International | Aug 10 2011
– Analysts report back from China
– Steel production powering along
– Property developer shifting to lower tier cities
– Credit tightness, power cuts and high inventories are of little concern
By Greg Peel
At 6.5%, China's July's CPI reading is above the 6.4% result in June and the highest reading since June 2008's 7.1%. The result gave the Australian market the jitters yesterday morning and killed off an initial rally from 5% down until traders realised that the bulk of the rise was due to a 14.8% rise in food inflation, up from 14.4%, and that was mostly because pork prices are up 56% year on year. Economists have been expecting Chinese inflation to peak around now, and the result showed Inflation ex-food had actually fallen. Pork prices are also expected to stop soaring.
The PPI was also higher at 7.5%, up from 7.1% in June, although industrial production growth fell to 14.0% in July from 14.6% in June (15.1% expected) and retail sales growth fell to 17.2% from 17.7% when 17.5% was expected. The latter figures indicate a slowing in China's domestic economy, but they should given Beijing's tightening measures. What the world was really worried about, in this time of turmoil, is more tightening from Beijing to fight inflation. However (a) Beijing is unlikely to act foolishly given the turmoil and (b) the inflation result is not "bad" enough to prompt swift action. All up, the data set might be considered a "good" one right now.
Moreover, oil is around 20% cheaper than it was a couple of weeks ago and most other commodities have tumbled in price as well.
When the Chinese data were released into a hyper-fragile market on Tuesday, it was as if the last boat had just left the burning dock as far as some investors were concerned. Without China, what has the world, and particularly Australia, got left? But step away from the immediate scene to assess the wider picture and Australian investors have some cause to be less stressed. Postcards from China have been surprisingly upbeat.
Analysts from both ANZ and Macquarie have reported this week on independent fact-finding missions to China from which they have now returned. In particular the analysts were interested in the state of the integral Chinese steel industry and its relationship to the booming Chinese property market, which some fear is under threat. Talk of tighter credit conditions along with rolling seasonal power cuts has caused concern in Western markets.
ANZ visited mainly large steel producers and found they remain mostly unaffected by such matters. The industry is running at close to full capacity and steel production for the first six months of 2011 was up 9.2% year-on-year. Annualising the numbers suggests a 12.2% increase in output in 2011 to 701mt – well up from consensus forecasts of 660mt. Demand is strongest in long products used primarily in real estate and heavy construction projects, while flat product output is more subdued as demand growth for autos, ships and white goods eases.
Macquarie visited one large steel producer in Hunan, where the analysts found it is construction in the lower-tier cities now driving steel demand. Macquarie's findings mirrored those of ANZ including the split between long and flat products, although it was noted that while growth in the demand for flat products had slowed, the increase in the base levels over the last few years means absolute demand is still substantial.
The biggest problem facing larger Chinese steel producers at present is not credit tightness and power supply but the high cost of iron ore and coking coal. China is learning to cope with the new quarterly price settlement system but high raw material costs are seeing profit margins squeezed to a very skinny 2.8%. This reality belies the fears which have been building in Western markets regarding the current high level of at-port inventories of iron ore and coal. There were concerns of a glut.
ANZ points out that while port inventories have indeed grown, up 23% from the start of the year, consumption has grown to keep pace. Hence days-of-cover, which measures how long it would take to run out of inventory were no more to arrive, has only risen 2%, or one solitary day, to 47 days. On the other hand, inventories of steel stocks have fallen quite sharply, which ANZ concludes is likely a response to those skinny margins prompting destocking of existing product. Steel restocking in China usually occurs in the fourth quarter, but ANZ suspects this year may see an early push in the third quarter.
Credit tightness and power restrictions appear to only be impacting on smaller steel producers, ANZ notes. Larger state-owned facilities have their own power sources, can access foreign lending markets via Hong Kong, and otherwise have state backing. Beijing is trying to force consolidation of smaller enterprises by various means including imposing strict environmental restrictions, but these seem yet to have worked. Tight margins also mean producers are living “hand to mouth” on inventories. Domestic supply of raw materials is being keenly sought by smaller players producing lower quality steel, but the big producers of higher quality product still need to import higher quality iron ore and coal on seaborne markets.
Property development is the main driver of steel production, and here the world has also been very concerned about a property bubble-and-bust. Rumours have spread around the market of entire Chinese high-rise cities emerging overnight and remaining completely vacant given the incapacity of average Chinese to afford the new apartments. Beijing has been attempting to place limits on the number of investment properties able to be owned by an individual and has used credit controls to force developers into producing more social housing and less higher-end stock.
However, Macquarie notes reports from developers that the share of property buying, in the lesser Changsha region the analysts visited, on fundamental demand (owner-occupier rather than investor) accounts for around 80% of total sales. Developers in the now established coastal mega-centres of Beijing, Shanghai, Shenzhen and Guangzhou have been skirting Beijing's social housing rules by shifting their development to inland provinces where the rules are not yet as restrictive, and developers are planning to follow this strategy for some time yet, moving down the chain to third and fourth tier cities.
ANZ expects a catch-up in social housing construction in the next 6-12 months. The analysts note 2011 will see only around 6 million low-end units constructed compared to Beijing's 10 million target. Low-end housing is also lower margin, but it would seem Australian commodity producers have little need to worry about construction coming to a screaming halt in China.
Indeed, the picture painted by the travelling analysts appears to lean towards the more sanguine view of China's ongoing growth potential – that which cannot see how ongoing industrialisation and urbanisation process can provide anything other than strong long term growth – and away from the more alarmist fears of a property bubble, excess inventories, dangerous debt levels and rampant inflation.
I believe that while there is a lot not to like about general policy emanating from Beijing, in financial aspects I suggest there are many refusing to accept that Beijing has come a long way. And Chinese sovereign debt does not appear to be under any threat of downgrade.
One thing that was clear to ANZ is that Beijing and the state-owned steelmakers are responding to high raw material prices by continuing to look for opportunities to move up the chain through acquisitions and joint ventures. While Australian producers are clearly targets, strict but accepted Australian foreign ownership laws mean Africa and the Americas are where China is doing most deals.
The bottom line is that in this time of volatility, China is still robust.
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