China’s Property Market And Commodity Prices

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By Greg Peel

Commodity prices have taken a pounding this last month given a confluence of global factors. This has come at a time when Australian resource sector valuations have already been hit by tax fears. The simple fact is the debt crisis in Europe has led to budget slashing from all governments, including Germany's, as the weaker economies try to reduce debt obligations and the stronger economies contribute reluctantly to eurozone bail-out funds.

While Germany runs one of the world's larger trade surpluses, it still runs a fiscal deficit. Indeed, not only does every single one of the sixteen eurozone member nations run a budget deficit, every single one exceeds the ECB's limit of 3% of GDP. The closest anyone gets is little Luxembourg with a ratio under 5%. One wonders what the original “rule” was all about if the ECB has to date sat back and let it be universally breached.

While a weaker euro will provide a boost to the competitiveness of eurozone exporters, particularly Germany and France, it is inevitable that the European economy will face a contraction as all nations try to reduce their debt levels. When budgets are being cut and revenues are being directed to debt reduction, it means nothing is going toward economic stimulus.

While economic recovery and subsequent commodity demand from both Europe and the US has been tepid at best post the GFC, the signs had been positive. Asia, and particularly China, have been carrying the can since late 2008 but slowly the developed world was getting back on its feet. Fortunately recent manufacturing and housing data suggest signs are clearly improving in the US, because Europe will now drop out of the equation.

Which puts the global responsibility ball clearly back into Asia's, and China's, court. The problem is, however, that China is actually trying to slow its own economy right now, which is not exactly helpful. Indeed, given Europe's contribution to economic recovery post-GFC has been negligible and China's totally dominant, it is a Chinese slowdown the commodity market most fears. Europe might be China's biggest export customer, but it is China's domestic economy stimulus that is driving the ship.

Beijing has indicated that it wants to rein in its GDP growth rate from around 12% now down to 8%, and in particular it wants to burst the property bubble which has been driven by stimulus monies finding their way to speculative investors as well as genuine property developers. Given comparatively very low levels of mortgage gearing in China compared to the West, Beijing has no qualms in smashing the speculators and crashing the local property market as it will have little impact on the genuine home owner. Indeed, it will return house prices for China's new aspiring middle class back to affordable levels.

The problem for commodity markets however, is that new houses require lots of raw materials such as steel and copper. China's stimulated building boom has been a large source of global demand.

Global steel prices had been rising steadily prior to this month in the wake of big iron ore and coal price rises, but it's been a downhill trend ever since. Never mind Europe, “Beijing's moves to cool the property sector proved a turning point for the steel market,” a Macquarie analyst notes. “While we don't believe real demand has come to an abrupt halt, it does seem likely that the market has shifted to a destocking phase”.

Basemetals.com notes steel billet, mostly used in the construction sector, fell to 100-day lows on the London Metals Exchange on Friday night. The benchmark billet price fell to US$425/t representing a 31% fall from the April 8 high of US$618/t. The good news, however, is that price action is showing signs of stabilising.

As the steel price falls, one might expect a similar reaction in iron ore markets. Indeed, spot prices for iron ore delivered from India to China have fallen back to US$150-160/t, notes basemetals.com. Yet news out this morning from Rio Tinto ((RIO)) is that the company had secured a March quarter contract price from Japanese steelmakers near double the 2009 price, and that a similar offer has been made to China. Such a price hike matches earlier prices achieved by rival BHP Billiton ((BHP)) and indicates no price pressure yet emerging.

The point to note about property speculation, however, is that speculative demand is more about pushing up prices of existing properties rather than building new ones. It is the speculators that Beijing wants to smash, and hence the right sort of tightening measures should not impact too much on genuine builders, or their demand for raw materials.

Citi's commodity analyst Alan Heap notes speculation accounts for about half the Chinese property market. “As a consequence,” says Heap, “the impact [of tightening measures] on commodities demand should be relatively modest”.

There is a risk nevertheless, and that is that the aggressive tightening measures adopted by Beijing earlier in the year will affect a only a lagged response from the speculative property market, opening the possibility that Beijing will move too quickly to pursue even blunter measures which would impact on the real property market. On that basis, commodity demand would be impacted, and Beijing is unfortunately still a bit inexperienced at monetary policy.

Given housing accounts for a third of all Chinese fixed asset investment, Heap suggests a broad slowdown could even challenge Beijing's targeted 8% GDP growth, let alone the current 12%. But there is also good news.

Heap echoes the views of other analysts that while Western central banks and governments tend to make slow, measured policy changes, Beijing is more likely to jump all over the place. If it feared the Chinese economy were suddenly at risk of contracting too rapidly given policy measures as well as the European situation, a rapid back-flip is on the cards. Such a move would likely provide catalyst for a rapid Chinese property rebound, says Heap, given the level of pent-up demand.

In the meantime, Citi had already forecast slower apparent Chinese consumption in 2010 following the rush of 2009. The analysts had assumed a drop to 10% aggregate base metal consumption growth from 20% in 2009, with copper growth in particular falling from 39% to 9%. Such numbers reflect the level of inventory restocking undertaken in China last year.

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