Tag Archives: Agriculture

article 3 months old

Commodity Markets Robust

By Greg Peel

There were a couple of days last week where commodity prices seemed extremely vulnerable. Traders in oil, base metals, grains and even gold looked to equity markets for direction, and collapses sparked fears of economic slowdown and falling commodity demand. But as the equity markets bounced so did commodity markets, and in the current period of relative stability commodities have managed to assume some of their previously lost identity.

Adding to the return to calm was the presentation made by outgoing BHP Billiton CEO Chip Goodyear on the announcement of the company's record FY07 profit. Goodyear gladdened the hearts of commodity investors around the globe in suggesting that China and India would drive extraordinary demand for materials for decades to come. Goodyear's authority on the subject stems from his position as the CEO of the world's largest diversified miner. As to the impartiality of his predictions well - that's another matter.

Nevertheless, Barclays Capital cites Goodyear's words as an impetus for the return to calm. Equally as soothing was the news that Rio Tinto's (RIO) takeover of Alcan was far from in jeopardy, despite seized credit markets, given its US$40 billion issue of corporate paper closed oversubscribed.

As an investment asset, commodities are still a relatively new kid on the block. Given CDOs are relatively new as well, it would not have been all that surprising if investors had suddenly run away in panic from these similarly untested risk instruments. But that has not been the case. Barclays reports issuance of new commodity structures - investment instruments of varying nature that are linked to commodity prices - has continued to gain momentum unabated. Liquidity has been ample, and there has been no apparent contagion from the credit crisis. Investors that have sought to close out positions have been able to do so well above par.

Barclays notes oil has been particularly volatile, adding weather-related concerns to economic slowdown fears, but a return to supply/demand disfunctionality should see oil eventually head back northward even if if falls into the low US$60s first. Nor is Barclays convinced a few subprime defaults will upset the general global demand picture.

Grains have remained strong, and will continue to be so, says Barclays. Within the base metals complex, zinc, tin and lead have the best upside, nickel still looks weak, and copper and aluminium will be weighed down in the short term by inventory increases.

The gold story continues to be one of push and pull. Gold ETFs have hit record volumes as some investors have shifted into the supposedly safe haven. But there always remains the risk in these volatile times that another big sell-off in equities could spark another round of asset liquidation - gold included. Indian demand for metal has been strong, but a reduction in miner dehedging in the second half will remove some bullish support. Central bank selling remains a wildcard, as while analysts expect sales to dry up ahead of the September cut-off, they've been caught out before.

And no one knows what the reaction might be from certain influential central banks, concerned over the fate of their fiat currencies, if gold starts to push back to US$700/oz once more.

article 3 months old

Will China Now Export Inflation?

By Greg Peel

For the last few years the emerging markets boom has driven up commodity prices, particularly base metals and oil, to levels which have surprised even the most astute of analysts. The China story in particular has led to the commodity super-cycle - a secular shift in world commodity valuation that stepped-jumped expected average prices to much higher levels and blew away slow-moving analysts still clinging to anachronistic concepts of mean reversion.

As the world was coming off a period of extremely easy (some would now say too easy) monetary policy following the effects of the dotcom bust and 9/11, it was a given that strong global economic growth would force tightening phases and higher interest rates. However, in the earlier stages economists remained baffled as to why global inflation had not skyrocketed as a result of skyrocketing Chinese demand.

It soon became clear, however, that China was absorbing the imported inflation of higher commodity prices and recycling it back to the world as exported deflation. This is because the mass-production machine was able to sell particular everyday goods - from computers to mobile phones to fridges - at ever lower prices. While a pegged renminbi has made this possible, the bottom line is that the world has outsourced its manufacturing industry to emerging markets in which the average wage was significantly below that of so-called Western countries. Given the sheer enormity of the populations of the likes of Brazil, Russia, India and China (BRIC), those wages remain well below Western levels today.

And deflation has not just occurred in goods. India has given the world the notorious Mumbai call centre, allowing everything from insurance to phone plans to be sold at a lower cost to the provider.

Inflation has, nevertheless, been experienced across the globe, but not at levels that were initially assumed. That which the BRICs cannot provide, such as child care, financial market services and medical care for example, has dramatically increased in price. The world is paying a lot more for energy now, and food prices have become the latest to soar given a conspiracy of weather conditions and developments in biofuels.

Which brings us to China's latest problem.

As noted in "Chinese Inflation Runs Rampant" (Asia; 14/08/07), China has just recorded a 5.5% inflation figure for the month of July, precipitated by extraordinary food price hikes including China's staple, pork, which rose 45% in the month.

The Australian and New Zealand central banks, among most others, have been forced over the past two years to constantly raise interest rates against the threat of inflation in strong economies. These moves have been necessary (according to central bank thinking) despite the dampening effect of exported emerging market deflation. Now that China's domestic inflation measure appears to be out of control, how long will it be before Chinese deflation turns to Chinese inflation? Are we suddenly staring double-digit interest rates in the face once more?

No, say Macquarie Bank economists, but that doesn't mean the world should not keep a wary eye on Chinese developments.

For one thing, a lot of the rise in the pork price has had to do with an outbreak of a dangerous disease that has forced the destruction of many pigs. This has curtailed supply, and pushed prices higher. Once supply stocks can return to normal, and Chinese pig farmers rush to cash in on high prices, the situation should ease. Hence inflation should ease. Importantly, Macquarie notes non-food Chinese inflation in July was a far more modest 1.0%.

That is not to dismiss the fact that Chinese export prices have actually begun to rise considerably in recent months, matched by data suggesting US import prices from China have risen. Imports from China account for about 14% of all imports to both Australia and New Zealand. China is no longer having the same deflationary effect it once had.

But even these numbers are divergent from the trend, say the Macquarie economists. There should be some reversion and hence there is not an immediate concern for our local economies. But nor should we remain unwatchful as "tradeables", such as that which China readily exports, account for some 45% of our CPIs.

There is no doubt that the Chinese figures are more than just an aberration. The price of eggs in China also rose 30%, just quietly. There is no chicken disease outbreak at present, as far as we know, and although Chinese authorities are suspicious of price collusion there is a simple reality that surging global ethanol production has forced up the global price of grains at a time when drought and flood has hampered the supply side. Chickens are fed grain - hence higher egg prices. The same is true for pigs, as well as other meat sources. Nor are Australia and New Zealand immune to similar effects on the supermarket shelf.

Food aside, slow but constant moves by Chinese authorities to revalue the renminbi will only make all Chinese export prices higher. Indeed, it is anticipated that incremental currency moves will systematically wipe out a lot of Chinese manufacturers who are already trading on paper thin margins. A reduction in the supply of goods must also force up prices. Macquarie notes that if the price of goods from China starts rising in any "meaningful" way, inflation expectations would start rising at "a more rapid clip".

Next step, much more aggressive monetary tightening.

article 3 months old

Chinese Inflation Runs Rampant

By Greg Peel

If there was one thing Chinese authorities were afraid of, it was that surging 11.9% economic growth would bring with it a consequent surge in inflation. As food prices have jumped across the globe, nowhere else have they been more felt than in China. This is particularly politically sensitive, as it affects China's vast low income population most specifically.

China has been at pains to fight against the economic bubble, without actually forcing a hard landing. Interest rates have risen three times in the past six months, and one to two more increases are expected by year end. But when the currency is artificially pegged at an undervalued level, and real interest rates are negative, inflation is always going to be a problem.

From June to July China's inflation rate jumped from 4.4% to 5.6% - the highest monthly rate since February 1997. Within that jump were a surge in pork prices of 45.2% and eggs of 30.6%. Pork is a staple of the Chinese diet.

The country has been suffering from its own version of foot & mouth. Pigs have suffered from an outbreak of blue-ear disease and thousands of animals have been destroyed by authorities. However, pork (and egg) prices have also been affected by higher feed prices, which in turn have been driven by surging global grain prices. Chinese pork is a victim of the US subsidy of ethanol.

A Chinese statistics bureau spokesman tried to put a brave face on the inflation increase, noting that the problem was only really in food. Prices in clothing and other non-food goods have risen only 0.9% from July last year. Industrial product prices and services prices remain relatively stable, and the bureau is not expecting overall prices to rise sharply. Consumer prices year to date rose 3.5%.

Chinese authorities are providing free vaccination against blue-ear, but are also making investigations as to whether the food price surges may involve any price collusion amongst farmers and food companies.

The government cannot afford to allow the Chinese economic machine to roll on and create a western-style, ever-widening gap between the new haves and the disadvantaged have-nots. China is not a stranger to the odd revolution.

FNArena has reported in the past that even the most bullish of equity market analysts suggest that if one thing could derail the bull run (even including a credit crunch) it could be high food prices in Asia.

article 3 months old

Soft Commodity Prices To Underpin New Zealand’s GDP Growth

By Chris Shaw

The New Zealand economy continues to post solid growth despite high levels of official interest rates, but the good news according to Macquarie Equities is this solid growth should continue in coming years.

The broker’s view is based on a positive outlook for soft commodity prices, which are important for the Kiwi economy as dairy, meat and forestry products make up 40% of its total nominal exports.

Of the three dairy has been the outstanding performer, having risen 7.8% month-on-month in July to be up more than 110% year-on-year. In the same period global forestry prices have increased by around 17%, though the broker notes the impact of this for New Zealand has been largely offset by its strengthening currency.

The beef and lamb sectors in contrast have found the going much tougher, as the small increases in prices in recent months have been more than offset by currency appreciation.

The broker sees scope for further price improvements in this sector though as lamb prices should climb thanks to a combination of lower Australian output as herds are rebuilt following the drought and falling global production on the back of EU subsidies. Forestry prices are also expected to push higher as supply falls following a decision by major exporter Russia to increase its export taxes. 

Dairy prices on the other hand are tipped to correct from recent highs but the broker expects prices will continue at relatively high levels for some time. This should produce solid returns for several more years, assuming the New Zealand dollar depreciates somewhat from current levels.

The high prices are attracting more farmers to the dairy market and this should show up in both higher output and higher incomes levels for the farmers themselves, the combination suggesting overall GDP growth will continue to be solid.

article 3 months old

A Strong Economy Need Not Mean Rising Inflation

By Greg Peel

Mind the output gap.

That's the advice from the economists at the Commonwealth Bank. Comm Research suggests that a strong Australian economy coupled with low unemployment will not necessarily lead to uncomfortable inflationary pressure. Yet this is precisely what the RBA is concerned about.

It stands to reason that if business is booming, and everyone has a job, there will be upward pressure on wages which will in turn affect upward pressure on the prices of everything from houses to bananas. This is classic demand-side inflation. While there has already been upward pressure on prices which have led to recent interest rate rises, driven largely by strong global commodity prices, the RBA has been somewhat surprised by the lack of an obvious jump in wages in a virtually "fully" employed economy.

But the demand-side will only provide an inflationary influence as long as it outruns the supply-side. The price of a widget will increase if widgets are highly sought after and there's not enough to go around. But if widgets are highly sought after, and widget makers can comfortably increase their supply, then there's no reason for the price of a widget to rise.

Comm Research makes note of what has been a common theme in this protracted commodity price rally - the world has been caught short by the rise of China and other emerging economies and has had to scramble to bring capacity up to meet the step-jump in demand. This is not an overnight phenomenon. It is clearly evident that despite the enormous surge in commodity prices, resource-rich Australia has still struggled to post much more than a flat trade balance to date. There have not been enough existing mines and oilfields to provide production enough to satisfy demand. There are major constraints at rail and port facilities. No matter how much they want to, resource companies have not been able to get enough "stuff" out to the buyers in any expedient time frame. As a result, the value of the commodity price boom has not shown up in the terms of trade in Australia when adjusted for the limitations on sales. And we keep importing more and more goods as Chinese deflation brings the prices of imports down.

But while Australian industry may have nodded off on the couch during the demand-poor past decades, activity is well and truly back in full swing. Comm Research notes private investment spending has run at between 6% and 17% growth over the past four years, and public spending has grown at 7-9%. Recent state budgets suggest there is plenty more capital works spending to come.

"The bottom line is that our capital stock will grow at the fastest rate seen since the 1960s," the economists suggest.

While the world is largely in agreement that there is no end in sight to the China story (which includes other emerging economies) and as such demand is unlikely to falter, analysts have been suggesting for the last couple of years that the supply side will surely catch up. Analysts have been constantly pushing the magical catch-up date out to the future as all sorts of problems have emerged in the catch-up, ranging from the capitulation of old machinery to extended worker strikes. Nevertheless it's been all hands to the pump, and catch up the supply side soon will.

In Australia, as in most of the developed world, the catch-up problem has been further exacerbated by a simple lack of workers, be they professionals or general hands. At 4.2%, Australia's unemployment rate has fallen to its lowest in thirty years, suggesting employment is close to "full". That is, everyone who wants a job already has one, and as such if you open a new mine or build a new factory, who are you going to get to man it? In the meantime, this period of high commodity prices may well pass us by. The only option left open is to offer a higher wage than the next company while profit margins provide such an opportunity.

This is exactly what the RBA has been worried about. If wages grow as a result of lack of labour supply then this not only increases the cost to industry (thus pushing product prices up) but also puts more money in pockets to be spent on buying "things". Ergo, Australia suffers wage-led inflation. However, the RBA has been surprised of late that evidence of such wage rises has not emerged.

Again, Comm Research turns to the supply side.

Australia's immigration rate is now at the highest it's been in fifty years, and an increasing proportion of those immigrants are "skilled". Labour force participation is at a record high. This means that there are proportionately more Australians sticking their hand up for a job. There are an increasing number of single parents who need to work. There are an increasing number of families who need two incomes in order to pay the mortgage. There are an increasing number of seniors remaining, with encouragement, in the workforce beyond the traditional retirement age. There are more welfare recipients being required to work for their benefits. And the birth rate is growing modestly, so there are more children to ultimately send down the mines.

Thus when one considers the level of unemployment in Australia, one must consider that housewives, for example, are not counted as unemployed. Thus a whole group of individuals can join the workforce without moving the unemployment figure, and the increased supply will help to alleviate wage rise pressures.

The conclusion is thus that with the supply side rising to meet the demand side, inflation is not as much as a given as might otherwise appear the case. Comm Research also notes that with capital spending growth running ahead of labour force growth, the likely result is increased productivity. This is another inflation-friendly development.

The economists also make note of the "output gap". Over to Investopedia.com:

"An economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity. There are two types of output gaps: positive and negative. A positive output gap occurs when actual output is more than the full-capacity output. Negative output gap occurs when actual output is less than full-capacity output.

"The measure compares the actual GDP (output) of an economy and the potential GDP (efficient output). When the economy is running an output gap, either positive or negative, it is thought to be running at an inefficient rate as the economy is either overworking or under-working its resources. Economic theory suggests that positive output gap will lead to inflation as production and labour costs rise."

As the graph below indicates, Comm Research is forecasting the output gap to move into negative territory in the next few years. The result is that Australia's economy should be quite able to remain strong without there being a fear of rampant inflation to spoil the whole ball game. And as such the RBA need not be looking at a long period of monetary policy tightening.

There are risks to this scenario however, Comm Research notes. As Australia's housing boom has retreated, so has investment in property. Hence we are undergoing a rise in rents as supply, in this case, is failing to keep up with demand. This will impact on inflation until such time as property investment can catch up. The other concern is one of FNArena's favourite subjects - food prices. If it is true we are witnessing a secular jump in food demand and prices, then this will also be inflationary.

article 3 months old

Are We Facing A Secular Food Price Boom?

By Greg Peel

If you live on the east coast of Australia you will no doubt have come to the conclusion that the weather has gone crazy. While Australia is known as the land of drought and flooding rain, it would seem the motif has been taken a bit too far of late. Recent news broadcasts, for example, have juxtaposed reporting on the cessation of irrigation access in the parched Murray-Darling system, while at the same time showing scenes of the Hunter Valley and Gippsland underwater.

Whether or not this has anything to do with global warming is by the by. The reality is the price of fresh food in the supermarket has skyrocketed of late as livestock and crops are dying of thirst one minute and being washed away the next. However, fluctuations in food prices are an age-old phenomenon. It is a fact of life that good seasons follow bad, and prices rise and fall as a consequence. That is why food prices are removed to arrive at a "core" inflation measure. Short term volatility in food prices will otherwise only ensure misleading short term volatility in the CPI measure.

On a global basis however, all focus is on the most staple of foods - the grains. Grain prices have also been skyrocketing of late. A lot of this has to do with, or at least has been sparked by, drought or flood conditions across the globe - from drought in the food belts of Australia and Europe to ill-timed downpours in the US bread basket. But there are two other elements that have become significant factors in the grain price surge - biofuel production and changing food consumption patterns in Asia. The production of ethanol has led to a reduction in acreage being given over to food production, which in turn has pushed up the price of remaining grains, and, as a consequence of feed costs, meat as well. At the same time, wealthier Chinese and Indians are now demanding a diet that includes more consumption of meat, as well as embracing other Western-style staples.

As a nation blessed with self-sufficiency in food production (we only import 10%), Australia is indeed a lucky country. The problem is however that Australian food is a huge export market. We export, for example, 60-70% of our beef and 60-70% of our wheat. Then there's our fish, and our wine, and so it goes on. The price Australians pay at the supermarket is now inexorably linked to global food prices. Thus even if the weather were to return to some sort of normalcy, we cannot be locally ensured of returning to lower food prices if global influences are still suggesting higher prices.

But thinking locally for the moment, recent rainfall across NSW has been such that the Department of Primary Industry is now anticipating a bumper 2007-08 wheat crop, perhaps the best since 1982. Bureau of Meteorology modelling further suggests we have now moved out of the El Nino weather pattern, and into La Nina, meaning further rainfall ahead. Under any normal circumstance, this should be promising for a lowering of local, and global, grain prices at least.

But at the same time, water allocations to irrigators in the Murray-Darling Basin have been cut back to zero for the time being. UBS reports the Basin provides 48% of Australia's grain production, 52% of fruit, 28% of vegetables, 43% of lamb, 61% of pork, 31% of beef, and 100% of rice (and 77% of cotton). The removal of irrigation rights to this region is no small matter. Unless the region begins to receive something more akin to average rainfall, food prices in Australia have only just begun to rise. And if that's the case, ongoing inflation and interest rises will become a reality.

There is no need to be too panicky, say the UBS analysts. ABARE is suggesting a 50% chance that 2007-08 will see a return to average rainfall. While this is not amazingly comforting, at least ABARE is not suggesting that the rivers will never see rain again.

But the weather is only part of the equation. Wether it rains or not, there has long been a building argument that the rise of China and other emerging economies will ultimately have the same impact on "soft" commodities as it has on "hard" commodities. In other words, the secular jump in global metal and mineral prices, known variously as the "super-cycle" or the "stronger for longer" theme, will be followed by a similar jump in global food prices. As vast populations shift from being subsistence peasants to part of the global workforce, and while the middle classes begin to enjoy greater levels of wealth, there will be a greater demand for food, and in particular a greater demand for the sort of food the West takes for granted.

UBS does not buy into this argument. The analysts suggest "price rises we’ve seen to date are largely the result of a confluence of one-off temporary factors and in some places reflect a shift in relative prices rather than inflation per se". Such one-offs include the biofuel boom and a change in EU dairy subsidies (and as any Kiwi will tell you, milk prices have gone through the roof). There is nothing to suggest, says UBS, we're in the midst of a broad-based and secular food boom.

While changes in EU subsidies are one matter, one can only assume from the research that UBS does not see the biofuel boom as lasting (ie there is no elaboration). While a fall in the price of oil would pretty quickly flow through to a fall in the price of corn, there is little to suggest biofuels are going away anytime soon, particularly considering the massive subsidies being thrown at the industry across the globe. Unless this latest move in the oil price over US$70/bbl is just another temporary aberration, then one must assume biofuels will be around for a while yet, and that grain prices will reflect such.

On the matter of Chinese food consumption, UBS notes that China is simply not yet a major agricultural trading economy. Only 3% of agricultural products are imported at this stage, and as such there is not a lot of price flow-on from global prices to domestic prices. On that basis, UBS concludes we are not about to suffer a food price boom.

So all in all, UBS analysts are unconcerned about Australian inflation as a result of sustained high food prices. It is likely to rain, current prices are being pushed by one-off factors such as ethanol and the Asian food consumption argument is a myth.

Anyone with a mortgage might like to hope they're right.

article 3 months old

UBS Inflation Survey Points To Rate Rise

By Greg Peel

In a refreshing bout of candour, the economists of UBS basically suggest their statistical measurements of inflation are about as useful or useless as any collection of numbers that never seem to come out the way once expects. Lies, damned lies and statistics, one might say. However, that hasn't stopped them attempting to pre-empt the Australian second quarter consumer price index result.

The Q2 CPI is due on 25 July, two weeks ahead of the RBA's August rate decision. There is no doubting this number will feature significantly in whatever the RBA will chose to do. It is not the only consideration, however. The employment data due out on Thursday will also provide some clues, as will other indicators of economic growth, and offshore developments.

The UBS inflation survey looks specifically at 30% of the items in the CPI measurement and makes seasonal estimates for the rest. The result for Q2 headline inflation is +1.1%, which compares favourably to the economists' earlier forecast of 1.0%. After two results close to zero in Q4 and Q1, this would bring annualised inflation into a level of 2.0%. This is the bottom of the RBA's target zone of 2-3%.

The bulk of the rise is made up of price increases in petrol and vegetables, which will be no surprise to anyone who's been near a servo or supermarket lately. (I just paid $14.99/kg for some plain old green beans, for heaven's sake. Bananas? That was nothing.). But the RBA is more keen to look at the "core" inflation rate, which removes the supposedly volatile elements of food and energy. UBS has this at 0.6%, for an annualised rate of 2.4%. Again, not too threatening.

(In thinking about this concept of removing volatile elements, it occurred to me to ponder the question: what if food prices don't go down again? While droughts break and floods recede, it's no stretch to consider that the scarcity of water in general in Australia will push fruit and vegetable prices up for some time, if the Murray-Darling crisis is anything to go by. In the meantime, the global demand for biofuels has pushed up the prices of grains, perhaps irrevocably, which in turn pushes up the price of meat. If the oil price makes a secular shift upward, the flow-on effect reaches everything from production to transport costs of a vast range of goods and services. In other words, oil inflation moves from headline to core. But if food prices make a secular shift, where is it felt? Outside of one's regular trips to Tetsuya's, or perhaps the Scottish Restaurant, it can only ever be felt in the trolley. How does food inflation ever make it to core? Yet food inflation is fundamental to one's very existence.)

So far, based on the UBS estimates, there appears no reason for the RBA to hike rates. However, the story starts to break down when we look at the RBA's "statistical measures".

Basically, it's no good just to separate "headline" and "core" inflation measures. General volatility is also felt across the seasonal patterns of four distinct quarters. Thus in order to arrive at a smooth, seasonally adjusted, trend-revealing measure of inflation, the RBA has to take the original figures and knead them, sit them in the fridge to prove for a while, and then get out the rolling pin and work them into something nice and consistent. Only then will it be apparent what the true state of inflation is, and only then can a legitimate monetary policy decision be made.

The good news is that Q2 is usually the least inflationary quarter of any given year. Annual price hikes across arrange of goods and services that can be reliably expected rarely occur in Q2. The bad news is that this means, from a statistical point of view, that the Q2 numbers have to be adjusted upwards. Hence we're not out of the woods yet.

The last two quarters provided an average gain for RBA statistical measures of 0.5%. With inflation running at about 2.5%, this means the gains still don't manage to breach the target zone. But were this quarter's figure to come out at 0.7% there would be a clear breach. Economists suggest this number would trigger a rate rise. Some even suggest 0.6% is enough.

UBS crunched the numbers and came out with a figure of 0.8%. That's it - we're heading for a rate rise in August.(A view which was again repeated by economists at GSJB Were this morning).

Or maybe not, says UBS. Maybe the aggregated margins for error across the various statistical measurements render the estimates not very reliable. They haven't been very reliable in the last two quarters, the economists admit. But then forewarned is forearmed, as they say.

And UBS does point out that the results for the second quarter 2007 are nearly identical to those of the second quarter 2006 - just before the RBA started its last tightening phase.

article 3 months old

Chinese Inflation Starts To Bite

By Greg Peel

The Western world continues to see inflation as the greatest threat to a healthy global economy, but core inflation measures continue to surprise on the benign side. It is no secret that mature economies have enjoyed relatively low inflation rates in past years, in the order of 2-3%, despite rising commodity and oil prices as a result of China recycling materials into cheaper and cheaper exports of consumer goods.

The deflationary effect of Chinese exports has been fuelled by cheap labour, easy financing, and little control over the multitudes of competing manufacturers that have simply appeared overnight across the country. These competing manufacturers are running on margins that are so tight the slightest changes in the currency can bring many of them down. It is for that reason that China has maintained an artificially low renminbi while implementing incremental measures to curb competition and control cheap finance. China is trying to control its economic runaway train, but doesn't want to go as far as triggering a hard landing.

The Chinese government has also been at pains to encourage domestic consumption as a buffer against constantly increasing foreign reserves. The Chinese economy becomes even more perilous if the global trade imbalance persists and the government can't get the locals to consume some of what is currently being exported. While sales of goods like cars and fridges have jumped markedly, China is still a relatively poor nation and the cultural tradition is to save money rather than spend it.

While any increase in domestic consumption would affect an increase in domestic inflation, this inflation would be of the healthy variety, allowing interest rates to rise and the currency to revalue with less of an impact on the global imbalance. However, one of the greatest dangers to China is that domestic inflation increases without any marked increase in consumption. And that's exactly what's happening.

The consultants at GaveKal remain long term bullish for the global economy but have suggested in the past that one of the greatest threats to "Goldilocks" is the rise of food inflation in Asia. The price of food has a greater impact on the Asian weekly budget than it does in the West, given that the Chinese, for example, still need to eat as much as we do but still earn a lot less. Hence food inflation has a greater impact on domestic consumption and that's exactly what the Chinese government does not want.

The current surge in global food prices has a lot to do with various droughts and floods but it also has very much to do with the surge in demand for ethanol. Increased grain prices flow right through the food chain. For example, it costs more to buy the grain to feed the chickens that lay the eggs, and hence eggs cost more.

Indeed the price of eggs has risen by 37% in China in twelve months. Meat and poultry - which many a poorer Chinaman has just been able to add to his diet given an improvement in wages - have risen 26.5%.

Associated Press reports the government has ordered local authorities to submit plans for raising minimum wage levels across the country in order to offset the impact of food inflation on low-income families. This will be implemented on a province by province basis, given the disparity across the have and have-not regions of China. Currently the minimum wage in the business centre of Shenzhen is US$106 per month, whereas rural Jiangxi only offers US$35 per month.

Of course, a rise in wage levels is itself inflationary, which suggests that China will likely need to step up its painfully slow program of interest rate increases and currency revaluation. However, even the smallest adjustments in the renminbi will cause many a marginal business, from steel-making to footwear, to hit the wall. While natural attrition is not a bad outcome in a country where competition has run riot, the 10% level of economic growth could collapse pretty quickly if businesses start turning up their toes to any great degree. This would then reduce Chinese demand for raw materials, and hence impact on the global economy.

The world has always been waiting for Chinese inflation. The assumption has always been that higher and higher commodity prices simply must eventually be passed through to higher prices for Chinese exports, but to date the Chinese have largely absorbed these costs by letting their margins erode to nothing in order to just keep recycling cash into debt obligations. The whole system is perilously balanced. However, what was not necessarily foreseen a year or so ago was the rise in the demand for ethanol, which is a response to the high price of oil, which is largely a result of increased Chinese manufacturing. The end result of all of this is increased food prices.

The world has also been expecting a significant global reduction in foreign investment in US dollar assets, if for no other reason that countries in Asia and the Middle East keep suggesting just that. The odds of a hard landing for the global economy keep increasing every time Chinese export receipts and Middle Eastern petrodollars keep being invested back into the global reserve currency. However, the figures indicate that so far it's been a case of a lot of talk and little action. Although in the case of China, so quickly are foreign reserves growing that any shift into other currencies or commodities has little impact on amounts still being placed into US Treasuries.

Reuters reports that the European Central Bank noted this week that foreign investment in the euro has remained stable since 2005, suggesting that the US dollar is still the currency of choice amongst central banks. As yields on US Treasuries have begun to rise, the assumption has been that this is due in part to foreign divestment. However, the numbers do not bear this out.

US strategists are not now expecting specific foreign selling of US dollar assets. They are, however, expecting a reduction of reserves being channelled into the US, which is still negative for bond prices and the US dollar. In the meantime, China, for one, will need to keep revaluing its currency.

The irony is that while many in the US are calling for protectionist measures to curb the Chinese machine, any revaluation in the renminbi will mean higher export prices for voracious US consumers and hence a reduction in spending. It would also precipitate a fall in the US dollar which reduces the average American's purchasing power once again. If Americans stop spending, the global economy is not looking so rosy.

article 3 months old

Outlook For Australia’s Agriculture, Bulk Export Values Improves

By Chris Shaw

With recent data on the state of the Australian economy showing more signs of strength  than weakness a boost is not really needed, but according to Commonwealth Bank commodity strategist Tobin Gorey one is likely coming from higher agricultural and bulk commodity prices.

Gorey notes the latest data released by the Australian Bureau of Agricultural and Resource Economics (ABARE) indicates better rainfall is expected in most areas, which should boost the value of agricultural exports.

While meat and livestock exports will be the slowest to recover given the time taken to restock herds, the group puts the total increase in value for exports from the sector at around 3%. This may seem only a minor increase, but as Gorey notes the group has allowed for some price falls given grain and oilseed prices in particular are currently at elevated levels.

Higher mineral and bulk commodity prices will also provide a boost, the ABARE estimates calling for the value of energy mineral exports to increase by 6.5% in 2007/08. Within the sector coal should record a significant increase, Gorey noting the group expects the value of thermal coal exports to hit $8 billion in 2007/08 from $6.8 billion this year, which was down on 2005/06’s $7.2 billion. The value of metallurgical coal exports is forecast to increase only slightly in the coming year.

Similarly iron ore exports should surge thanks to a combination of higher prices and higher volumes, with ABARE estimating total exports of $18.7 billion in 2007/08. This is up from a forecast $15.9 billion this year and $12.9 billion in 2005/06.

Even the metals and minerals sector will contribute, ABARE estimating total exports here will rise by 9% in value, following on from the 30% gains achieved last year.

As Gorey notes these increases will flow through into all sectors of the Australian economy, as the transport and construction industries should benefit from higher spending by mining companies and the government will enjoy higher tax revenues as a result of stronger company profits.

At the same time the higher commodity prices have lifted Australia’s exchange rate, so bringing down the total level of imports. This generates some improvement in the balance of payments, further strengthening the economy overall.

article 3 months old

The Week Ahead: The Fed Decides

By Greg Peel

The Shanghai Composite Index suffered a 3.3% pullback on Friday as investors squared up ahead of the possibility of a weekend rise in interest rates. That rise was not forthcoming, but is nevertheless expected any time soon. China tends to make its moves after close on a Friday, but unlike most central banks that set a regular monetary policy timetable, China can act at the drop of a hat.

Attention has squarely turned to the Fed rate decision due on Thursday. While a rate rise above the current 5.25% is not anticipated, investors will be examining every word of the accompanying Fed statement looking for clues of the committee's current mindset. When we last tuned in, the Fed saw an economy that was recovering comfortably - which was good news - but it maintained warnings that inflation was still an issue and would be very closely monitored. Wall Street reacted positively last week to the CPI figures that suggested core inflation was well under control. However, not everyone feels comfortable with this assessment.

The core inflation measure is the headline inflation measure minus food and energy. While core inflation rose only 0.1% in May, headline inflation rose 0.7% - the highest jump since September 2005. Food and energy prices are considered volatile and thus misleading in monthly inflation measures. But some Wall Street analysts are looking to surging grain prices (particularly in light of ethanol demand) and constantly rising oil prices and asking: Can food and energy be ignored?

Another inflation measure which is popular with the Fed is the core personal consumption expenditure (PCE) deflator. This is considered to provide a better view of underlying inflation than prices provide. However, this figure for May is released a day after the Fed decision.

If Fed rhetoric were to shift further towards the hawkish, this would not be good news for equity markets. While it is considered that a rate rise is unlikely this year, were the Fed to find the economy stronger and inflation higher than it had anticipated, a rate rise may well eventuate. However, the Fed has a bigger problem to consider in the renewed crisis surrounding the sub-prime mortgage market (See "Wall Street Uncertain On Debt And Taxes"; FYI, Saturday). A rate rise in the short end is not what a perilously balanced debt market needs right now.

Tonight brings existing US home sales for May and Tuesday new home sales. If these figures are poor, they too will impact poorly on the current mortgage crisis. Tuesday also sees June consumer confidence and the Richmond Fed manufacturing index for June. Wednesday brings durable goods orders for May and the FOMC meets.

Thursday is rate decision day accompanied by first quarter GDP and first quarter personal consumption, which will again be indicative of the state of the US economy but too late to influence the Fed. The May help wanted index is also released. Friday then tops out the week with a swag of data: May personal income, construction spending, and core PCE deflator, and the Chicago purchasing managers' index and Michigan Uni consumer confidence index.

This week in Australia, by comparison, is fairly dull.

Today brings second quarter ABARE commodity prices and tomorrow HIA new home sales for May. Thursday is second quarter job vacancies and Friday RBA credit aggregates.

Around the globe other interesting releases will be Europe's April current account (Tuesday) and May money supply (Thursday), New Zealand's first quarter current account (Thursday) and GDP (Friday) and Japan's May CPI (Friday).

Friday's global market movements are covered in the aforementioned article from Saturday. Suffice to say the SPI Overnight was down 66 points. The Australian stock market is currently supported by iron ore price upgrades and the ongoing war between Canada and the US (over aluminium). The interesting factor in resources stock valuations at present is the currency consideration. As Iluka (ILU) highlighted last week, are we soon to see an analyst step-up of AUD averages for 2007 and accompanying earnings downgrades in the resources sector? And how will the banks fair this week in the face of the mortgage crisis in the US which saw financials hammered on Wall Street on Friday? Interestingly, there has been a rev-up of low quality mortgage securitisation in Australia. Watch out for more on that later.