the use of steel inventory as collateral for loans…
“Banks, too, are giving less credit against warehouse receipts.
“Fake warehouse receipts have become a problem for some banks and because of this, many banks have boosted monitoring of existing stocks at warehouses and temporarily stopped accepting steel stocks as collateral for loans,” said a Shanghai-based branch manager from a Chinese bank who declined to be identified as he was not authorized to speak to the media.
Steel mills and end users rely heavily on trading firms to keep steel flowing from producers to consumers. Steel traders often buy consignments with full payment, ensuring cash flow to the mills. End users can buy small volumes from the traders, more convenient for them than the big volumes the mills sell.
Industry sources estimated cases that have already come to light account for about 5 billion yuan ($787.50 million) of bad debt in Shanghai, one of China’s biggest steel trading centers.
———
This is not going to end well.
The Great Leap Forward, redux.
Great article, though one question: I agree that as China further moves further towards upper-middle income status, it will rebalance towards consumption and the commodity intensity, and level of, investment will drop. Will demand not be bolstered by other large importers entering the stage of development china is now leaving (India, ssa)?
Here is the S&P report which says very much the same thing Michael is saying, except that it focuses on the effect of China’s rebalancing on the economies of sub-Saharan Africa.(your “SSA” term)
Unfortunately, a lot of the recent boom in some SSA economies were based on higher international commodity prices for their exports (i.e. better terms of trade).
Besides SSA, Australia & South America, being major commodity exporters, will also probably be negatively impacted by China’s rebalancing.
So who are the winners, if any? Can anyone tell me who will gain (i.e. better terms of trade) by China’s rebalancing?
Ooops!
Sorry, here is the PDF File for S&P report that I mentioned:
http://static.ow.ly/docs/For%20Sub-Saharan%20Africa%20China's%20Rebalancing%20Poses%20Risks%20and%20Opportunities_KBU.pdf
The winner will be China. Lower commodity price will benefit mainly China. Economic surplus of Chinese economy will growth not because export growth but because import commodity prices will be lower. In spite Mr. Pettis prediction, China will be the winner one way or another and the winner takes it all!
Vinezi Karim,
Consumers will benefit from lower commodity prices, and countries, where consumption makes higher percentage of the economy, will benefit more (read: the USA).
To add to the context, the USA is on the fast track for energy independence. They will have population growth through immigration to support economic growth.
Of course, with a better economic situation of the USA everyone else will gain eventually as well as its a high consumption country (read: imports). In addition, China itself will gain from the re-balancing, assuming they will be able to do so.
What are your own thoughts?
As Mr. Pettis put in the article, the largest consumer of commodity is China, not USA so China will be most benefitted by prices reduction. This year China is importing more commodities than last year in ton but less in terms of dollars. Besides energy, American economy as a whole was not very much affected by commodity prices as they produce a lot internally. Europe and Japan were the most affected regions.
USA is on the fast track for energy independence.
Vinezi, are you kidding us?
India has a very different economy to China. It is far less investment driven, less export dependent and with a better consumption balance. Undoubtedly they will need infrastructure but are very unlikely to develop it at the incredible pace that China has. Remember it is the rapid growth in demand that has been driving prices. it is safe to assume there will always be some level of demand and very likely that will be higher than a decade ago. However will it ever be as high as stimulus driven 2009, plus the incremental supply growth since then? Very unlikely in my opinion, which means there will be oversupply over the long term, and eventually lower prices.
Do you think a drop off on Chinese demand for commodities might partly be offset by a surge in infrastructure building in India and Africa?
In india there hasn’t been and will never be a massive hyperaccelerated infrastructure buildout. Different political system and growth model (and culture).
Africa appears to be a derivative of China.
Good article, Michael.
Just as a clarification, are you also projecting a decline in the price of OIL?
Does this include oil? First text search hit was Phil’s comment.
A few typos corrected…
Michael, you are playing the well-known trick of putting up paper tigers and destroying them!
I disagree on the following:
1) Chinese demand will GROW more slowly and not fall, as you appear to suggest – all mining companies agree on this. Most miners assume growth in metals/steel will fall from 15-20% a year last decade to less than 5% a year this decade in line with all the stuff you are talking about (rebalancing, etc). At the end of the day China is still “underdeveloped” with very low incomes per capita and low urbanisation – there is more growth to come. China is NOT out of line with per capita measures of metals intensity relative to its stage of growth…it is simply bigger than any other country that has gone though this pahse of growth. One of the reasons China is such a large share of global demand relative to GDP is that it is going through an industrialisation/construction phase than many other developed countries went through at equivalent stages in their development – remember US steel demand per capita is now half the level it was in the 1950s and 1960s and China still hasn’t reached 1950s levels of US urbanisation or wealth.
2) Mine supply is rising over time but a lot of the supply growth is:
a) replacing declining supply at existing operations where resources are depleting rapidly
b) replacing really high cost domestic Chinese supply (China is responsible for a lot of the supply growth in recent years from inefficient, high-cost supply sources, which are depleting ir will close over time – Chinese iron ore production is 350mtpa (63% fe basis) and I think 200mtpa of this will close in the coming years)
c) being delayed or cancelled (there are more announcements than reality – I still see a shortage of copper projects in particular – despite massive investment and high prices, Chilean copper mine production is LOWER than it was in 2007!)
3) the stuff on rising stocks in China reflects mainly anecdotal evidence for a recent rise in stocks as demand weakened in China – in copper, for example, stocks are already below normal again following a few months of lower imports. The stuff about copper stocks in this report is WRONG! In general, stocks have risen but not alarmingly and only for cyclical reasons (China’s business cycle turned down at end-2012/early-2013 as the Chinese prudently tightened monetary and fiscal policy to fight inflation – it is now (prudently) easing both.
4) Of course commodity prices over time should fall as markets rebalance but most of the collapse has already taken place in the wake of the global financial crisis and the withdrawal of the Chinese 2009 fiscal stimulus. I don’t envisage a “collapse” by 2015, especially in copper – in fact copper should be near current levels in my opinion. With rising costs in China, there is in fact a case to made for prices at the margin to rise in some commodities (e.g., aluminium, nickel and themal coal). For iron ore, prices have fallen well below cost support and should rise over the next few years but as the need for high-cost Chinese supply recedes will eventually fall permanently below $100/t but not before 2015.
Are you serious or are you just long copper and talking your book? Almost everything you say makes no sense.
Haha, TR
That is exactly what I thought.
Piggly, I don’t have the sources in front of me just now but there are a lot of places you can easily find that kind of information. I don’t think however that it matters too much whether a country exports a particular commodity to China or not. Reduced Chinese demand will affect the price of the commodity whether or not the seller sells to China or someone else. Transportation costs matter, of course, but more generally all copper, for example, will trade within a range of the general price for copper, and if copper prices drop sharply all new sales of copper will be at lower prices no matter the destination.
Mark Speigel (and Phil and RS), I would want to make a strong distinction between real and nominal prices. Explosive money growth may boost nominal prices, but it is supply and demand that will determine the real price.
Jim Lennon, if you think predicting a 50% decline in hard commodity prices consists of no more than knocking down paper tigers, I suspect you are more interested in being thought clever than in being thoughtful. As for your four points, three of them are largely assertions and so I can’t argue with them except to suggest that you should learn to distinguish between production and capacity.
By the way I have explained many times why the once-widely-made claim that in China per capita measures of metals intensity are not out of line with developed countries is irrelevant, and I am glad to say that this particular argument among China bulls seems to have died away.
Finally your point number 3 is simply wrong, but wrong in a way that can easily be corrected simply by reading a few research reports or newspaper articles on the subject. Certainly the PBoC and the CRC are acting very worried about the quantity of bank loans collateralized by steel, copper and other liqudid commodities, but perhaps they too only do paper tigers.
Vinezi Karim, and others who have asked about prices on other commodities, I am not sure my analysis is as relevant. I exclude gold because it is really a monetary asset – a sort of fiat currency, ironically enough. What drives gold prices include, most importantly, general monetary expectations and central bank behavior, so it really doesn’t fit into my analysis.
As for energy, I would bet overall that oil prices too will decline, but since politics plays such an important role in the energy sector my analysis there is much more muddied. Decisions in the US about expanding energy production, or new problems in the Middle East, will have important impacts on energy prices. Finally, although you didn’t ask, I think agricultural commodities may actually stay strong because if China doesn’t mismanage the adjustment process household income should continue rising in China at a strong pace, perhaps anywhere from 4% to 6% annually, and rising household income helps drive demand for food.
Cjared and Patfla, thanks for the 200 year info. Among other things the 200-year numbers seem to undermine the fairly common argument that rising populations must result in rising commodity prices.
Bena Gyerek, I am not sure India and Africa are big enough to make up for declining Chinese investment, but the US might be. If there were a major infrastructure boom in the US that would be very positive for commodity prices, but I suspect that given arguments over debt it would be tough to fund.
declining commodity price of the last 200 years was due to industralization, the use coal and oil allowed more raw materials to mined faster and cheaper, machine farming tools and oil based fertilizer allowed food production to reach unprecedented level, but this may all end if we have really reached peak cheap oil.
Pettis has been warning about steep declines in iron and copper prices for two years now, and paper tiger or no paper tiger prices have dropped a hell of a lot. I wonder if Jim Lennon keeps getting it right as often as Pettis.
I have also been reading up on Gerard Minack since reading this blog entry and he really seems to know his stuff about the supply side, and at least he has much better figures and credible claims than Lennon (and he doesn’t confuse production amounts, which for obvious reasons may have declined in some cases since the crisis, and production capacity, which is a completely different thing and far more important to future pricing).
Finally Standard Chartered just came out with a piece saying that they copper inventories in China in the past few moths have gone from extremely high to even more extremely high. I also saw in todays paper (I forget which) that Chinese banks are being killed by steel loans, both confirming the point that it really doesn’t take much research to see that there is a lot of inventory of nearly everything in China.
John,
do you have any reference material from Gerard? It sounds like you recommend them but i can’t find them anywhere.
Thanks
incase John doesn’t reply: you might be able to find some notes via Morgan Stanley, but not a lot is available free, I think they have recently put a paywall up for the more technical (and interesting) papers. Also he is often published (a few times a year) in a popular subscription investment newsletter in australia (associated with Alan Kohler) but again this is paid for (this is the only source I have, but it does give access to older articles). There are some interviews on youtube, but they don’t really show the detail of his work – he has some fascinating charts, that’s what you want to see. I tried to find the research work that Mr Pettis refers to but I had no luck. Maybe it might be made public in the future.
It is a shame as I have seen some really interesting articles from him over the past few years. He first came to my attention in 2008 when he suggested the ASX could drop (50%) to 3200 and it did (I get the feeling even he was surprised about that), so I have privately nicknamed him Mr 3200. More credible people recently named him Australian Economist of the Year or some such title. I presume that most of his work is kept tightly in his employer’s control (MS).
There might be some other stuff about that I haven’t seen, but after seeing some of his complete articles, the edited versions which other publications summarise seem more like fluff pieces than actual good reading.
Thanks Michael for your prompt responses. KevinM, I am sure my opinion is of much less interest than Mr. Pettis’, but as always I will add my “nominal” two cents. Everything we hear about the race to find more oil around the globe suggests an onslaught of supply coming down the road. Improvements in production technology (deep sea drilling and hydraulic fracking) are tapping more and more difficult to reach reserves. Fracking’s global potential has only started to be realized. If China (water supply issues aside) and other countries adopt this technology without all the consternation as here in the U.S, we have only seen the beginning. (Forgive me environmentalists.) This leads to me a final and not so subtle point.
Many in Obama’s administration have been openly hostile to fossil fuels. Sorry, but they have. New drilling permits and pipleline construction have been slowed down from recent years. I can only think a Romney administration will be positive for U.S. production which will directly impact global prices. There is also a major opportunity for the U.S. to gradually shift from oil to a very abundant and cheap supply of natural gas.
The wild card is Mideast politics and conflict. Let’s face it Egypt, Libya, Afghanistan and Syria themselves matter very little to global oil supply other than their influence on wider sentiment in the region. How these tensions unfold is anybody’s guess.
Lennon: One of the reasons China is such a large share of global demand relative to GDP is that it is going through an industrialisation/construction phase than many other developed countries went through at equivalent stages in their development – remember US steel demand per capita is now half the level it was in the 1950s and 1960s and China still hasn’t reached 1950s levels of US urbanisation or wealth.
Me: Before Michael explodes I will intervene and tell you that the comparison of China with the US, today or in the 1950s, is a very common but still stupid mistake. No country as poor as China has per capita steel demand equal to that of the US, today or in the 1950s. That is what it means to be poor. That doesn’t not mean that it uses too little steel or else every poor county in the world would consume, like China, five times its GDP share of steel, which is clearly an impossibility. Chinese steel consumption far, far, exceeds that of countries at its level of wealth or productivity. Those are the appropriate comparisons.
Lennon: At the end of the day China is still “underdeveloped” with very low incomes per capita and low urbanisation – there is more growth to come.
Me: Are you kidding me? Being poor means there is more growth to come so naturally it must grow? Do you realize that China is not the only poor country in history or in the world? Do you make the same arguments for all of them?
Too many misunderstanding around! The big source of productivity gain in China is moving people from subsistence economy to market economy, from agriculture to industry, from rural areas to urban areas. They have a lot to do in this regard and can easily pay for it with yhe produvtivity gain as long as they can keep creating high quality jobs for the new urbanites. The very question is how to keep creating these high quality jobs for the new urbanites. Until now exports helped a lot but not anymore. So how they can keep productivity growing without a new sorce of demand for the necessary industrialization. Domestic consumption can not replace lower exports and that in my view is the big problem. The trade off is not between investments and consumption but mainly between consumption and exports.
Lennon: One of the reasons China is such a large share of global demand relative to GDP is that it is going through an industrialisation/construction phase than many other developed countries went through at equivalent stages in their development – remember US steel demand per capita is now half the level it was in the 1950s and 1960s and China still hasn’t reached 1950s levels of US urbanisation or wealth.
Have you actually done the numbers? In the 1950s the US economy was between 3 and 4 times China today as a share of global GDP but its steel consumption never reached anything close to the current Chinese share. To say that at different stages countries have different levels of steel consumption is not the same thing as saying that every possible level of steel consumption is natural and at no time can we ever say a country’s consumption is excessive. I suppose if Haiti were to consume 90% of global steel you would also argue that this doesn’t imply excess use of steel based on the same argument, right?
Lennon: Despite massive investment and high prices, Chilean copper mine production is LOWER than it was in 2007!
Me: Of course it is, dummy! If demand drops so will the amount sold. This is an accounting identity, although not one that Pettis, as far as I know, has ever seen necessary to remind anyone. But copper producing capacity didn’t drop. That is what matters and that is what Pettis has been talking about. If capacity rises, the marginal cost will drop substantially, and if demand drops, the price will drop. Notice that the amount sold will also drop. As my daughter says: Duh!
Sorry but global consumption is at an all-time high this year 15% higher than in 2007. Chinese mine production is lower despite huge capacity additions coming onstream because grades are falling at older operations. Average costs are rising sharply because newer mines have lower grades.
From today’s MoneyNews
(http://www.moneynews.com/Street%20Talk/Pettis-hard-commodities-collapse/2012/09/18/id/456563):
“Australia’s Resources Minister Martin Ferguson agrees that the boom in commodity prices is over. “The easy earnings we get out of high prices are now gone,” Ferguson told Bloomberg TV. “We have to accept that here on in it’s going to be a lot of hard work to actually expand capacity rather than rely on increases in prices.”
It doesn’t seem like we are going to see a reduction in capacity growth. If Australia and everyone tries to make up for lower prices by increasing output, pirces can only drop even lower.
Oh, and JohnWax, I work for a large fund and have been following Michael for four years. As some one who has made money off his insights, I can tell you pretty quickly whose paper tiger I would follow. A lot of his predictions have seemed surprising at first, but offhand I can’t think of any big ones that were wrong. My ex-Bear Stearns friends tell me that in the 1990s he was doing the same thing in Latin America.
great article, great comments, thanks as always.
can someone help me out with some links to more information on some points in the discussion. I have been following Mr Pettis for a long time now but I haven’t seen the information he refers to about why the “typical” intensity of use model is not applicable. what is written here in the comments makes sense, but I would like to read some more.
Also regarding the difference between production and capacity for hard commodity producers, can someone direct me to some good information about this (for commodities specifically). The difference with regards to manufacturing or real estate is clear and easy to understand, but I do not understand the difference with regards to resource extraction …
I have never really considered the details of the difference between production and capacity in resource extraction, as I was under the impression that producers are rarely in a position to produce “below” capacity: because of the bias of financial modelling and capital investment towards economies of scale, ie operating at 60-80% capacity has a higher marginal cost than operating at maximum capacity, therefore production is (almost) always the same or close to capacity (therefore there is no notional difference between production and capacity … no?). However this is the case for an individual operation which is different to the collective of all producers … is that where the difference lies?
I understand that the past decade saw a surge in commodity prices from limitations in production caused by capacity contraints (production = capacity). and so now production has been increasing as investment in new / larger capacity has occurred (production = capacity). but my understanding of the typical economics of individual operations / companies is that as / when prices drop below their marginal cost, few are able to partially reduce production and still remain profitable (or maximise profits), so they shut down completely or get bought out by someone with a lower capital cost (and therefore lower marginal costs) but they would still operate at that maximum capacity (because the marginal cost curve is still the same for the operation) … (? production = capacity ?). so in this last part of the cycle the capacity might still exist (at the mines which are closed) but it is not utilised so the production is the figure which is relevant… no? the unutilised capacity has no value because it is no longer profitable … no? (or is it the fact that the “threat” of this unutilised capacity which contributes to stemming any potential increase in prices again that is the important economic point?)
I am missing something here … what?
Or is this just a characteristic of the industry where economics of scale (and investment bias towards “bigger is best” even when it is not necessarily the most profitable for a project) dominate actual behaviour to make it quite different to rational economic behaviour? i have only very rarely heard of an operation reducing its production to a portion of its capacity. and collectively the response in the industry is for sub-optimal operations to be closed down completely. closure and reopening costs (and timing) are significant, so I struggle to see operations which are shut down as still retaining some (unutilised) capacity… my point being that I struggle to understand how / when production is not the same as capacity …
or do I have my definition of capacity for resource production wrong? do you regard an inert / undeveloped resource as capacity, even though it needs five years and billions of investment capital to make it productive?
any comments or links would be greatly appreciated.
I like this post, but it might have been helpful if the distinction between “hard” and “soft”
commodities was made. It would seem to me that, barring some disastrous scenario
where not just Chinese investment but Chinese household consumption falls, Chinese demand
for meat (http://www.earth-policy.org/plan_b_updates/2012/update102), and thus world demand for soybeans, maize, etc. will continue to grow.
According to the Australian Financial Review yesterday (Tony Boyd, ‘Bucketload of queries for Fortescue’):
“Power repeated yesterday the Fortescue conviction that Chinese demand for iron ore will remain strong for a very long time. Also, he stressed that iron ore demand would exceed supply. Fortescue’s views on Chinese demand are in keeping with those held by BHP Billiton and Rio Tinto. Rio’s most recent market presentations include charts showing Chinese steel production rising steadily until a peak in 2030.
The same charts show Chinese crude steel demand rising from about 630 million tonnes in 2010 to 950 million tonnes in 2020 and hitting a peak of 1 billion tonnes in 2030. Rio’s forecasts for China’s real annual gross domestic product will grow at a compound annual growth rate of 7.1 per cent between 2010 and 2025. Its forecast for China’s GDP per capita is 6.8 per cent between 2010 and 2025.
However, doubts are being raised about the relationship between these bullish growth numbers and consumption of metals. There are two key flaws in the conventional approach to modelling China’s future demand for industrial metals, according to a report last week by analysts at Nomura led by Matthew Cross.
Nomura believes China’s demand for industrial metals will grow much more slowly than the consensus expects and this will be obvious within 12 to 24 months. The report says China will be unable to grow steel, copper and aluminium demand at 5 per cent compound annual growth or more if the economy is only growing at 7.5 to 8.5 per cent a year.”
I wonder what info Jim Lennon uses to back his assertions.
” I exclude gold because it is really a monetary asset – a sort of fiat currency, ironically enough.”
Could someone elaborate on this? How is gold a sort of fiat currency?
While gold has limited industrial value in electronics (it is a good conductor) and health ((tooth fillings, etc., because it resists corrosion and doesn’t react with the body), it’s market value is much higher than its intrinsic value (it’s value as a useful commodity).
In short: just as a $100 bill is uch more valuable than the paper and ink used to create it, a gold bar mainly gets its value because of people’s *belief* that it is valuable.
Gold’s value is not based on a *belief*. It is based on the desirable qualities of an ideal store of value:
* is truly rare
* above ground stocks can not be changed much by new supply (150+T tonnes vs 2T/yr)
* durable, does not decay
* fungible
* high value per size thus portable and discreet
* highly liquid
Imagine storing tonnes of copper or oil in your backyard to get the same value as storing a few gold bars.
And I forgot that compared to all paper assets (and even real estate without the rare allodial title) it is not simultaneously anyone else’s liability.
Gold can not go “poof its gone”, but paper money regularly does throughtout history.
Note I am repeating some of the dogma on the gold bugs, but I don’t believe a gold standard is sustainable nor a solution to anything, as I explained in an earlier comment on this blog.
wow….what a moron. take a look at the CRB for the past 10 yrs and then tell me how commodities are in a bear market. how does this guy get an article up on this website? i’d love to have Jim Rogers interview him & rip him a new one.
he he he …i think michael may have just ripped you a new one
take a look at the CRB for the past 10 yrs and tell me commodities are in a bear market! wow…where did they dig up this guy & how does he get a published article? i’d love for Jim Rogers to interview him & rip him a new one
Are you the same Jim Lennon, the commodities analyst at Macquarie, who said in December 2010 :
“Well supply is increasing – in every commodity we look at. the critical question is, is supply increasing more than demand’. And for most of the commodities we’re looking at we would have to say that supply is increasing at less than demand or growth is increasing over the next year or so. On the whole, I would say we’re certainly very positive about the commodities outlook. A lot of focus has been on the inability of major producers to deliver projects on time and on budget and certainly every time we look at our supply numbers for most of the commodities, we’re lowering the supply forecasts over the next couple of years. And in certain commodities, particularly copper, coal and iron ore, we think that markets could get critically tight over the next couple of years if there are further delays in these projects.”
And also:
“We’ve given up trying to forecast prices based on cost because prices more than double the underlying marginal cost of production, so where the price goes, is very difficult to determine – but certainly it’s got upside. We also like lead and tin in terms of some of the minor base metals simply because again the supply-demand balance is certainly pointing in the form of ongoing deficit for those commodities. I would say that zinc and aluminium are less attractive simply because in the case of aluminium, of the larger … inventory, and in the case of nickel because there are seven Greenfield projects hitting the market next year. however the potential for aluminium and nickel to out perform based on financial demand as well as delays in these projects is there. zinc we see as in between – certainly the market is in surplus this year, and through the early part of next year we still see a bit of a surplus, but gradually zinc could move into a deficit, particularly going into 2011. so that could be a performer later on. but certainly copper, lead and tin are our top picks.”
I guess I am not surprised you are still calling for higher prices. They are going to have to a very long way up to make up for all the decline since your last bullish forecast. I am not trying to be provocative here, only wondering how much you expect prices to rise.
A few flies in the ointment.
Increasing monetary bases.
Reducing exposure to US Treasuries, which are Tier 1 assets, being used for purchasing durable commodities. We have to remember that Treasuries are a commodity that is a declining value asset.
We forget that the middle and upper class sector in China (actual numbers) is growing. They are the folks fueling demand. Average income means nothing, it is aggregate demand.
China is still on a building binge. That the new construction exceeds demand is moot when you consider that it is far better to spend on infrastructure (public and manufacturing) with a declining currency than to hold the currency. A new steel mill constructed today will still be a steel mill in 10 years.
Keep the workers employed or face civil disobedience. This means it is far better to have raw material reserves than declining value money sitting on the sidelines.
Therefore the price could still flatten or increase some, although indexed against current prices, the value paid would probably decline or at least flatten.
The old saw about an “ounce of gold is still worth an ounce of gold” holds for other durable commodities. Better to hold a thousand tons of steel than a hand-full of Treasuries.
It is all about tangibles versus declining value fiat.
In conclusion, I agree that the true costs will flatten or decline. However material stocks could and probably will increase some. Energy costs will be the bug in the ointment.
World War Three will consume all the commodities the world can produce, and then some. Mr. Pettis makes what appear to be reasoned arguments, but they are the product of his being so close to the trees he no longer sees the forest.
Yes, we collectively are facing a deflation. However, a key is how that (and prices) are measured. In looking at the Economist’s chart showing the decline in commodity prices, there is a note saying prices in dollars are normalised. O.K.; with a constant dollar price, we can expect continuing deflation but with a debased dollar, pricing commodities is like building a house with a rubber measuring stick.
Let me take some time to explain my thinking in more detail.
Although I am nearly certain that Europe’s GDP is going to continue to shrink due to the austerity measures being required by the troika (ECB + IMF + EU), and thus I could jusify shorting the Euro and/or European stock market indexes (or bank stocks), there is not a certain timing of various outcomes (e.g. Spanish bailout request) and the level of ECB printing (and whether it is truly sterilized). Tack on the potential for them to keep kicking the can with more lies.
So I am looking to short something that is certain to decline, no matter what is the timing of ECB and Fed actions. I am looking for something that is highly leveraged (dependent and focused on) to the consumers in Europe and the USA (and especially Europe), because the global PMIs are negative, and especially negative in Europe, and the GDP of Europe is shrinking. So the loss of conspicuous (high-end, high profit margin) consumption is ongoing now, and has been for months already. So anything that is leveraged to that consumption, is crashing now.
That is China. China just isn’t telling us the truth (they claim 7.5% GDP). We know it in several different ways.
* the wealthy are fleeing China with the illicit money
* electricity consumption (which is also a lie) is 1 – 2% growth
* coal, steel, and copper stockpiles increasing from “extremely high” to “very extremely high”.
* China is making aggressive moves to claim islands far from their mainland and closer to the other claimant countries mainland (e.g. Philippines and Japan).
* China’s PMI is below 50, meaning shrinking manufacturing GDP, yet exports are 40% of their GDP. And imports are declining also. And the boost in consumer spending hasn’t occurred.
* Foreign investment (FDI) is no longer entering China, and there is net exodus.
* Bad loans (NPLs) rose 333% in the past month. Still at a low level at $80 billion, but rising so fast.
* China’s debt load is as bad as Greece. Some claim there is this huge savings in China, but they forget that it was either in state banks earning negative REAL interest rates, which state banks loaned to local govts and state corporations, who wasted it (and stole it). Or the savings is in the real estate bubble, on buildings that earn no rent, because the billion common laborers can’t afford and live in slums. Some people claim that ghost cities and unoccupied condos are isolated phenomenon and not significant. I am sorry but Chanos documented 50 sq.ft of office space for every warm body in China (babies and elderly included) and that is not including residential.
* Chanos was correct short on Enron, he has been correct short on China and coal and iron ore (he made a lot already), and he says he is re-entering his shorts on China, and that it his is largest bet (about 20% of his hedge fund’s portfolio!).
Let’s analyze what went wrong in China. China made rapid economic advances from nearly nothing starting in mid-1980s, but especially significant in the 1990s, because it had this huge labor pool that could work for pennies per day. Unfortunately, instead of letting their currency (Yuan) freely float at a market rate, so that their new middle class could reap the benefits of buying imported goods cheaper, China followed a mercantile policy of pegging the Yuan to the dollar, in order to steal the work of its own people by devaluing the Yuan (as the dollar was devalued and as China should have been gaining strengthen in the relative market due to FDI inflows, etc).
So instead of having a market driven sustainable economic model, whereby those who work hard, are rewarded with the ability to invest and spend at market rates, and thus to maximize the efficiency of balancing the economy between consumption and exports and maximize the efficiency at which the remaining poor are lifted up, China instead chose to force all billion of its people to be dependent on cheap labor exports– a mono-economy.
The effect of this was to cause the economy to be unbalanced and for much of the work and savings to be wasted, because it could not seek market driven “best opportunities”. Instead those with savings either had to accept negative REAL interest rates in savings accounts (Yuan debased faster than interest paid) or they had to chase bubbles like the real estate bubble. This was a vicious cycle, with the banks lending that money out to the entities that helped drive the investment in real estate, thus feeding the bubble.
The wise Chinese know this and thus the corruption is rampant. They know their system is doomed, and so they get what they can. Stealing everything they can, and taking money out of the country.
The dumb masses are duped into nationalism and the concept of “Communist Party is God”. As this failed model implodes, the wise leaders will be out of China and the worst ones will stay behind to lead China into external conflicts that feed that dumb nationalism, and the masses will be duped into putting their anger at external “wrongs” instead of the wrongs of their own system.
China is toast. If you understand how bad the model is, then you understand it is much worse than even Professor Pettis thinks.
It is going to get very ugly.
I can confirm anecdotally from a 20 year veteran in Australian mining, that indeed the miners are stockpiling and not cutting production that much (and certainly not cutting capacity). They expect a cyclical downturn only. Pettis explains it is structural and permanent. He hasn’t been wrong on China yet.
I lean towards it won’t take 2-3 years, because China is unraveling now. Stockpiles are going from “extremely high” to “very extremely high”. China is lying (listen to the Chanos interview). When the dam breaks, the water doesn’t trickle out.
[QUOTE]Rio’s forecasts for China’s real annual gross domestic product will grow at a compound annual growth rate of 7.1 per cent between 2010 and 2025. Its forecast for China’s GDP per capita is 6.8 per cent between 2010 and 2025.
Nomura believes China’s demand for industrial metals will grow much more slowly than the consensus expects and this [B]will be obvious within 12 to 24 months[/B]. The report says China will be unable to grow steel, copper and aluminium demand at 5 per cent compound annual growth or more if the economy is [B]only growing at 7.5 to 8.5[/B] per cent a year.”[/QUOTE]
I am short RIO! And that is 12 to 24 months, if growth is 7.5%, but China is lying. Growth is much lower, perhaps even negative. Shorten the timeline as the lies blow up in their face.
Professor Pettis, can you present any logic for why the China and hard commodity crash must be 2 – 3 years from now, and not now?
When everything is a lie, then it is much worse than we know, and you think they can keep the lies hidden for 2 years or do you think they are not lying or do you think it is not that bad yet?
shelby, good commentary. two points:
Mr Pettis does suggest in previous articles that the change in leadership could delay any serious / dramatic impacts of poor economic mismanagement as they take action to avoid destabilising control or increasing social unrest. I guess we only need to see how long politicians can push problems along for as we continue to watch the happenings in europe, so this timing makes sense to me (plus i think the deniers can probably keep kidding themselves for another 12-24 months). He also replies in person below.
As a fifteen year (Australian and International) mining veteran I would suggest that miners mostly forecast future prices far below what the actual prices turn out to be on the way up the pricing curve. and on the way down they mostly forecast future prices far above what actual prices turn out to be … I used to think that (particularly the larger) mining companies were a good source of information on commodity forecasting, but now the inherent bias is too obvious for me. however companies such as bhpbilliton can be useful in predicting floor prices, eg they operate on the lowest cost quartile so that does provide an indicator of a floor. I believe that in todays dollars iron ore costs for the majors are in the 40-60USD/t, and given the significant closure and startup costs (and commodity diversification), they can afford to operate on negative margins for a few years. so this is probably a useful price range to think about (although timing is a different question). If you are interested take a look at historical data (a bit of work in this though). commodities are *commodities* and for that reason I believe they are some of the easiest pricing models to understand … prices revert to the lowest production cost in the long term (until the next supply / demand imbalance) … they are commodities … (it is strange how the popular commentariat are ignoring this?)
Interesting point about price projections too high on the way down.
Seems to me a period of transition would be more likely to be political paralysis, thus limiting decisive action on for example a massive stimulus program.
Since we are wildly speculating, and if I am correct that China is near 0 growth right now, this inaction on stimulus could be causing major fractures in the political and economic system. This could be shifting the balance-of-power to those who want to lead an angry mob of Chinese out to external conflicts to shift focus of anger.
Something may be going on. The new Premier has disappeared.
The debt uptake has not been impressive, many other indicators turning bearish.
We had a bounce in expectations from ECB and Fed. Volatility and complaceny are near multi-year lows. Bullishness indicators near all-time highs. Feels to me like everything bullish is priced in and we have some big negative surprises coming.
yes we are certainly in a period of time where we *cannot* separate politics from economics right across the globe. although I understand that over history this has actually been the “normal” and that the recent period (10-20 years) prior to the trigger events of 2008 when we have been able to mentally “separate” politics from economics has been an aberration rather than the normal. (although of course the deliberate use of prolonged low interest rates to promote growth via consumption was always political.) I guess maybe the difference is that the natural link between politics and economics is just so obvious now, and the actions and reactions of both politics and economics is more short term and therefore very obvious. What I think is particularly interesting is how the social aspect of this is also becoming very obvious as people and interest groups really start to get involved in the discussion about what we have collectively been doing for the past few decades and what / how we should move forward from the current situation. I don’t think China is the only country facing significant social involvement in political/economic decision making in the coming years.
Having said this though, it surprises me how much of the political discussion is focused on balance sheets and budgets and not on the social aspect of economic issues (ie unemployment). It still seems that politicians (and the media?) are almost clinging to the abstract numerical concepts rather than focusing on the really hard social issues which are becoming more and more urgent. I guess fear is the cause of this? Maybe this is completely normal and the only way that society is able to address these tough and complex social issues is by fighting it out?
I know this is an economics blog and not an investment forum, but i get the feeling that investors who really focus on the interaction of economics / politics and society (in each separate economy/nation) will have an insightful perspective on the direction of the markets in the medium term.
The money printing by the central banks is not going to reach the consumer, so I don’t see how it can raise the hard commodity prices. These QE actions are pumping money into banks or sovereigns, but sovereigns are cutting budgets (at least in Europe, China, and planned for USA on Jan 3). Thus the QE is not sufficient to reflate the consumers, as there is a net negative funding for consumers.
The banks are receiving this money and they will create asset bubbles, probably in the remaining emerging markets that are not yet debt saturated, food, oil, etc.. But why would they create an asset bubble in some thing that is popping and has massive deflationary forces (e.g. western real estate, China, or hard commodities)? They would be buying and letting others sell, thus they would be the suckers.
I don’t think so. Instead the banks will buy what isn’t yet in a bubble, e.g. gold, silver, miners, food, oil, underdeveloped emerging markets, etc..
Shelby,
I greatly appreciate your comments, in particular regarding the nature of Chinese statistics. However I must disagree with your comments about money printing not reaching the consumer (or the labour market). The Fed has been printing money for several years, as we know. This was cannon fire across the bows of mercantilist economies. If you are looking for consumers that benefit, ask the consumers working at the new Kia plant in Georgia, making 360,000 cars a year (cars previously imported from South Korea). And not just jobs from production moving to North America, but exports have been growing as a result of the lower USD. I know I’m simplifying something very complicated. There are all sorts of steps in between. But economics is complicated. Ben knows what he is doing, and it’s never wise to bet against America.
“Ben knows what he is doing, and it’s never wise to bet against America.”
Shelby that was the funniest thing I’ve read in a month! In the tone of a John McEnroe temper tantrum, “You can’t be serious!”
Check this out because it is easy to follow…
Bernanke was Wrong http://youtu.be/INmqvibv4UU
PS Whoops sorry. I meant cjared. Not Shelby.
Huh? Civilian participation in the labor force has plummeted since 2008:
http://data.bls.gov/timeseries/LNS11300000/
The only stimulus that reached consumers was the “cash for clunkers”, “$8T new home incentive”, and the other spending increases of the government. The central bank printing ends up in the hands of fewer numbers of wealthy people (and the people who did not take risk and produce to get it, so it reduces the knowledge and investment in the economy). We appear to already be in negative marginal utility of new debt, meaning the more the central banks print, the faster the real GDP declines (of course they lie about inflation to hide the statistic).
Shelby,
I think we are talking in two different time frames. I am thinking in terms of decades, to which programs like “cash for clunkers” will have no noticeable affect. What I see happening is the same process North America goes through every recession with it’s labour force. Industries which got out of hand during the previous expansion period recede (real estate related in this case). New areas expend their labour force. First by hiring temps, who will eventually become full time further into the expansion.
I also see that with every subsequent cycle, our economy gets more complex. This increasing complexity makes each ramp up marginally more difficult. In a practical example, in the 80s when Chrysler added a second shift to produce mini-vans, it just hired a bunch of guys for the line. In this expansion, machine tools are computer operated and required much more specialized training. Manufacturers are complaining that they can’t hire people with the right skills. But the training takes time.
What this means for the aggregate employment numbers it that it will take much more time for recovery. But that does not mean the policies are bad. It really just means we have a sophisticated economy.
I have yet to read of anyone with a reasonable solution to the problem of having a sophisticated economy, a sophisticated labour market, but we want the jobs market to recover this month, or this quarter. It’s not going to happen, it was never going to happen.
What is happening is that we are building those fancy factories, sophisticated payroll service companies, engineering and design companies, etc. and with time, we will have “full” employment again. But with a better structured labour force overall, as has happened after every recession. The capital required to do that is cheap, because Ben is ensuring liquidity. It is happening, just slower than the public wants, but at the speed a sophisticated economy reacts.
The “complexity” you describe is the Knowledge Age. And it requires that the government and the illiterate get-out-the-way. So of course, they don’t understand it and will fight futilly.
The reasonable solution is obvious but can’t occur politically for the masses, although it is occurring now for those who are embracing the Knowledge economy (we are detaching from the dying economy):
http://www.mpettis.com/2012/09/23/can-china-increase-export-competitiveness/#comment-16735
I described in more detail the theoretical basis:
http://www.mpettis.com/2012/09/23/can-china-increase-export-competitiveness/#comment-16585
On the issue of whether policies such as QE did (or QE3 can) increase inflation and demand for hard commodities (i.e. further the bubble at the end of the industrial age), the following article explains that QE can’t directly cause inflation:
http://www.financialsense.com/contributors/charles-hugh-smith/why-qe-wont-generate-inflation
But the furtherance of the debt-bubble means misallocation of capital continues, which is destroying non-discretionary supply and creating overcapacity in discretionary supply sectors, while also sustaining a higher level of non-discretionary demand (many people in third world can eat 3x per day now, consume more fuel for necessary activities, etc). Thus inflation in non-discretionary items.
The linked article also supports the concept that the rise in the stock market due to QE, is mispriced and we will get correction. The Fed did a study that showed that stock market bounces around time of announcements from Fed was responsible for most of the gain in the stock market since 2008. Factor in that it wasn’t QE that drove up the economy post-2008, rather it was the government deficit spending and China stimulus. Now we have austerity every where, including Europe, USA (fiscal cliff Jan. 3 which is affecting investment now), and China’s bursting fixed investment bubble. So final demand for hard commodities (especially discretionary) is declining, while QE doesn’t drive money into stock from the banks, but rather from expectations that QE boosts the economy. Yet we see the global economy is not getting the deficit spending boost now that it got in 2008.
John Wax, yes I saw the Standard Chartered piece. Very interesting and a little funny.
Lurker, you are right. It does not make sense to compare levels of capital stock between some of the poorest countries in the world with those of the richest, and from there to make predictions about how much growth remains. Comparisons should be made among countries of equal levels of productivity. That this isn’t obvious is something of a mystery to me.
Gelboak, I have made the point many times that this analysis applies mainly to hard commodities. I agree with you about food. If the rebalancing is not mismanaged, Chinese household income could continue growing at 5 % or more (by definition it must exceed GDP growth) and that should create strong growth in demand for food.
Benbubble, it is probably because the article is a little too long for you to read comfortably, and employs lots of abstract words (not, of course, that I am calling you a moron), but in the article I point out that metal prices began rising around 10 years ago because of the double impact of Chinese demand and limited supply. I now argue that it is set to go down. I am glad you posses the arithmetical skills to see that prices today are higher than they were ten years ago, but you do see, don’t you, that this automatically follows from the analysis?
From your language I see you are a big fan of Mad Money, the TV show for people who fantasize about acting like traders on TV. Good for you. It is the Jersey Shore of financial wanabees. By the way, when you asked in shock how does “this guy” “get a published article”, you do realize, don’t you, that this is my blog? Weirdly enough it is quite easy for me to get published on my blog.
bwahahaha! noice.
Hi,
I am Andrew Jackson, a financial writer. Today I came across your site ( mpettis.com) and enjoyed reading some of your articles.
I just want to know do you allow guest posts? I would like to write for your blog on some relevant topics that is still to cover on your blog.
I will make sure that my articles will be completely original to serve the quality. I do believe your readers will enjoy reading it.
It will be a thrilling experience for me if my article finds a place in your blog.
Please let me know about your decision.
With best regards,
Andrew Jackson
To Andrew Jackson and all the others who regularly ask to post their own entries on my blog, sometimes on bizarre topics that have almost nothing to do with anything I write about: No thanks — I have no interest. I am not selling anything.
Gloria, I am probably being a little provocative here, but the value of gold far exceeds its value as an industrial commodity largely because governments (and later people) have defined it as a monetary asset. When gold bugs make a distinction between fiat money and “real” money (gold and silver) it is largely because they do not know the history of gold.
Overtheedge, if you simply assume away the value of cash and assume that nominal prices must rise, then yes, it is better to hold commodities that to hold cash. A lot of people made the same assumption you did in the midst of the inflationary 1970s. The trade didn’t work too well.
ManAboutDallas, oh yes, I forgot all about World War Three. Sorry about that.
Shelby, it is I guess refreshing to move from a period, just a few years ago, when everyone insisted that China is not nearly as bad as Pettis thinks, to a stage where nearly everyone insists that China is a lot worse than Pettis thinks. It might be, but I think we should resist getting too caught up in mass-thinking. It is mostly noise.
As for the commodity crash coming in 2-3 years, you misunderstand me. I said it will have lost 50% within 2-3 years, which means price declines can occur at any time within that period. For all I know prices may crash next year.
By the way, in this blog I have absolutely no interest in giving investment advice. I am only trying to use my knowledge of history and the logic of accounting identities to understand what is happening in the world.
Another comment:
It seems that in Australia now we have finally admitted that the commodities “pricing boom” is over, but apparently that does not matter because we are now benefiting enormously from the commodities “investment boom” (followed by a “volume boom”). Benefits from increased volumes make sense (assuming they are profitable, which I know is not a sure thing). But I have just started thinking more about this so called “investment boom”, particularly in the context of your writing about the chinese investment boom … investment in a lot of non-productive assets …
Surely if we generally agree that prices will be declining (and potentially significantly within a short period of time) then a lot of this late commodities investment in Australia has a chance of becoming unprofitable (perhaps even before they are productive). Now this does not surprise (it is the natural, albiet irrational, behaviour of investors in a bubble), but I guess what I am just realising is that we are having a national conversation about it and we seem to have agreed that it is a good thing … surely pouring billions into new capacity which is unlikely to be profitable is not a good thing? Some people are saying “but we will still have the ports and the rails that can be used” … but how is that different to the chinese building steel mills and roads which “can be used” but won’t be used at a level which is “profitable” (and possibly not at all). Particularly so given that the investment in Australia is private investment, so long term commercial profit is essential for those assets to continue to be operated.
Is this really the case where instead of benefiting from high cost (peak of the cycle input costs) capital investment in assets which are unlikely to be profitable, that we would be better off simply offering investors capital guaranteed generous cash returns and using that money to invest in other industries so that we have diversification away from mining (and so a better opportunity for a more balanced economy). Have we got this so badly wrong? That our Treasurer is talking up the benefits of an investment boom (despite falling prices) and no one is pointing out how absurd this may be?
Certainly we benefit from the employment and the supply opportunities that this capital investment provides, but we also all agree that this investment is diverting labour, supply and capital away from other investment in Australia … and we all agree on how serious that problem has been so far. So what are the actual benefits? Surely not all of these projects will be profitable, surely we know this? (Or am I too harsh? They will all be profitable through bottom of cycle prices?)
Is this another case where I am so naive as to believe what the informed commentariat are telling us … and then when I think about it I imagine I must be missing something because I struggle to believe that such people would not be talking about such absurd things … Or am I actually missing something?
Professor, I did understand this blog is an academic interest– not an investing site. I copied from what I wrote in a private investment forum, some portions of which seemed to have some applicability to the discussion here.
Agreed on trying to filter the noise. Two recent examples:
1. The rapidly rising NPLs may soon be larger than the announced $158 billion of “planned” local government stimulus.
2. Article in Bloomberg today claimed that China’s exports rose 7% to through Aug, while Japan and South Korea both declined. This boosts the market, because people don’t ask what the profit margins were. Not likely that China was outperforming both Japan and South Korea so significantly on exports, except by having overcapacity with very low profit margins (if you give stuff away at negative value-added, you see a large gross, but no net). China’s government has been loosening credit to exporters, thus probably sustaining this subsidy. Perhaps someone could do a more research to confirm.
Professor, about the monetary nature of precious metals, are you aware that the stocks-to-flows ratios for precious metals is orders-of-magnitudes greater than for other commodities, i.e. the above ground inventory swamps velocity of consumption and even trading.
Professor Fekete (monetary scientist) explained that to me.
Thus gold and silver are much more stable forms of money, and are the fulcrum on which all unstable forms of finance gain leverage.
The gold bugs have the delusion that only gold and silver need to be money, which is wrong, because debt and interest rates can’t exist if they can never exceed the rate at which gold can be mined and increase the total above ground inventory (there would not be enough gold to pay the interest at some point due to compounding and thus fractional reserve would be necessary).
Also there is the political power vacuum of a non-fractional reserve which can’t stand, because the people will always choose those who promise more than they can pay for, i.e. people will always choose excessive debt when it can be hidden in the collective.
So since there is this oscillation between hard money and fractional reserve, it might be tempting to say that gold and silver are fiats, but actually they are the fulcrum– the only hard foundation that people can turn to when they need to discipline the out-of-control fractional reserve system.
Gold and silver will be going much higher, because they go up during periods of negative real interest rates (I am sure you know that too).
Interested to learn from any provocative insight you have.
(hastily written)
Shelby, over very long periods of time the value of gold and silver may be “stable” but that is mainly by definition, and that certainly isn’t the case over shorter periods of time. The world has gone through crisis after crisis thanks to the unstable relationship between circulating gold and the needs of the economy. Currency money (and government debt – see Alexander Hamilton) was created in large part to manage the instability created by gold. One of my PKU students is writing his PhD thesis on how changes in the price of silver relative to gold created tremendous booms and busts in China in the 19th and 20th centuries.
Barry Eichengreen makes the point that thanks to the spread of democratic franchises we cannot return to the gold standard. The standard mechanism of dealing with a financial crisis under the gold standard forced unbearable hardship on the working class. As long as workers were effectively disenfranchised, bankers could impose gold standard “discipline” (which means forcing producers to take great losses in favor of creditors), but once they became politicly important, gold had to give up its role in enforcing monetary discipline. I think Eichengreen is right.
I am superficially aware of the silver manipulation that apparently caused China to abandon silver money, and I referenced it in an article I wrote in 2006 (my other older archives are mostly junk as I was learning):
http://www.gold-eagle.com/editorials_05/moore070306.html
I had agreed already that a non-fractional reserve (i.e. gold standard) system is not sustainable (i.e. long-term stable) in my post to which you replied. Perhaps my hasty articulation was not so clear. And I had explained in my prior comment, that this is for at least two reasons, both of which you reiterated (in essence).
However, neither is a fractional reserve system long-term sustainable and stable, because it transfers power over everything to the (central controllers of the) collective. We’ve had 56 instances of fiat currencies that have returned to their intrinsic value of zero (and this doesn’t include shaving coins during the Roman empire):
http://en.wikipedia.org/wiki/Hyperinflation#Examples_of_hyperinflation
Fractional reserve systems eventually all fail too.
Precious metals are more stable in the sense that they are the only way for individuals to vote (and vote in real-time any time) in the monetary market place. And only gold and silver have this property, because of their high above ground stock-to-flows ratio (which means their intrinsic value of flows-to-stocks can’t manipulated too quickly, note silver is a much smaller market). Thus they are the fulcrum upon which individual trust of fiat rests, and thus are the only stable foundation that individuals can stand on when they need to vote against corrupt fractional reserve systems (democracies are the antithesis of decentralization and thus are in the pocket of the controllers of the fiat system).
In no market is price stable. You know that a dynamic equilibrium exists where supply and demand meet. Monetary supply and demand oscillates between hard money and fractional reserve money, as individuals vote with their confidence. Fiats exist by confidence (and for a short time by military force) only.
As in all markets, the masses are all on the wrong side of the boat at the turning points. The masses are not yet in gold at this time of extreme corruption of the (global) fractional reserve system.
What data do you use to claim the working class did worse under gold standards? The only ones that were hurt were those who relied too much on debt, and they were quickly liquidated. The working class did much better under the gold standard. Depressions were much more frequent and much less severe in the 1800s and even the one in 1919 was over very quickly. The 1929 one would have been quickly over (Americans were eating more butter, and doing better and only those who lost jobs were hurting and this was quickly bottoming), except FDR ended the gold standard, confiscated the gold, and then proceeded to massive government spending to for example give everyone a spoon to dig ditches and walk on crops so they could be replanted (and now China blows up new buildings to rebuild them again).
So in a sense, the gold standard is more stable (self-regulating and self-liquidating in a free market), in that the individual banks did their own fractional reserves and there were frequent bank runs in the 1800s.
But people don’t like maximum degrees-of-freedom, because it involves too much risk. People want to be insured. So the system was morphed into a central banking system.
I have a lot more to say about this on a philosophical, economics, and physics level. See next comment…
Maximizing chance, also maximizes prosperity through maximum independent actions (i.e. best fitness to diverse scenarios).
Imagine a world with no chance, it would all be government bonds. No investment would ever occur. Risk is required in order to get knowledge and fitness (which is prosperity). This is why insurance is guaranteed failure, it pools capital into bonds (centralized knowledge can’t take risk) and thus eliminates investment.
Bottom line is that centralization is always failure.
===============
The highest state of being (economics & philosophy & physics)
http://esr.ibiblio.org/?p=4591
“driven by values”?
Values incorporate righteousness, because people value what they think is right. So that would be stage 3 or 4.
Rather I think the highest state is driven by maximizing degrees-of-freedom, i.e. the ability to promote the proliferation of values.
This is again a statement of the Second Law of Thermodynamics, which says the universe trends to maximum entropy. And entropy is the number of independent possibilities (i.e. values).
Rather one should find a way to maximize their own freedom, by maximizing the freedom of others, which is what degrees-of-freedom entails.
This model can be mistaken as (corrupted by) collectivist ideology, simply with a lack of clear thinking and articulation of what the process of freedom is, e.g. “democracy” is not freedom.
So I am arguing that democracy does prevent a gold standard, but that democracy is not sustainable, because it is the antithesis of freedom (as in degrees-of-freedom a/k/a independent possibilities).
A useful example of the loss of efficiency due to loss of degrees-of-freedom is a car without a reverse gear. It has to drive around the block to go backwards even a little distance. Imagine a bicycle chain whose links were too big to fit the spokes of the chain (silly example of how granularity of possibilities is important for fitness of outcomes).
Centralization (loss of degrees-of-freedom) is failure directed, but it can be long-tailed before it does (e.g. the 30 year bond bubble that I think will soon collapse into gold at the bottom of Exter’s pyramid).
Gold enables each individual to exercise his/her vote on the monetary system, thus increasing degrees-of-freedom. This is why only gold can retire this debt bubble (and kill the current democracy jail we are in) and why it is at the bottom of Exter’s pyramid.
“only gold and silver have this property, because of their high above ground stock-to-flows ratio”
Hello Shelby. I note you mentioned this a couple of times, and yes it’s true the production of gold adds only around 2% to existing supply each year, and so this makes it fundamentally different to fiat (which is unconstrained due to printing and / or lending). But what about the development of EFT gold funds? surely this is of a similar concept to leverage?
I do agree that gold is experiencing a surge in perceived value due to changes in sentiment regarding other fiat (and that this may continue for a while), but in contrast I have serious concerns with gold ETFs and other derivative products. I admit to not understanding the complexities (but this in itself is a warning sign for me), but from my armchair view I must assume that serious shifts in sentiment in a gold ETF is going to have some impact on physical gold sentiment.
Do you have any comments on this?
Also surely you realise that the same feature you consider to be price sustaining can also contribute to massive devaluation: because gold volume is dominated by gold in storage (rather than production and consumption) a small shift in sentiment (and therefore trade volumes) can quickly lead to a massive devaluation (and of course increase in value). The consumption / production constraints have limited influence on pricing, but sentiment can cause massive swings … personally I feel more comfortable predicting trends in a commodity priced by the former than the latter …
Indeed I think all the necessary conditions (you mentioned only a few) are in play for a gold price bubble to develop.
These charts will give you some perspective on the immaturity of the current gold sector cycle:
http://www.macrotrends.org/1300/gold-at-3000-only-if-bubbles-repeat
I think this above chart shows the gold cycle starting earlier than it did, because they are using the government’s dubious inflation and not shadowstats.com
http://www.macrotrends.org/1310/the-four-biggest-us-bubbles
http://www.macrotrends.org/1379/dow-to-gold-secular-market-cycles
Dow/Gold ratio:
http://www.macrotrends.org/1378/dow-to-gold-ratio-since-1915
http://www.sharelynx.com/chartsfixed/115yeardowgoldratio.gif
I have some speculation about the above two linked charts.
The ratio appears to be in a megaphone pattern (since 1913 formation of the Fed), making higher highs (3 data points) and lower lows (2 data points with next low to come). So I am thinking it will be closer to 0 this time.
I think the megaphone represents the gradual failure of the Fed-based dollar. They’ve reined it in 2x already, and I am speculating that this 3rd time is the end of that nation-state (dollar reserve) system.
Remember that on a log chart, that the distance from 0.1 to 1, is same as from 1 to 10 (also 10x gain on investment too). Thus the coming low could move below the bottom of the charts linked above.
In my opinion, the debt crisis will be resolved once they move to a gold money system at the international exchange SDR level (and after TPTB have bought up all the assets dirt cheap). TPTB will then remove all nation-state migration and capital controls and people will freely travel and invest any where in the world. Then there will be a massive boom in economic activity.
Note I had written in a prior comment discussing my theory that dying industrial age capital is holding the future hostage:
http://www.mpettis.com/2012/09/23/can-china-increase-export-competitiveness/#comment-16735
“The global solution is to remove government controls over migration, capital flows, exchange rates, investment, etc., i.e. reduce the pervasive collectivism, statism, and socialism (and the resultant rising fascism). This would cause a boom, unleashing the full potential in the developing world and offsetting the misallocation of capital up to this point in this corrupt globalization we’ve been undergoing.”
http://esr.ibiblio.org/?p=4757&cpage=1#comment-394401
JustSaying (Shelby) wrote:
Michael – Best put down of an idiot I’ve seen for some time – almost as good as all your posts – thanks for the great insight.
Thanks. There seems to be a great deal of evidence that bad manners on these kind of sites are inversely correlated with intelligence or understanding.
err . refers to benbubble
Professor, I don’t think most people think China is worse than you do. To the contrary, I bet the following comment I received in email, is indicative of the way most investors view China. And the China stock indexes (e.g. for FXI a huge bearish deadcat bounce H&S inside of a symmetric triangle since the 2008 highs and lows) seem to support that most investors don’t get it.
> He wants to say what’s going to happen in 2015. Hahahaha. Does he
> realise how ridiculous and stupid he sounds? He doesn’t even know
> what’s going to happen next week. We are in uncharted waters.
> Anything can happen. They have no plan, they are just winging
> everything. I find it laughable how serious certain people take
> themselves and bloviate academically about a situation for which
> there is no precedent. And you are wasting your time with this kind
> of BS. What are you trying to prove?
Shelby, “about a situation for which there is no precedent”? There is a weird sort of mental process here. Anyone who thinks there is no precedent for what is happening in China probably gets most of his information from sites that exchange stock tips, and he clearly knows nothing about economic or financial history. But how can someone know so little without realizing that he knows so little? And if he realizes that he knows so little, how can he make such strong assertions about whether or not there are precedents, especially when he is so clearly wrong? I would really hesitate to make strong assertions about carpentry, legal precedents under British law, or string theory, especially in front of experts, because I realize how little I know about those subjects. Isn’t your friend a little embarrassed to be so pompous? By the way anyone who uses the word “bloviate” to dismiss academics is trying too hard to suggest that even with the very little (or second rate) education he has, he can nonetheless use words like “bloviate”, the use of which, ironically, is a form of bloviation. I am surprised he didn’t refer to me as a “pundit”.
Follows is a redacted portion of the discussion that followed with that same individual. I know from other discussions with him that he feels that any thing other than investing in gold and silver at this time (or perhaps undervalued real estate), is gambling. He says all the markets are manipulated and that the-powers-that-be can take the markets any where they want, thus implying that any analysis of fundamentals is gambling.
He is very adamant about fighting the bankers (“fiat masters”) and not let them take his savings with their casino markets.
======================
> Further, I can’t understand why you keep insisting that only your
> scenarios are true and as if there could not be any alternatives or
> even totally different outcomes. Timing is an important part of it.
> I’m not saying your scenario is impossible, but not definite and sure
> enough to bet money on it in a way that is materially different from
> gambling.
Did I insist that only my scenarios can be possibly be correct?
What bothers me is that you called Pettis an idiot, without even knowing what his evidence is.
And you said if someone can’t predict a week into the future, thus they can’t predict what can happen within 2 – 3 years. That is illogical. It is sometimes easier to predict over the long-term, than the short-term. Silver is an excellent example. We can predict it is going higher, but we can’t do so reliably over the short-term.
I would like to have intelligent discussion.
On intelligent discussion and on another topic, I still assert that you must deal with the power vacuum created by non-fractional reserve, before you can assert that a pure gold money system is sustainable. History has shown that the power vacuum always sucks in the masses with politicians’ infinite promises. To be credible, you have to propose some method of eliminating that power vacuum that hasn’t already been tried and failed numerous times throughout history. Your idea of allowing loans only to some people doesn’t address the power vacuum. Remember the Second Law of Thermodynamics (Coase’s Theorem) assures us that nature will always maximize entropy and thus not leave any vacuums laying around forever.
He has made several comments to me about China being strong:
1. they work very hard
2. they save a lot and sacrifice
3. the ghost cities are not significant
4. many poor so growth demand is insatiable.
5. the overbuilding will be utilized by poor once it is repriced (actually this was my point to him supporting a price crash)
My rebuttals summarized:
1. 1000 people with spoons can dig a canal that one guy can do with a backhoe.
2. Savings was squandered in unoccupied/underutilized (unproductive) real estate development either as owners, by depositing to banks which loaned it for such, govt spending on lavish infrastructure, and yuan debasement (negative real interest rates).
3. 64 million unoccupied units. Also, 50 sq. ft. of high rise floor space for every breathing human in China, including babies, elderly, the poor, and those in the provinces where the buildings are not. China’s cement consumption per capita is 3 times what any industrialized nation before experienced (at any stage) during their industrialization.
4. Supply meets demand at the cost of production + profit, not at some fantasy of any “free” price. There is an opportunity cost for investing the country’s savings in production which the poor can’t afford. As Pettis pointed out, high-end infrastructure can’t be made productive by people who haven’t climbed the ladder in their knowledge value, i.e. Google and Apple employees generate value per person that can afford to drive Lamborghinis, but the person who bolts wheels onto vehicles can not. Tangentially, I would argue and try to find more evidence that China’s model has retarded the development of the knowledge industry in China (another deeper discussion would follow), thus there are (probably huge) longer-term costs to the imbalances their model created.
5. The repricing is the crash we are expecting. That is the realization of the lost savings.
===========
I would like to expound on why supply must meed demand at the price of production + profit.
We can’t promise something for free, which is not free. Politicians promise to give for free, and the result is jail. For example, traveling from Makati, Manila to the airport, one can choose to either drive their vehicle on the traffic snarled free govt roads with a travel time in excess of an hour, or choose the “Skyway” private toll road for $0.50 and reduce travel time to 5 mins. The govt attempts to give away something that is not free for free, and thus demand exceeds supply and everyone is stalled in traffic gridlock jail. That gridlock is the antithesis of increasing degrees-of-freedom.
How ironic that China did exactly what I warned against in the prior comment and tried to give away road use for free and the result was gridlock and thus everyone suffered:
http://www.zerohedge.com/news/2012-10-01/china-stimulates-economy-suspending-road-tolls-golden-week-millions-end-stuck-traffi
(I especially like the chosen image on the above linked page)
Btw, I want to give proper credit to learning the concept of not being able to give away for free that which is not free from Jason Hommel (silverstockreport.com), which he said to me when we were discussing designs for peer-to-peer networks for the internet:
http://forum.bittorrent.org/viewtopic.php?id=28
How about the effects on shipping?
Being new to this blog, I see generally that there is a fear China has too much manufacturing capacity and too many hard commodities. Why hasn’t anyone brought up the idea of de-pegging from the US dollar and having the Chinese slave laborers make Chinese goods for themselves and the rest of the Asia-Pacific region could do the same.
In other words, the slaves make themselves their own goods instead of making goods for nations that counterfeit their own currencies exporting inflation to the slaves that feed their appetite for those goods. Ugh.
Ah….let me see….4 BILLION hard-working consumers in Asia-Pacific….1 BILLION lazy consumers in Western hemisphere who counterfeit their currency instead of working. Which is the better marketplace?
Ah…seems like a no-brainer to me. How is this KEY point being missed in this blog? Why is Michael Pettis missing this point, which to me, seems so obvious.
If I hear that tired old argument that the East needs the West to buy their goods via a counterfeit currency…I’m going to just start laughing. We might as well bring back slavery in the USA because the slaves need their plantation owners to buy their goods and keep them employed. Yeah, right!
I would be happy to address the point if you weren’t so incoherent. What exactly is your point? Are you arguing that de-pegging from the dollar would impact domestic consumption. This certainly not the “key point”, as I have argued many times, and it has been discussed thousands of times on this blog. Perhaps the silly and gratuitous references to “slaves” is clouding the issue.
I think he makes a valid point in retrospective only. Had the Yuan not been pegged, global growth could have been more balanced and sustainable.
It is not clear whether he realizes it is too late to get rebalancing without collapse:
http://www.mpettis.com/2012/09/23/can-china-increase-export-competitiveness/
I don’t know why he thinks you haven’t been calling for rebalancing, since it appears to be mentioned in every one of your recent articles on China.
I don’t know why he thinks a walled off economy for developing countries and China, would eliminate China’s imbalances without implosion of manufacturing. Perhaps he thinks the developing world could grow very fast in such an economy, and displace all of China’s overcapacity and imbalances, even while losing the developed country demand, which is extremely large chunk.
“Perhaps he thinks the developing world could grow very fast in such an economy, and displace all of China’s overcapacity and imbalances”
Exactly. See USA post WWII for an example of how fast that can happen. America had a LOT of hardworking people back then. China, India, Philippines, etc…do today. I’m sure they love to buy things as much as any “developed” nation does. With a weakening US dollar, and strengthening of Asia-Pacific currencies, I see the turn-around being really quick.
Removing the western (debt-based) consumption would first cause a crash.
I agree with you that eventually the only solution is as you say away from debt-saturated western consumption, but don’t you agree that first it will involve an implosion of the global economy?
(you did not propose some smooth phased transition, which would be unrealistic as is of the potential scenarios for a smooth phased of China’s imbalance…and is the reason I say China is worse than Pettis expects, because economic models don’t transition, rather they run for as long as they can then they avalanche collapse)
I agree that the rebalancing is global and interconnected (China’s mercantile model and imbalance supported and was supported by the western debt imbalances).
If we had done that rebalancing in 2008, we might have avoided some of the nasty outcomes that are may be unavoidable now (hopefully not WW3).
Whoops. Sorry. You misunderstood my slaves comment. I am arguing AGAINST slavery in this case. I am just so tired of the US media brainwashing about how “China needs the US” so I wanted to make it clear to the Americans reading your blog, they should not be so stuck on that chant.
Chinese laborers working 6 days per week, 10 hours per day, just so they can see the widget they are making being shipped to a nation where consumption is directly related to debt…well it is just an unsustainable model. Insanity really. America exports inflation and imports slave labor goods. It’s not fair. Foxconn riots prove my point.
Why not let the 4 BILLION hardworking laborers be the market for their own products? They are consumed with consuming just like all humans are. They are only lacking purchasing power. By de-pegging at an accelerated rate, creates accelerated earning power for the Chinese and decreases the costs of raw goods that need to be imported to make the things they will soon buy for themselves.
And I’m sure you have noticed, China has done currency swap deals with literally dozens of countries so they can trade in their own currency in preparation for not being a slave to the US dollar.
How long do you think it would take for the yuan to take over the role of the reserve currency of the world IF the need should arise quickly (hyperinflation in America)?
IF that happened, then the Chinese government can have fun as one member of the world reserve currency status which would allow them to run up their debt and deficits creating even more demand and GDP growth in the coming decades.
You do recall how incredibly fast America turned its manufacturing of bombs into washing machines post WWII, right? So why in the world couldn’t China turn their attention just as quickly to their domestic market and create products they will buy for themselves?
That depression forecast after WWII never happened because free markets quickly saw the chance to go from bombs to washing machines. I’m sure the Chinese could do the same.
Don’t you think this scenario has/is playing out over the last decade? So why all the concern about a “collapse” in hard commodities? Temporarily…I’ll give you that. But I have a strong feeling that won’t last long. Maybe it won’t even happen at all.
The Chinese, holding $3 TRILLION of US green paper, are not stupid and they don’t want that to vaporize. So I am guessing, they will turn their manufacturing juggernaut around slowly so there may never be a commodity price collapse like you predict.
So, given all my arguments which I hope is less cloudy…When you forecast a commodity price collapse by 2015…are you just meaning temporary?
PS Man hard to make a coherent point in such a little box…At the end I meant to say, China is not stupid. They can do a lot of “developed” nation ponzi propping with $3 TRILLION in cold cash. They can keep the US/EU/UK/Japan ponzi going WHILE they are nurturing their own domestic market. So perhaps there won’t be a commodity collapse ever. 4 BILLION people increasingly buying stuff would prevent that.
Having too much cash is an indicator of a problem– the economic model is not deploying capital optimally. China doesn’t even have a choice as to where it places the “cash”, so it isn’t really cash and isn’t liquid. Pettis explained it:
http://www.mpettis.com/2012/09/23/can-china-increase-export-competitiveness/#comment-16629
The developing world had this pent up demand for decades, so its existence is not a sufficient argument for bullish on commodities prices. Besides commodities prices having been trending downward for 200 years due to technology increases (in spite of the 98% debasement of the fiat currency in past century).
The overriding economic fact at this time is the massive debt saturation of the globe, and thus the massive misallocation of capital that accompanies it.
Thus look for defaults and re-balancing as the overriding theme going forward.
Agreed that eventually all those in the developing world will see a raised standard-of-living, but there isn’t much time remaining in this debt saturated global model. We will most probably need a global reset first.
China doesn’t have a model to drive to a prosperous future. Their model is extremely imbalanced and must be changed.
I Agree that the China growth model is flawed. The rapid growth has been at the cost of other developed economies manufacturing bases, and China has taken most of the “Low hanging fruit” and must now look to other ways to grow.
That being said, I believe that the consumer recession in the USA and Europe has been so severe and lasted so long, that any gradual renaissance in demand in Europe and USA will buoy demand for commodities worldwide. I suggest a more moderate view on a slowing China and reviving USA and Europe will create more balanced forward growth in commodities, and not a collapse.
Everyone is expecting the global negative PMI to bottom, and various metrics indicate they are pinning their hopes on central bank bond buying (and I assume hoping for massive stimulus program in China).
Government spending (including local & state) is in excess of 50% of GDP in Europe and the USA. The PIIGS are being forced to implement fiscal cuts and/or taxes in order to get ECB support for their massive debt-to-GDP ratios. The USA is currently headed for a fiscal cliff on Jan. 3 (reduced govt spending and increased taxes). This is not just conjecture, the GDP is shrinking in the PIIGS economies, and unemployment is rising. There is no end in sight yet, while total debt is being increased.
Only massive government spending increases can reflate the western consumer, because the real wages are declining. The bond buying programs (QE3 and Europe’s OMT) do not transmit to the consumer, only to asset bubbles (because the printed money is transmitted into hands of the wealthy).
China can’t do a massive stimulus, because food is 30% of their inflation index, and I’ve read that many people in China know the official statistics are already lying about their inflation rate. Also the only significant sector of the economy is fixed capital investment (since nearly everything is a derivative of it due to multiplier effect, probably even much of the services), and this is already in a bubble that is popping (and it probably can’t be reflated even if they wanted to, and I am speculating there is chaos now in China’s leadership such that they’ve lost control and it is “every man for himself”, i.e. the free market has asserted itself).
Thus there can not be a rebound in consumer spending. We are entering the end game of the global crash.
Volatility is very low right now. This appears to be the eye of the hurricane from the 2008 crash. I think the back side is going to be much, much more chaotic and horrific.
Debt deleveraging has not yet occurred due to the stimulus and central bank bond buying programs, and this global debt load is perhaps the worst in history (and then add the $quadrillion in derivatives on top).
Politically the government spending increases have probably topped out in both the USA and Europe. The central banks will drive asset bubbles and inflation in non-discretionary consumables, until the market walks away from bonds to gold. Then interest rates go up and the financial system resets.
Sources can be cited provided upon request.
i like your hurricane analogy, have not heard that one before.
david– China growth model flawed? Why blame them for the “developed” nations laziness? The US/UK/EU (not so much Japan) directly choose to borrow instead of work. It is their “borrowing” model that is flawed.
Reviving USA and Europe..huh? How? More unemployment checks? More disability checks? More food stamps? You mean the Nancy Pelosi Economic Growth Model of every $1 spent on welfare results in $2 of GDP growth? Or the Paul Krugman Economic Growth Model which states for every $1 of spent on digging a ditch and covering it back up, you can grow GDP $2?
I’m betting on Asia-Pacific as the balanced growth going forward. Once you give them a raise by dumping Bernanke Bucks, they will become the new zombie shoppers of the world. Remember there are 4 BILLION of them vs 1 BILLION in the developed world. –MikeM
It is refreshing to find a website that reflects my own views. Of course, I will not pretend to be able to write so clearly.
In the 1970′s, I studied how Japan manipulated raw material suppliers so as to increase their production unnecessarily. Essentially, they paid very high prices for a few years so as to enjoy decades of prices that were marginal for the producers. It was largely organised by their MITI. Some time ago, I realised that the Chinese were – in a planned or unplanned way, I don’t know – doing something very similar.
I think it is well-worth one’s while to study long-term trends. I do not have a source of iron ore prices. Anyway, the quality of the iron ore has improved remarkably in recent years. As a schoolboy, I visited the Dorman Long iron-ore colliery in Northamptonshire in the 1960′s and their iron ore was vastly inferior to the material coming out of the Pilbara and Brazil today. The best I can do is to look at the prices of scrap-steel – a good indicator of the price of iron ore as it is an excellent substitute.
The following webpage suggests that its current price is $400/ton
http://www.steelonthenet.com/pricing_history.php
I have put pictures of the scrap iron ore prices from 1900 to 2010 (from the CRB Commodity Yearbooks of 2005 and 2010) here:
http://fotosaver.com/ae/steel1.jpg
http://fotosaver.com/ae/steel2.jpg
I believe that 2 US cents in 1913 (when the Fed came into being) is equivalent to one US dollar today. The price of scrap steel was around $10/ton in 1913 – equivalent to $500/ton today.
However, in 1990, before the China boom, the price of scrap steel was $100/ton (say $200 in today’s money). This leads me to suspect that the price of steel will drop to $200/ton in the next 12 months. I also expect the FOB price of Australian iron ore to drop from around $100/ton to $50/ton. Even the most efficient iron ore miners are going to be losing money.
Here is a ridiculous forecast from the website I used above:
http://www.steelonthenet.com/scrap-prices.html
The fact that they prefer a flat forecast for the price over the next 3 years indicates that they have forgotten their history.
Alfred Nassim
Melbourne
I am trying to determine if China’s rebalancing process will be worse (i.e. a consumption crash) than the Professor thinks, because this would be catastrophic to hard commodity prices.
Professor Pettis mentioned some precedents for China’s unbalanced growth model, and noted that in all them growth eventually stopped:
http://www.financialsense.com/contributors/michael-pettis/2011/10/21/chinese-malinvestment-is-worse-than-most-people-think
However, professor in that speech you also bet that China won’t collapse within 5 years.
QUESTION: Is your basis the past examples you cited, e.g. in the audio portion of your speech you explained that Japan’s GDP declined but its consumption did not (so it achieved re-balancing of consumption share of GDP without consumption collapse)?
Have you looked for precedents where the model was driven significantly by an export trade imbalance, and the exports were to countries that all had actuarial debt-to-GDP ratios exceeding 200% (as we do now)?
http://www.financialsense.com/contributors/charles-hugh-smith/2011/11/14/the-world-is-drowning-in-debt-and-europe-laces-on-concrete-boots
You explained that the mercantile model Yuan peg (and thus trade imbalance) is one of the main 3 mechanisms that transfer wealth from the consumption sector to the misallocated fixed investment sector.
I think this current global debt contagion means both the current extremes and coming downsides are exponentially greater than precedents where the global contagion did not exist. You did note that Germany started WW2 early, because they were facing a debt collapse. China has 64 million empty high rise units, and 50 sq.ft. of floor area for every living citizen. You argued that the misallocation likely started in the late 1990s, and accelerated after 2002. Without the debt bubble in the west, this could not have accelerated.
This is one way I argue that you are underestimating how bad the situation is.
Do you think China won’t crash, if Europe and the USA do? If no, then do you think that the USA and Europe won’t crash and why? How can Europe and USA lower debt levels without crashing? Even the $trillions they’ve printed thus far has not decreased public sector nor consumer sector debt levels, and Civilian share of labor force has only declined (and thus real wages).
I see only a massive depression ahead. How do you see otherwise?
Some might argue that as a percent of GDP, China’s net exports are less than 10%, while total exports are 30%, but I assume some the imports are consumed in China. And I assume that some consumption is driven as a multiplier effect to support consumption and the subsidies for the fixed investment sector. So isn’t China still highly leveraged to global consumption?
Another way I will try to argue that China’s future is worse than professor Pettis expects, is if there is/are precedent(s) that meet the current situation as I described in my prior comment, then try to find one where consumption was reduced to 34% of GDP by the corrupt model, there was global frenzy to relocate into that country (foreign direct investment) thus increasing the debt-load of the export markets and thus making the rebalancing vulnerable to capital repatriation, and where the state had such iron-fisted control over free-speech and media to prevent organized dissension.
I think it will hard for you to find a precedent that has such a set of conditions that could facilitate extreme levels and the global contagion.
Typo: “And I assume that some consumption…”
Correction: “And I assume that some of exports’ share of GDP…”
I hesitated to write “exports’ profits” (and thus share of real GDP) since there are apparently very extensive subsidies from several mechanisms. And thus I am thinking the information of PBoC is so muddled, they may not even know what the economy is doing.
Professor also wrote somewhere that lately interest rate cuts were being directed from the party to the PBoC, thus I can wildly speculate that any political paralysis lately could possibly cause paralysis at PBoC.
Perhaps this comment is a little off-topic, but consider the political implications of a dramatically lower growth rate in China. The Chinese Communist Party appears to believe that, without rapid economic growth, there will be labor unrest that it may not be able to control. I am not a deep student of Chinese history, but I believe that emperors have been overthrown by popular unrest in the past. Are the CCP’s fears justified? How will the relationship between the Party and the people change if China suffers an American-style recession or worse?
You say that firms use their commodity stockpile’s increasing value to finance loans. That sounds a lot like home owners refinancing through extra equity earned when their home value rises. This lasts as long as prices increase. If they can’t refinance because of stable or decreasing market, home owners either short-sale, default or do an extreme form of belt-tightening to pay their mortgage.
What happens to these firms when commodity prices stop going up? Do they do likewise as the home owner? If they were forced to sell-off their stockpiles they will certainly do so at below market price. This should cause further downward pressure on prices.
China is a serious ponzi scheme in what is currently a very competitive global market for ponzi schemes. Hopefully I won’t be around when the brown stuff really really hits the twirly device but I have told the kids and the grand kids to be very very afraid. Darwin Awards will predominate and the Nobel awards will sink without trace. Buy a one-way ticket on Richard Branson’s new service to Uranus.
It is now almost 45 days from the time the post was uploaded and prices of Iron Ore have crashed further; the signs of rebalancing is more pronounced.
I was particularly attracted to the point on collaterilization, where Michael mentioned about using stock piles as collateral. This has far reaching implications as prices drop so significantly. In monetary terms for Aluminum and Copper together we are talking of 1 Million Tons of stock pile each, in monetary terms that would be in the range of $2 Billion and $6.6 Billion. For any significant change to happen on prices, one would have expected the pile to be liquidated, instead we see more going into it.
Any comments on this Michael?
Procyon Mukherjee
the article is interesting food for thought. It addresses certain risks.
However, it fails to consider:
1. China has still a long way to develop. Just look at IMF report “China’s Impact on World Commodity Markets” on commodity consumption per capita. If you believe in a crash of China, then the author may be right.
2. commodity prices are often liquidity driven, more than supply and demand driven.
QE measures and low interest rates provide liquidity to the market that boots inflation and commodity prices. China has an interest to diversify from its high US treasury holdings, and it will diversify into commodities, among others.
Hi, I think your blog might be having browser compatibility issues.
When I look at your blog in Firefox, it looks fine but when opening in Internet Explorer, it has some overlapping.
I just wanted to give you a quick heads up! Other then that, very good blog!
Michael,
Just to note that the modern crude oil price regime came into existance in 1987 and is centred in the futures markets which, almost needless to say, created the substrate required for speculative price runs and drops [as opposed to the earlier oligopoly and cartel pricing].
Taking creation of the GSCI, newer capital asset allocation models and loopholes in the 2000 CFMA into account as well as actual demand, one can make an argument that the price run to $147 was progressively more speculative, increasingly beyond fundamentals.
Which seems well born out by the quite sharp decline in 2008 [the type of move familiar to 'older hand' commodity traders]
http://inflationdata.com/Inflation/images/charts/Oil/Inflation_Adj_Oil_Prices_Chart.htm
Just thought I’d emphasize this [as I had in '08] while simultaneously agreeing with most of your post.
Juan
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