What are the drivers of demand in view of China's evolving economic environment?
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There have recently been concerns about China’s growth slowdown adversely affecting commodity markets. Judging the extent of any such impact is a question of China’s cyclical growth trajectory. But what about the secular impact? To assess that, we need to examine the drivers of China’s commodity demand in view of its evolving economic environment.
The good news is that China’s GDP growth is unlikely to fall below 6% anytime soon, in my view. Beijing has been fine-tuning its demand management policy to create a balance between sustaining growth and implementing structural reform and debt reduction measures.
Its fiscal and monetary policies are both in neutral ‘standby’ mode, ready to ease should any potential signs arise of GDP growth falling below 6%. In particular, monetary policy has been used to offset the financial stress stemming from the debt reduction and structural reform measures.
Beijing’s acute sense of policy sensitivity has allowed it to force through reductions in debt and excess capacity without inflicting a heavy cost on the economy so far. The pace of GDP growth has moderated and systemic risk has been contained.
China’s property market – one of the major drivers for investment and growth – is cooling but not crashing. Housing inventories have dropped to between 10 and 18 months recently from over 30 months at the market trough in 2015. This has kept developers building, even though sales are expected to remain weak.
While growth in construction and heavy industry could slow further, it should not, in my view, do so to the extent of threatening the official 6.5% GDP growth target.
Commodities, especially iron ore and coal, are strongly influenced by China’s construction cycle. In turn, this is affected by its property market conditions.
China’s metal imports have been dropping since 2017, reflecting a weak property market. A weakening construction cycle in China is thus not good news for metal prices.
But Chinese domestic supply has been constrained since 2015, when Beijing started to cut excess capacity, while metal demand has not dropped as much as supply. This has created a supply/demand bottleneck in the metal sector and helped to prevent any price crash.
China’s construction cycle is not only key to demand for commodity-exporting emerging markets. It also drives many developed market exports. The US, Europe and Japan (G3) are major capital goods exporters to China and their shipments closely track swings in China’s construction activity (Chart 1).
Chart 1: G3 exports correlate with China’s construction growth
Source: CEIC, BNPP AM(Asia) as of June 1, 2018
However, a moderate slowdown in China’s construction activity may not cause any major damage to developed market growth, just as the deep decline in 2015 did not derail Europe’s economic recovery. US growth did suffer in 2015, but it was mostly a result of the oil price collapse hurting its domestic energy investment.
So the cyclical impact of China’s economic slowdown on commodity prices is likely to be moderate. The risk for the commodity market lies more in the combination of a slowdown in China, oil price fluctuations and geopolitical risk factors such as Europe’s political turmoil and US trade conflicts with its trading partners.
China’s commodity demand is undergoing a structural shift from metals to energy and foods, reflecting the creative destruction process that is moving the economy from investment-led to consumption-led growth.
China’s industrialisation in the past three decades created huge demand for metals and energy. But since coming to power in 2013, President Xi Jinping has changed the objective function of the economy from prioritising growth to quality over quantity through structural reforms. The resultant growth moderation means that in the coming decades, China’s commodity demand will likely shift from metals to energy and high-quality foods as income levels rise.
Growth in China’s steel demand has already fallen from double-digit growth rates in the mid-2000s to low single-digit rates recently, reflecting the structural shift in the economy. This would seem to imply a large disruption to the steel sector and to the markets related to steel production, such as iron ore and coke.
Although the growth rate has and will continue to come down, the base for China’s steel (and other commodities) demand is still very large, which means that the annual demand increment in volume terms should remain large.
China’s per-capita energy consumption has also fallen but not by as much as the decline in steel demand.
The reason is that even as China’s need for steel-intensive construction and heavy industries has dropped, energy demand from the new industries (such as those featured in the “Made in China” 2025 industrial policy) and the new economy – characterised by household consumption, transportation, services, information technology, commerce and finance – has grown, offsetting the decline in demand by the old economy.
China’s economy mostly runs on domestically supplied coal, so not all of the new energy demand will be felt by global markets in the medium term. But this situation will change in the longer term as China is moving away from demand for ‘dirty’ coal to clean energy.
Meanwhile, oil will be an increasingly important energy source. China is already importing half of its oil needs and an increasing share of natural gas supply. The pressure that China puts on global energy supplies will increase in the coming years, unless stringent energy conservation policies are strictly implemented. In other words, China will be a positive force for the global oil and gas market in the long term.
China is also going through a structural shift in the demand for refined oil products. It used to have huge demand for heavy distillates, such as diesel and fuel oil, used in heavy industry and lorry transport.
But as its economic structure has shifted away from industry-based investment-led growth, diesel demand has slowed sharply since 2013 when the tertiary sector (a proxy to the service-based new economy) overtook the secondary sector (a proxy to the old industrial economy). Meanwhile, gasoline demand has soared, driven by the new economy’s inexorably rising numbers of passenger cars.
Last but not least, China’s demand for better quality foods, including grains, meat and dairy products (of which China is already a net importer, Chart 2), is expected to grow sharply as the general income level rises. The market estimates that, in the coming years, China’s per-capita grain consumption growth could easily double from around 1% a year now.
Chart2: China has been a net importer of these food items*
Source: CEIC, BNPP AM(Asia) as of June 1, 2018
Like energy demand, China will put increasing demand pressure on the high-quality food segment of the global agricultural market as domestic production is now increasingly constrained by the lack of arable land.
Nevertheless, the key variable to watch in terms of the impact of China’s food demand on the global agricultural market is the pace of future increase in domestic supply via yield-enhancing technology.
 See “Chi on China: Mega Trends of China (6) – Evolution of China’s Growth Model”, 6 April 2018.
 See “Chi Flash: PBOC Signals Easing Amid Economic Rebalancing”, 23 April 2018.
 See “Chi on China: China’s Deleveraging Strategy and Evidence (II) – Rising Credit Spread”, 30 May 2018.
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