One of the biggest factors that have led to the spiral in commodity prices over the last 10 years has been the vociferous appetite of China for commodities as it set on a path to build infrastructure and cities. Chinese consumption of various important commodities like Steel, Copper, Aluminium, Crude Oil, Rubber, Cotton etc has grown in high single digits or double digits continuously over the last 10-12 years. As a result, Chinese consumption that formed just a few percentage point of global consumption of most commodities in the 1990’s has today grown to nearly 40-50% of global consumption, especially in commodities like Steel, Copper, Aluminium and other major industrial commodities. Over the last 5 years China has also become a big consumer of Gold as investors in China look to invest in products that yield higher than the extremely low deposit rates in China.
The early part of Chinese growth was build around exporting cheaply made products all around the world. This was made possible at the initial stage by keeping wages extremely low, having working conditions that required labour to work extended hours besides providing cheap funding, land and infrastructure to exporting companies. As a result China contributed hugely to low global inflation in the late 1990’s and the first half of the last decade. This led to a significant growth in China’s trade surplus as well as accretion of huge forex reserves. High savings rate and a strong Fiscal position also helped China boost investment in infrastructure as well as in building new cities as urbanization grew rapidly. The rate of fixed capital formation grew at a rate above 20% in China over the last decade. As such China initially grew by rising net exports and then by high investments.
One would argue that such rapid growth should normally be accompanied by high inflation too. However a combination of a strong Fiscal Position, the move towards letting its currency appreciate starting a few years back, increasing supplies ahead of consumption & more importantly wage and price controls has kept inflation muted in China. Lately over the last couple of years we have heard of China trying to move away from investment led growth to consumption led growth. The proportion of investment to Chinese growth has become unsustainable & with all the issues that the global economy is facing it is unlikely that China can have growing net exports. Infact the probability is very high that as consumption picks up and the currency appreciates in China the trade surplus will only reduce.
The big change that has come about in China over the last few years has been the tendency for assets to inflate, especially real estate and secondly the move towards a more inclusive growth has led to wage and salary increases that are much higher than the growth in Real GDP. Minimum wages in most Chinese Provinces that were just around 700-800 Yuan per month in 2010 have gone upto nearly 1300-1400 Yuan per month this year. This is much higher than growth in the reported CPI as well as real GDP. The increase in actual salaries across the manufacturing sector has actually been much higher than the growth in minimum wages. This combined with an ageing workforce due to the one child policy is now leading to greater inflationary pressure across the economy in China. Some part of the inflationary pressure can be mitigated by the appreciation of the Chinese currency, however as people get more money to spend and as pricing power of companies grows in the economy we are likely to see greater inflationary pressures in the Chinese economy. It is widely believed that the infrastructure build-up in China across a large number of sectors is not viable if seen in purely commercial sense and the actual build-up is much ahead of requirements. As such there is a lot of underutilization of this infrastructure at this stage. It will be difficult for the Chinese government to continue to make this kind of fixed asset investment going forward. This combined with higher inflationary pressures will lead to the Chinese Central Bank having to balance interest rates in a manner where inflation remains controlled, while growth sustains at levels of around 7%.
As Chinese appetite for various raw materials grew the supply was unable to keep pace with the consumption. As such despite major Western economies having reached a plateau in terms of their commodity consumption and also a rapid expansion in the supply of various commodities prices kept on moving up over the last 10 years. As such China that consumed just around 100 MT of Steel per annum in the mid 1990’s today consumes nearly 680 MT. Similarly as China built energy intensive industries the coal consumption in China went up from just around 1.2 billion Tonnes in 2000 to 4 billion Tonnes today. Infact China alone consumes as much coal as the entire world does today. The Chinese government is now moving away from energy intensive investments and also brining about new efficiency norms and it is predicted that the current levels of coal consumption might be near the peak consumption in China for the next 10 years. Huge speculative investments in Real Estate and rapid price increases have led the Chinese authorities to put restrictions on new constructions, buying of second and third houses etc. It is estimated that nearly 30-35% of overall Chinese steel consumption goes into housing. A slowdown here will hit demand. Broadly across a wide spectrum of Industrial Commodities Chinese consumption has gone up from 10-15% of global consumption to 40-60% over the last 15 years. In summary, rebalancing of the Chinese economy and growing inflationary pressures will lead to a lower trend growth rate & an even lower rate of growth in commodity consumption.
Now let’s move to the other side of the story. Expectations of continuously increasing demand, huge investments by commodity hedge funds combined with supply delays led to a strong commodity bull market. However things have changed rapidly over the last couple of years. Investors had $132 billion tracking commodity indexes at the end of February. Overall commodity assets under management are at a staggering $ 410 billion currently. Besides this gold alone has $ 240 billion invested via ETF’s. Supplies of everything from copper to sugar to oil are now catching up with or exceeding demand as supplies have grown with increasing prices. The commodities super cycle or longer-than-average period of rising prices seems to be getting over. Investors encouraged by low nominal rates worldwide have poured huge amounts into commodity investments as well as holding commodities where the cost of holding is low as the increase in commodity prices has been much higher.
Rapid increase in supplies have led to a scenario where we have seen that in the US natural gas prices fell from over $ 10 per MMBTU to as low as $ 2 couple of years back and even now stand at $ 3.5. A similar increase in supplies is expected in commodities like Iron Ore and Coal over the next few years. Moderating Chinese demand combined with higher supplies will lead to rapid price declines. Significant LNG export facilities are coming up in Australia and some are also planned in the US. This will lead to the moderation of global gas prices over the next five years. China has today stocked up nearly one year’s consumption of Cotton in order to support its farmers as demand has moderated and prices fell. South East Asian countries have stocked up on huge quantities of Rubber and China has also recently started buying Rubber from its farmers in order to support them. Thailand has bought so much of Rice that it is finding it difficult to store it. Inventories of Copper and Aluminium have today reached multi year highs. The only commodity among the major commodities that has held up has been Crude Oil, which also has been stable over the last two years despite the supply issues related to countries like Iran & Sudan. Rapid increase in Shale Oil supply from the US as well as growing supply from countries like Iraq is likely to keep Crude Oil prices low despite the strong cartel in operation. The only jokers in the pack will continue to be agri commodity prices, which are difficult to predict as they depend a lot on weather patterns, but on the other hand they have shorter cycles due to the production cycles being short.
In conclusion, a combination of lower Chinese and a below trend global growth, high inventories and increasing supplies will keep a lid on global commodity prices over the next few years and will keep inflationary pressures down. We are also at the peak of the money printing cycle of the US Federal Reserve, as such this factor that has supported commodity prices since 2009 is also not likely to sustain beyond this year.
This will be particularly beneficial for countries like India where supplies have failed to keep pace with consumption and higher imports combined with higher prices have impacted both the Current Account Deficit as well as inflation. Subdued global inflationary pressures will eventually lead to a more moderate interest rate environment in the country and boost growth.