The slowing of Chinese growth and the rout in commodity currencies

Today’s commentary

I am less and less concerned about the eurozone periphery over the medium term because recovery in Europe looks poised to last. On the other hand, the slowdown in China could have wide-ranging consequences, particularly for countries dependent on commodities for growth. The currencies of commodity producers are declining, making interest rate policy trickier as their economies slow.

Let me start off with the good news here – and that’s in Europe. Spain, the market’s new darling is on the mend in various ways.

In 2012 Spain’s 10-year yielded near 8%. Today Spain issued largest euro sovereign issue ever https://t.co/RmwHIxm8tA pic.twitter.com/QMSN1oDyDO

— Edward Harrison (@edwardnh) January 22, 2014

Marc Chandler notes that there were 400-odd bidders for this deal with 40 billion euros of bid collectively for the issue. Marc says that, initially, the bond was priced 185 bp above mid-swap rates but, due to demand, the fix was lowered to 178 bp. The bond has a 3.8% coupon. So, that’s the sovereign.

Unemployment is still a big, big problem as the jobless rate rose in December above 26%. But I tend to think this is a one-off because credit is now flowing in Spain, arresting the fall in asset prices. We see Spanish articles demonstrating that the credit market in Spain loosening as a result (article in Spanish on good mortgage deals). This site is not named Credit Writedowns for nothing. In my world view, you end the credit writedowns and you end any deleveraging soon thereafter. That’s bullish for growth. Spain is now in Ireland’s camp, re-coupling to the core. Portugal and Greece are the laggards in bailout programs and Italy seems to be in a semi-permanent no growth state. But none of this is critical. It is just simmering.

I should also note that the composite PMIs for Europe were good. Reuters:

Markit’s Flash Eurozone Composite Purchasing Managers’ Index (PMI), which gauges business activity across thousands of companies, jumped to 53.2 in January from 52.1 last month. That was its highest since mid-2011, beating all forecasts in a Reuters poll.

Only France bucked the overall euro zone trend. The French composite PMI showed business activity contracted this month.

My only concern regarding acute problems is the euro money market where there are still signs of stress. It points to a weak banking system which – if credit writedowns do return – will be in a world of hurt.

So that’s good.

The bad news here is that China looks poised to slow further. All of the headlines coming out of China point to weakness – and the policy response seems to be more resolute this time in terms of allowing unbalanced growth to fade. Yes, policy makers will always intervene when the wheels fall off but now China is rebalancing in earnest and that means much slower growth in the future. Here are a few threads to the story.

Manufacturing. Fears of China slowdown as factory sector contracts “China’s manufacturing sector has unexpectedly slipped back into contraction, marking an end to six months of tentative recovery, and fuelling fears the economy is facing another slowdown. HSBC’s preliminary index of activity among Chinese manufacturers fell below the 50 level which separates growth from contraction in January. It gave a reading of 49.6, down from 50.5 in December, and well below economists expectations of a much gentler drop to 50.3. China’s manufacturing PMI reading has been in decline for four months, but January was the first period in which the reading tipped into contractionary territory since August.”

Credit. China Moves to Avert Shadow Lender’s Default “A coal company facing repayment of a three billion yuan ($500 million) loan has received government permission to restart one of its mines as creditors and officials scramble to avoid a default that could batter confidence in China’s loosely regulated shadow-banking sector. China Credit Trust Co., a so-called shadow lender, notified investors in products linked to the loan on Wednesday about the permit to resume production, according to a notice reviewed by The Wall Street Journal. The restart could allow the debtor, Zhenfu Energy Group, a little-known company in Shanxi province, to generate revenue to help repay investors. The scramble to stave off default highlights what economists and analysts describe as a predicament for the government. Though defaults have occurred on risky investment products in recent years, the government has arranged bailouts for investors. Some economists say that the bailouts only encourage reckless lending practices. Zhenfu has taken on outsize importance because it is one of the first troubled loans to come due this year, with a payment date of Jan. 31. Whether to grant a reprieve is the first of many such decisions Beijing and local governments need to make this year. Nearly 40% of the $3 trillion in local government debt comes due in 2014 and much of the money has gone to finance real estate and other investment deals. Often, the investments are financed by so-called trust companies, a pillar of China’s shadow-banking sector, as was the case with Zhenfu. Some $19.7 billion of trust financing, to local governments and other borrowers, comes due in 2014. A number of analysts have predicted that some of these financial products will default.”

Oil usage.  PetroChina delays operation of refineries on overcapacity “PetroChina has put off starting up two new refineries and delayed expansion of another to counter the threat of overcapacity as oil demand growth slows in the world’s second largest oil consumer, a company official said on Thursday. China’s oil consumption last year grew at its slowest in more than 20 years, calculations on government data showed on Monday, as soft economic growth sliced demand for transportation and industrial fuels such as diesel. “China’s oil consumption growth is slowing down and overcapacity in the oil industry is looming. Rapid expansion in refining capacity will result in a glut and increasing net fuel exports,” said the PetroChina official who declined to be identified because he is not authorized to talk to media.”

Demographics. China’s Working Population Fell Again in 2013 “China’s working-age population continued to shrink in 2013, suggesting that labor shortages would further drive up wages in the years to come. The nation’s working-age population—those between the ages of 16 and 59—was 920 million in 2013, down 2.4 million from a year earlier and accounting for 67.6% of the total population, the National Bureau of Statistics said Monday. The country’s workforce dropped in 2012 for the first time in decades, raising concerns about a shrinking labor force and economic growth prospects. Last year, the statistics bureau said the population between the ages of 15 and 59 was 937 million in 2012, down 3.45 million from a year earlier, accounting for 69.2% of the total population. The bureau didn’t explain why it began using a different starting age of 16 to measure the working-age population in 2013. The share of the elderly, or those who are more than 65 years old, was 9.7% in 2013, up from 9.4% in 2012, official data showed.”

As difficult as all this is for China, I think the real difficulty is in the countries that have supplied China with commodities – countries like Australia, Brazil, South Africa and even Canada. Their currencies are selling off. And in the case of North American commodities exporters Mexico and Canada, the shale oil boom in the US limits the export volume they can generate from the captive audience in the US. So, we should anticipate higher inflation due to falling currencies in those countries, limiting the ability of central banks to reduce rates in order to keep up economic growth.

In October, I showed you another example of the primacy of monetary policy from Canada. People are looking for tight fiscal and loose monetary policy as the policy nirvana. This nirvana won’t come true if the Canadian Dollar continues to drop in value. Yes, the Canadians have a lot of scope for ease because inflation is low but I believe the policy space for Cnada will be limited by the tight fiscal, loose monetary paradigm – and this will contribute to slowing growth.

In Australia, inflation already is jumping with core inflation also rising at a brisk 2.6% pace. Will this prevent the Reserve Bank of Australia from cutting? No. And the Australians have further to cut. Nevertheless, the reality is that cutting into a collapsed credit cycle when writedowns start to rise is pro-cyclical, not countercyclical, because the lost private interest income from lower government bond yields is not offset by credit growth. What I see therefore is another case of tight fiscal and loose monetary into the teeth of a credit cycle slowdown that will not be the right policy mix to turn things around.

We can see the impacts of poor commodities exports greatest in latin America. Take Brazil for example. The economy contracted in the third quarter of 2013, the last quarter for which data exists. And that is the worst performance in two years. 2013 will be the third year of sub-three percent growth if Q4 doesn’t light up the sky. meanwhile the decline in the currency has contributed to high inflation running above the 6% target and that has limited the scope of monetary policy. Moody’s downgraded Brazil from positive to stable in October, worried about credit metrics, low growth and government finances. So what is Brazil going to do: suck money out of the private sector by raising taxes. That’s right. Growth is slowing and the Brazilian government wants to raise taxes – ostensibly because inflation is too high and the government has a weak fiscal position. What that tells you is that, yet again policy space is limited and the economy will continue to underperform with the Chinese slowdown as a major contributing factor.

I should also point out that oil production has not only been demand-side limited, there are supply side issues. Earlier today, Andy Lees of writes for the Macro Strategy Partnership noted that Brazil’s latest giant offshore oil fields were not yielding the blockbuster results expected. He writes: “Petrobras and its partners will abandon the major Bem-Te-Vi offshore oil prospect according to a Reuter’s source. It, along with at least part of the Bigua prospect in the same block is being returned to Brazil’s oil regulator. The article says they will instead concentrate their efforts in another prospect Carcara. While Petrobras never announced it, Bem-Ti-Vi was part of a group of sub-salt fields that kicked off the boom in 2007/08 and that the government described as a “super giant”, which along with Jupiter, Guara and lara (recently disappointing auction) contained an estimated 6bn barrels. The fact that they have returned it rather than sold it says there are no economic reserves there.”

This piece wouldn’t be complete unless we mentioned Argentina, where things are going from bad to worse. The currency is collapsing and the threat could be hyperinflation. Argentina has been cooking the books for years, producing phony inflation figures. The statistics say 10% when the real numbers are 25%. I believe Argentina’s problem is peak oil, meaning that its ability to increase output of oil production for export revenue is constrained by price. The country expropriated its oil assets from Repsol, complaining that the production problems were due to a lack of investment. As I believe we will see in Mexico, the real problem is aging oil fields that cannot be induced to produce at higher production levels. The result is a loss of export revenue, a falling currency, and with poor economic management, runaway inflation and eventually economic and social turmoil. Argentina is not the model.

China will continue to slow. This will put a break on commodity prices and exports. The result for commodity exporters is declining currencies, rising inflation and slower growth. A loss of productive capacity in aging oil fields is also a concern in Latam exporters like Mexico, Brazil and Argentina. In the case of Argentina, the situation could become critical. But in Australia, South Africa and Canada as well, where there have been big gains in house prices, we should look to see how asset prices respond to the developing natural resources bear market.