Commodities

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

To picture the current state of the metals and mining sector, conjure up an image of a guy surrounded by a boisterous crowd chanting: "Drink! Drink! Drink!"

The guy in the middle is China.

Thanks, China!
Base metals have staged a big first-half recovery this year
Source: Bloomberg

The commodity-consumer-in-chief released a slew of economic figures on Friday. You'll no doubt be stunned to learn that second-quarter GDP came in bang on Beijing's target.

The more pertinent data for the metal heads, though, concern the amount of credit being pumped into China's economy. Tom Orlik, chief Asia economist for Bloomberg Intelligence, sums it up this way:

Aggregate financing rose 1.63 trillion yuan ($244 billion) in June, topping all 29 analyst forecasts in a Bloomberg survey. That means last month alone saw new credit exceed the 2015 GDP of Chile, Ireland, or Vietnam.

Patriotism dictates that I welcome the idea of another Ireland just popping up, but even I concede that one is probably enough. And this is the paradox of China's current growth model for the metals market: It is boosting demand while simultaneously eroding the foundation of that demand.

China's debt levels are high already, estimated at roughly 2.5 times the size of the economy at the end of 2015.

I Owe Yuan
China's estimated total debt as a percentage of GDP
Source: Bloomberg
Note: Includes estimated corporate, household, government and bank debt.

That's on par with the U.S. The difference, as Chris Watling of Longview Economics points out, is that the Chinese economy is at a far different level of development and the boost provided by credit is fading over time. According to Watling, it took 1.5 yuan of credit growth to generate 1 yuan of GDP between 1996 and 2008. Since 2013, that ratio has risen to 4.

Part of the problem is the continued reliance on old stalwarts of the Chinese economy, namely construction and state-owned enterprises. In the latest chapter of the Chinese ghost cities thriller, a new report by the country's National Development & Reform Commission found that small- and medium-sized cities were planning new areas that by 2030 could accommodate 3.4 billion people -- enough to house all the Chinese plus several hundred Irelands. Meanwhile, investment by state-owned firms appears to be crowding out the private sector.

The State of Things
A lot of the extra financing pumped into China's economy is heading to inefficient state-owned firms
Source: Bloomberg
Note: Data show the year-on-year change in fixed asset investment.

Beijing knows this is unsustainable but it also doesn't want to risk a hard landing after years of rapid expansion underpinned by heavy investment and credit growth. It's notable that the jump in credit in the first half of this year came on the heels of what looks like an outbreak of labor unrest.

Working Thesis
Reported incidents of Chinese worker strikes and protests spiked around the start of the year
Source: China Labour Bulletin Strike Map

All of which provides a boost to metals prices and mining stocks, but a fragile one. Movements in the prices of industrial metals have tracked the rise and fall of Chinese credit pretty closely over the years.

Credit Where It's Due
Doses of stimulus in China have stoked big rallies in metals prices over the years
Source: Bloomberg
Note: Aggregate Chinese financing data shows the year-on-year change in the trailing 12 month total.

Credit expansion in the middle of the last decade and, especially, in the wake of the financial crisis did wonders for metals bulls. But you can also see that the bang per buck has been fizzling in recent years, mirroring the trend of needing ever more credit to squeeze out an extra yuan of GDP.

This latest bounce in metals prices actually looks pretty modest compared to history. Yet it has boosted mining stocks inordinately, especially those of more leveraged companies like Freeport McMoRan and Glencore.

It's All Mine!
The riskiest mining stocks have rallied the hardest on the bounce in metal prices
Source: Bloomberg
Note: Indexed price performance

If you're banking on China keeping this going with ever bigger doses of credit, just remember: Keep drinking.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net