Are mining companies going to come unstuck because of China?

Sunday, May 14 2017 by
9

Mining companies or commodities businesses have made some big gains in 14 months. And these gains could come unstuck if China sees a slowdown.  

The “Unsurprising” rebound of the mining sector

This chart shows the steady decline in the mining sector.

mILdp6F.png

The FTSE Mining Index has fallen by 15% since hitting a two-and-a-half year high in February. Also, Goldman Sachs downgraded ratings for several mining companies, citing Beijing is tightening its monetary policy.

Below is a table showing the previous troughs in the mining sector and its later recovery:

M9Id3VV.jpg

One reason for this weakness is the softening demand from China.

Is this a data blip, whereby China would continue pumping credit into its economy?

Or, could this be an end to the Chinese credit boom?

To answer in full, some unrelated topics on the mining sector needs covering but plays a big role in the demand for commodities.

Why China so important to mining businesses?

If you look at this chart, it is not surprising to see why:

vu22ged.png

For coal producers, their revenue stream is very much dependent on Chinese demand. Those who mine copper, zinc, nickel, iron ore and lead are also very exposed to any Chinese slowdown. Especially the major players (See table above). 

The question investors should ask: “Why am I showing you this chart?”

Because China is going to experience another slowdown

The billion dollar question is when will this happen!

One of the biggest factors for natural resources is its huge infrastructure projects. And the biggest is the Chinese Housing Market.

wHvugOJ.png
The last time China saw home price decline was two years ago. And that fall of minus 5% sent commodities prices to collapse.

Since the summer of 2015, the rebound in China’s home price began. Prices started to turn positive in late 2015 and peaked in late 2016 to 13%. That saved the mining industry from a series of defaults.

Is the above chart signalling a decline?

We don’t know until you detail further evidence.

China Housing – in detail

On a month-on-month basis, you could suggest a rebound, pointing to last month data!

RQ5zbiJ.gif

Or, it could be a blip.

About their home prices, China is becoming more expensive. With prices at $171 per square foot, compared to the U.S. of $131. That’s despite average income being six times smaller. (China’s GDP per capita is $7,368.68 vs. the US’s $45,759.46)

We can put that down to overpopulation in China for high housing demand or a shortage of supply. When you look at the home ownership numbers, China is 90%, whereas the U.S. is 63.6%. Should the U.S. be building more homes than China?

Some Examples of China Home Prices

In cities like Shanghai's Inner Ring Road, an average 80 square meter apartment costs an upwards $886,000.

Another example is Xiamen, where average property price is $300,000. Even when the minimum wage is hardly $200 per month and the average wage is around $1,000.

These home prices are unsustainable.

Some regulations restricting home purchases in some cities, they remain ineffective.

That’s because newly-house construction is buzzing around 12% in the first quarter (year-on-year), with sales of properties rising by 19.5%

People can skirt around it by buying multiple properties in one transaction.

Let’s look at the level of construction occurring in China.

The Construction Bonanza of China

We saw the level of raw materials consumption from China. In this part, we assess the applications for these materials.  

Investigating the amount of construction happening in China is mind-blogging. Take construction, for example, you see the speed in this graph:

Fc1HgK9.png
Although not up-to-date, it explains why China is important for commodities producers. When the boom was happening, the Chinese population increased by 115m or 8.7% from 1998 to 2013. But the speed of residential construction is up ten-fold!

I know China needs to re-modernized by replacing old homes for new ones. The rise in construction is too excessive.

That excess led to tens of millions of empty apartments. One estimate could be as high as 60m! (Enough to house the entire population of Britain and Germany.)

Here is a picture:

B1ETe5n.jpg
When it comes to building roads and transportation networks, it’s a must in China. The railway lines grew from 50,000km in 1980 to 67,000km by 2014.  

That is all good, but the problems lie in the level of debt incurred from this infrastructure boom. Take a State-owned firm called China Railway Corp Group. It has total liabilities of $636bn (£480bn). How much of it are interest-bearing loans? We don’t know.

One reason is the cheap fares in the public transportation system.

Share your thoughts on Chinese transportation costs, please leave a comment below.  

So, how is China funding all these glamorous projects?

What is funding this Infrastructure boom?

Something is extraordinary happening in China. The main funding source is something called WMPs or “Wealth Management Products.” Unless you’re a finance buff or a Chinese financial expert, you wouldn’t have heard of it.

Below is a basic review of WMPs and more: -

Definition: Wealth Management Products are investments made by savers. They aren’t recorded on the banks “balance sheet” (known as “off-balance sheet”). These investments are unregulated and are the reason why it’s called shadow banking.

Features: The reason so many Chinese investors is the high-interest rates earnings.

However, yields from these WMPs have been coming down. At the end of 2015, WMPs is paying out 4.68% from 5.06% in 2014, compared to deposit rates of 1.5%)

One other attractive feature is the short duration of these products. In 2015, the average product had a duration of 3.5 months. This isn’t surprising as it works out the same as the one-year deposit rate. Without waiting for the whole year. 

The biggest drawback is these products are uninsured. So, if they fail, the savers who invested will lose all their money.  

Size: The amounts of WMPs outstanding is 29.1 trillion Yuan or $4.2 trillion.

YFn2hK5.png
Other products are not WMPs but have similar features. Adding these together will amount to $9 trillion. Below are the other products: - 

YacD46M.png

The number of products related to WMPs is over 181,000 products. Here is the split of where the money gets allocated:

ed9QVcY.png

The biggest components are bonds and bank deposits. Unsurprisingly, the Chinese property market is a beneficially of WMPs. According to the Centaline Group, China’s property developers raised Rmb1.14trn in 2016 ($180bn) through privately raised company bonds, corporate bonds, medium-term notes and related sources.

What are problems with WMPs and similar products?

First, the mismatch between deposit rates and WMPs rates. It relies on high returns from projects.

Second, building properties, roads and trains take time. It takes even longer for the projects to pay itself and earn a return. Therefore, these are considered illiquid assets.

For roads and trains, the toll charges and transport fares in China are the cheapest in the world. It can cost you 20 pence to travel 88km on a subway in Beijing! That is good for customers but bad for those who fund the projects.

Third, by getting savers to invest in WMPs, Chinese banks can lend without adhering to Reserve Requirement Ratio (RRR) that stands at 17%.  (See “For more information” to find resource)

Fourth, the growth in WMPs resembles a Ponzi Scheme. You wonder how lenders get paid at such short duration (with interest!). Even these projects take time to complete and even more time to become profitable.

Here is a Ponzi scheme graph:

LZV9Plm.gif

This shows the S&P 500 vs. Bernie Madoff fund and it goes up in a straight line. Compared that with the above chart titled, “WMP Boom” and you see the resemblance.

The thing about Ponzi Scheme is it doesn’t last forever. At the same time, we don’t know when that bubble will burst.

Now, to evaluate the debt levels in China.

Are debt levels in China dangerous?

First, there is a lack of consensus between institutions of the size of China’s total debt levels. The China Academy of Social Sciences (CASS) has the number at 249% of GDP at the end of 2015, whereas the McKinsey Group had it 280% of GDP in the middle of 2014.

The problems aren’t about the level of debt because if it was, then Japan should go bust, as their total debt level is 500%.

You have to understand each country’s debt story individual.

One factor to consider is a country can have high-level of debt but got to have the cash deposit to back it up.

Take the Greek example, Greece’s public debt stands at 180%. The problem lies in Greek’s deposits.

JRGhiCe.png

As soon as the Greek’s cash deposit drops, it needed a bailout.

To explain the importance of falling deposits, you got to understand the mechanics. (Here it is sentence-by-sentence)

When Greek banks see, their deposits declining it disrupt the banking operations. It means they don’t have the money to issue credit or refinance existing loans.  

Even worse, as people start taking more money out, the banks have no choice, but to call back their loans.

Which, in turn, cause Greek businesses to cut costs and jobs to payback the loans! Hence, the high unemployment rate in Greece of 23%.

Is this happening to China?

Not exactly, but it’s more complexed.

China has been growing their deposits at a tremendous rate. If you believe the numbers, its total households and corporations stand at $22 trillion.

We don’t know if the data is true, but you have to ask the question. If a country see enormous build-up of deposits, why is there a big increase in total debt?

Let’s use the “Company” analogy to explain China’s debt and cash build-up.

Surely, when a company increases cash profits, along with low net investing, then the bank balance would swell! (without dividends payment to shareholders)

In China’s case, the economic structure means high infrastructure investment. Let that be 50% of their economy. And categorized that “capex spending.” Also, include deposit rate payments as dividends payment.  

China as a Company

First, we need to know how much profits China produces. That is almost impossible, but we can estimate.

China’s state firm produces 2.3 trillion Yuan in profits ($400bn). Assuming it contributes 40% of China’s total profits, then total profits in 2016 is $900bn. (Drop a comment below if you know the total cash profits generated in China Inc.)

Let’s say cash earnings are similar at $900bn and China’s capex is roughly $4.5 trillion or more. (China’s GDP is $11 trillion)

So, China needs to find $3.6 trillion to make total deposits stay the same. But, it needs to borrow more because it has to pay dividends on that huge deposits, which comes to 1.5% or $300bn.

Second, it needs to find more money to increase their cash deposits.

In the end of 2016, China’s total deposit is $22 trillion, then using a conversion of 6.85 RMB to 1 USD, it comes to 150 trillion RMB. Last year, deposits were 139 trillion RMB. The 11 trillion RMB equates to $1.6 trillion.

(N.B.: I use RMB and Yuan interchangeably to refer to the Chinese currency.)

That means China needs to find $5.4 trillion or half its GDP.

(N.B.: The calculations above are estimates. It’s there to illustrate and understand the dynamics of China’s economy.)

Look at China’s debts to GDP, it sorts of paint the picture of an economy, that is growing using excessive credit.  

kfP4myH.png

Then, there are rumours of “well-off” Chinese looking to move capital aboard. They do by making properties and bond purchases. Why do rich Chinese want to invest aboard?  

Would you invest in countries where the economic growth rate is 1% or 2%, instead of 6% to 7% in China?

It is similar to saying, “Would you invest in a company that is growing fast AND has a cheaper valuation?”

P.S. The “valuation” is a reference to “Per Capita.” Because a country with high per capita is less likely to grow.

(Again, drop in the comments section below, if you have a better analogy.)

Let’s explore why capital is leaving China.

The Flight of Capital from China

To set the tone, let’s start with China’s Forex Reserves.

PcAiImH.png

It peaked late of 2014 at $4 trillion. Now, it stands at $3 trillion. To be frank, the level of Forex Reserves doesn’t tell us the whole story. Because trade numbers can be suspect.

One aspect is China been overreporting on their imports, especially import payments. According to Deutsche, it said, “In 2015, the China Customs reported total goods imports of USD1.7tr. But the actual payment importers made was much higher, at USD2.2tr. The difference is a stunning half trillion of US dollars.

That under-reporting imports mean China isn’t running a trade surplus with the rest of the world. Again, I don’t know the full extent of their trade figures, but it is one avenue of capital flight.

Other sources of capital flight are through foreign outward investment. Here is a brief history of these corporate deals:

0TDD16S.jpg

Although they are big numbers, people shouldn’t sleep on China ability to attract foreign direct investment (FDI). In the last ten years, FDI totals $1.3 trillion.

Professor Gunter calculated China saw capital flight total $3.8 trillion.

Why are people leaving?

Some people points to the pollution and health, while others say the wealth is from ill-gotten gains via corruption.

Whatever the reason, that capital is super important for stability. People don't want to find out that one day their deposits have disappeared or has no monetary value. It also explains why WMPs are important to fill the void left behind by capital flight.  

The Danger Signals to watch for

One signal to watch for is Chinese interest rates in the bond market and the overnight interest market.

Let’s start with the overnight interest market. And in China, it is called the SHIBOR, or the Shanghai interbank overnight lending rate. That lending rate has risen to 2.8%, the highest in two years.

If you know your financial history. Then, during the financial crisis of 2008, Western Economies saw short-term lending rate spike because banks don’t trust each other.

When banks do this, it means they are scared of the other bank not paying back their loans.

It sounds ridiculous, but it’s not.

Even in China, where they control the banks state, it requires capital injections to boost confidence in their banks. That liquidity means banks can borrow and lend with little risk of default.

The same is happening in the bond market with rates surging pass 2015’s levels.

FdVTycN.png

Final Thoughts

Most of this sound gibberish, which is why you should a section called “For More Information.” It contains opinions from experts in various topics discussed. The mining sector should watch China closely.

There is a 65% probability of a mini-slowdown in China this year with an 80% happening next year. The Chinese government can keep this credit bubble going. But the consequence would be big in the future, which would lead to social unrest.

At the same time, cancelling these infrastructure projects increases the unemployment rate. That too provokes unrest.

And this leads to a Catch-22 dilemma.

Weighing these two options, I would bet that China will slow down credit expansion. It leads to lower demand for natural resources for a period of (say) 20 months. That means Chinese home price will moderately decline for a period.

Afterwards, the government will restart the engine at full speed.

A great metaphor would be: “China is a car driving at full speed in the free motorway. As they reach a city it slowdown, until it leaves the city, its back to full speed again. How long will it reach their next city?”

And on that note, no one knows, but it will happen.  

Thanks for reading this long piece. Hope it gives some insights into China.

So, what are your thoughts on the state of the Chinese economy and its effects on the mining sector?

Please share, like and subscribe to my blog. Cheers!

For More Information

On the subject of “WMPs”; -

A.   From the Reserve Bank of Australia, “Wealth Management Products in China.”

B.    From Bluenotes.anz.com, “Eyes on China's WMPs.”

C.    From Seeking Alpha, “Risk and Chinese Wealth Management Products.”

On the subject of “China’s debts”; -

A.   From the IMF, “Resolving China's Corporate Debt Problem.”

B.    From the Telegraph, “No crisis yet in China's debt-clogged banks, says S&P.”

C.    From the Australian, “China’s debt spirals out of control.”

On the subject of “Commodities”; -

A.   From the Diplomat, “What’s New About Xi’s 'New Era' of China-Latin America Relations?

B.    From the Treasury.gov.au, “China's emergence in global commodity markets.

C.    From the World Bank, “How important are China and India in global commodity.”

On the subject of “China’s rates and bonds”; -

A.   From Reuters, “China raises short-term interest rates in fresh tightening sign.

B.    From Reuters, “China's money rates up on concerns over PBOC liquidity checks.

C.    From the FT, “Foreign investors cut holdings of China bonds for first time since 2015.

Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.


Filed Under: Market Outlook, Commodities,

Disclaimer:  

By reading my articles and newsletters, you agree to use the research of Walbrockresearch.com at your risk. The purpose of this site is to educate and entertain readers. In no way, we are giving investment advice though the information provided is to my knowledge accurate at the time of the report. You should do your research, or seek advice from qualified professional investment advisors.

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