By John Richardson
THE ABOVE CHART, from this 22 April blog post by Mathew Klein, fund manager and author, underlines the arguments I’ve been making.
“Only 37% of China’s national income is spent by Chinese households on goods and services. That level is lower than anywhere else in the world—except for a few small tax havens and commodity hyper-exporters when prices are high,” wrote Klein.
“For Chinese nonfinancial corporations, employee compensation is only worth about 44% of gross value added, whereas the equivalent measure of the labour share in the US, Europe, and Japan is ~60%”
Meanwhile, as the chart tells us, fixed investment in industrial capacity including capacity that’s dedicated to exports, has outpaced household consumption since 2005. Household consumption as a proportion of GDP is now in decline.
“Globally, according to the World Bank, investment represents on average 25% of each country’s GDP. But China’s investment share of GDP has never been below 40% during the past 20 years,” wrote Pettis, Peking University professor of economics, in this December 2023 article for the Carnegie Endowment for International Peace.
Pettis’s core argument, and I agree, is that China is caught between the rock of being unable to raise domestic consumption by enough to maintain GDP growth at 4-5% and the hard place of being unable to instead raise exports to achieve the same objective.
As I’ve been discussing since 2011, China was always going to face to the challenges of a rapidly ageing population. I warned then that, sooner or later, savings rates would increase to meet rising healthcare and pension costs resulting from a growing number of retirees.
The problem is compounded by relatively weak healthcare and pension system, and as Klein argues, weak employee compensation compared with developed countries. If employee consumption was to rise to rise to developed-country levels then, of course, China’s export competitiveness would struggle.
Back to the subject of investments and exports and the Pettis analysis.
“If China were to maintain current growth rates [4-5% per year] while keeping its high investment and manufacturing shares of GDP, its share of global investment and manufacturing would expand much faster than its share of global GDP,” he said.
China investments in new industries: “Too large for the rest of the world”
“In that case, it could only do so if the rest of the world agreed to accommodate that growth by reducing its own investment and manufacturing levels to less than half the Chinese level,” wrote Pettis.
He added that even without the geopolitical tensions and policies in the US, India, and the EU to boost domestic investment and manufacturing, this would still be highly unlikely.
Under a scenario where China continued to focus on investment-led growth, the rest of the world would have to agree to reduce the investment share of its GDP by roughly 1 full percentage point to 19% of GDP, well under half of the Chinese level, Pettis added.
“This would also require China’s debt-to-GDP ratio to rise from just under 300% to at least 450–500 % in a decade,” he wrote.
“Given the huge difficulties the Chinese economy is already facing at current debt levels, and the difficulties Beijing has had in its attempts to reduce the debt burden, it is hard to imagine that the economy could tolerate such a substantial increase in debt,” continued the author.
Klein’s blog post opens with contextualising just how, quite frankly, pie-in-the-sky is the idea that the rest of the world’s manufacturing and investment will expand less than its GDP in order to accommodate a rise in China’s exports.
He quotes Janet Yellen, US Treasury Secretary following her recent meetings with Chinese government officials. Yellen said on the US Department of Treasury website:
“There are features of the Chinese economy that have growing negative spillovers on the US and the globe.
“We are seeing an increase in business investment in a number of ‘new’ industries targeted by the PRC’s industrial policy. That includes electric vehicles, lithium-ion batteries, and solar.
“China is now simply too large for the rest of the world to absorb this enormous capacity. Actions taken by the PRC today can shift world prices. And when the global market is flooded by artificially cheap Chinese products, the viability of American and other foreign firms is put into question.”
Much was made of China’s “booming exports” in Q1 this year (year-on-year in value terms they were up by 5%) as industrial production also sharply increased. But, as always, it is the numbers behind the numbers that count.
The second chart below, from the same Klein blog post, reflects that we are seeing in petrochemicals is the same across all industries: Record levels of overcapacity.
“Total Chinese industrial production has been running about 5% below the 2014-2019 trend since 2022,” wrote Klein.
“While some of that gap may reflect the retrenchment of foreign demand for durable goods after the initial panic-buying during the pandemic, it also coincides with the harsh imposition of Covid Zero, which squashed Chinese domestic consumer spending.
“Tellingly, the end of those restrictions does not seem to have led to any catchup in either retail purchases or industrial production,” he added.
He also quoted to some worrying statistics on automobiles. He said that the number of finished vehicles recently produced was below the 2017-3018, with most exports comprising traditional internal combustion engines rather than electric vehicles.
“Chinese retail spending on vehicles has grown at an average yearly rate of just 2% over the past six years. Spending in the past 12 months has been a third lower than what might have reasonably been expected based on prior trends,” wrote Klein.
The PP business reflects the macro picture
The thing about petrochemicals and polymers is that they reflect what’s happening in the broader economy – because they play indispensable roles in all the manufacturing and service value chains.
Polypropylene (PP) therefore mirrors the above macro-economic picture, starting with what the ICIS local production estimates tells us about the country’s operating rate in 2024.
If you annualise our estimates for local production in January-March of this year (divide by three and multiply by 12). this suggests a full-year operating rate of just 75%. This would compare with the average 1992-2023 operating rate of 87%.
As I’ve discussed before, 1992 was the start of the China’s economic and so Petrochemicals Supercycle. It thus makes sense to start measurements from this year.
The chart below puts this forecast record-low operating rate into the context of China’s surge in local capacity versus local demand.
Capacities as a percentage of demand averaged 79% in 1992-2023. I forecast that this will rise to 140% in 2024-2030, based on my estimates for demand growth and our base-case assumptions on capacity growth.
Meanwhile, as China struggles to boost domestic consumption, I believe that the country’s PP and other petrochemicals demand growth has arrived at a New Normal of averaging 1-3% per year. We can see the emergence of this pattern from the latest data on China’s PP demand.
Note the 2022 turning point when PP demand growth fell to 2% over the previous year (this fits-in with my 1-3% long-term forecast). This followed China’s Evergrande moment in September 2021, as trade tensions with the West also built and as the demographic pressures increased.
Declining local demand growth combined with the surge in Chinese capacity explains the next chart.
The China CFR PP price spread between CFR Japan naphtha costs has averaged just $203/tonne so far this year, the lowest since our price assessments for the above three grades began in 2003.
Note the table at the bottom of the chart. This shows average spreads for the three grades between 2003-2021 (during the Petrochemicals Supercycle), average spreads since then and the percentage recoveries required to return the spreads to their long-term historic levels.
Until or unless spreads return to their historic averages there will have been no full recovery. The big scale of the required recoveries underlines the depths of today’s crisis.
A further illustration of the huge value of ICIS data, when combined-together in the right ways, is the chart below.
Using the approach explained in the chart’s foot notes, total sales losses among China’s top ten PP trading partners in January-March 2024 versus the same months last year came to $224m. Thailand and Malaysia were each $1m ahead.
In 2023 versus 2022, there were total losses of $1bn among China’s top ten trading partners. Kazakhstan gained $94m, the Russian Federation $6m and Malaysia $4m.
Returning to the Mathew Klein blog post, he quotes Chinese government data indicating a surge in the value of Chinese exports of motor vehicle to $80bn/year, up from $9b/year as recently as 2019.
“China has flipped from a major source of net demand for finished vehicles into a major source of net supply, he wrote.
As in autos, disappointing local PP demand growth versus the build-up in local capacity explains the table below.
Exports in January-March this year totalled 619,367 tonnes versus 315,904 tonnes during the same months last year – a 96% increase. If the same export momentum was maintained throughout 2024, this year’s total exports would reach 2.5m tonnes compared with 1.3m tonnes in 2023.
The above table also shows China’s top ten export destinations in January-March 2024 compared with January-March 2023.
The shift in export destinations, including most notably the big jump in exports to Brazil, can partly be explained by the next graph, which shows the PP price premiums for selected overseas destinations versus China. I’ve only focused on injection grade as this is said to be the main grade China is exporting.
But “any port in a storm” might be the approach for China’s PP exporters over the next seven years as they attempt to reduce domestic surpluses.
In my 2 April post, I suggested that China’s net PP exports could average 7.2m tonnes a year between 2024 and 2030. But I see it as more likely that growing trade tensions will leave China in a more-or- less balanced position with few imports and lower exports than we have seen so far this year.
Conclusion: Back to Gillian Tett and Fool’s Gold again
I keep reflecting-back on Gillian Tett’s masterful Fool’s Gold, her account of the Global Financial Crisis.
In the book, she details how too few bankers, politicians, regulators and financial analysts were able to take a helicopter view of events that led up to 2008 because they were trapped in “silos” of their specialist knowledge. This meant that the problems with mortgage-backed securities were largely missed.
So I believe has been the case with the events in and surrounding China. Experts in PP and other petrochemicals were good at building plants, in developing technologies and in sales and marketing, but not so good at seeing the connections between China’s demographics, its property bubble, its relatively weak domestic consumption and the shift in its relationship with the West.
What is done is done. How we move forward, as discussed before, is through the sustainability transition. This can enable producers in countries and regions such as South Korea, Singapore, Japan and Europe to reinvent themselves, despite the vast oversupply in petrochemicals in general – which is largely the result of events in and surrounding China.
But this will require a new type of helicopter thinking, linking together energy, petrochemicals, downstream industries and a host of environmental, economic and societal factors.
I will be using the blog to suggest how this might work during the next few months.