Don't Get Too Excited About China's Commodity Reflation, With Supply Set to Rise

Production growth could put an end to the rally in prices.
Photographer: Kevin Frayer/Getty Images

The surge in prices of a raft of commodities in the past several months, propelled by China, will probably wane this year thanks to expanded production, according to Bank of America Merrill Lynch.

sharp rally  seen in products from thermal and coking-coal futures to glass and even garlic since mid-2016 carried signs that China's great ball of excess liquidity had found its way into commodities. Rather than speculative investors, it's good old fashioned laws of supply and demand that have propelled prices, Helen Qiao and fellow economists at Bank of America Merrill Lynch wrote in a Jan. 13 note.

China's commodity-consuming property market was still going strong in 2016, with lending and buying curbs starting to kick in only late in the year. On the supply side, policy makers have for some time pressed producers to shut down highly polluting and excess facilities.

"The notable rise in commodity prices in 2016 was mainly due to capacity reduction on the supply side," Qiao and her colleagues wrote. 

Coal proves a case in point, the team said:

Source: Bank of America Merrill Lynch

The bank cited the case of steel in early 2016 as a template for what could happen with other commodities now. After steel prices jumped in the spring, production rose in response, damping price pressures, the analysts wrote.

And on the demand side, slowing momentum in infrastructure and property investment and easing policy support for auto purchases should eat into commodities buying. 

Source: Bank of America Merrill Lynch

In the auto market, a tax on small-engine cars is set to rise to 7.5 percent from 5 percent, spurring sales growth to drop to 7 percent from an "impressive" 18 percent last year, the analysts wrote.

"While government-led supply-side reforms will likely expand beyond the coal and steel industries this year, the risk is that if margins are attractive enough amid elevated prices, closed capacities may be restarted," they wrote. 

Given that commodities account for about 30 percent of the PPI basket, the BofAML economists expect Beijing to be more tolerant of supply restarting, as it seeks to maintain "overall price stability" in the economy.

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