China Slowdown Affects Commodities

The mainland's impact on the world has grown with its economy. Any change will alter the price of the metals the country consumes

China is a developing economy that definitely punches above its weight class. It's a huge trading economy and voracious consumer of industrial commodities. And nowhere is the struggle by the Chinese government to wrestle down its high-flying economy being watched more closely than in the worldwide basic metals markets.

The July 21 move by the People's Bank of China to raise its reserve requirements by 50 basis points, to 8.5% on mainland lenders, marks the second such rate hike in two months. And it's causing turmoil in global copper, zinc, and nickel prices.

The worry: that Beijing will have to throw even more ice water on its overheating China economy, which clocked 11.3% growth in the second quarter of 2006, well above consensus forecasts (see, 7/21/06, "Is China Growing Too Fast for Comfort?").


 Asia stocks fell broadly on July 24 to factor in the risk of an economic slowdown on the mainland. Especially hard hit were mining companies such as Australia's BHP Billiton, and Korean and Japanese steelmakers with heavy sales exposure to China. Copper futures contracts for delivery in October fell 3.2% in trading at the Shanghai Futures Exchange.

Over the long haul, China's growth prospects still look dazzling, of course. It's the short-term that could cause commodity traders a bit of vertigo. "We are maintaining our positive outlook for Chinese commodity demand over the one-year horizon," Jonathan Anderson, Asia chief economist for UBS Securities in Hong Kong said in a note to clients on July 24. "However, we should warn that for the next couple of months, we are probably in for a rougher time than expected."

Just how rough, depends a lot on how fully Beijing financial authorities can convince global investors it has a workable set of policies to engineer a soft landing. So far the Central Bank has only stepped up rates ever so gingerly. In April, the People's Bank of China raised bank lending rates by just 27 basis points.

Two months later, it raised reserve requirements, or the percentage of deposits mainland lenders must keep with China's central bank, by 50 basis points. The hope for both moves was to drain some excess cash from the banking system.


 So far, though, such gentle moves have not produced the desired result. The pace of fixed investment, loans, and money supply growth have all tracked higher than government targets set at the start of the year. The betting now is that China will have to act more aggressively to raise interest rates and even let the yuan appreciate against the dollar to cool things off (see, 7/18/06, "China: Growth May Bring Tighter Money").

Chances are such strong measures would slow things down markedly, particularly Chinese demand for base metals, which had been phenomenally strong in recent years. The mainland consumes about 20% of global aluminum and copper, about 30% of steel, iron ore, and coal, and 45% of cement produced each year. Fears of a slowdown, however modest, helped send copper prices down 11% in the week ended on July 21—one of the worst weekly showings in a decade.

Australia is especially vulnerable. It is home to the world's biggest mining company, BHP Billiton (BHP), and 22% of the market capitalization of the benchmark All Ordinaries Index is tied to the material sectors, says Sydney-based JP Morgan Chase equity strategist Martin Duncan. Australian stocks have fallen about 8% since early May as worries about the sustainability of China's growth machine have started to build.


 Duncan expects downward pressure on the price of base metals such as copper, zinc, and nickel until the outlook for China's economy comes into sharper focus. "The short-term to medium-term, basically the next 6 to 18 months, could be rough," says Duncan.

The rise of China has largely been a positive trend for the world economy. The mainland is now a $2 trillion-plus economy with an outsized impact on trade and global commodity prices. The flip side: If the Chinese economy gets into a jam, the repercussions will be felt far and wide.

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