Beware the China credit cycle impact on demand

US novelist, screen and TV scriptwriter Wynne McLaughlin was absolutely right when he said: “Maybe history wouldn’t have to repeat itself if we listened once in a while.” As was the case in 2014, there is major risk that consensus opinion is again overlooking the influence of China’s credit cycles on oil prices, polyolefins and other commodities prices – and on global economic growth.

To explain what we mean, here is the history of China’s credit cycles since 2009.

Half of total global stimulus in 2009-2013 came from China. And yet, the rise in Chinese credit was largely overlooked as everyone focused on smaller stimulus efforts by the US Federal Reserve and other western central banks.

China increased lending by $10tr in 2009 when its nominal GDP was only $5tr. This was a desperate scramble to stimulate local demand in order to compensate for export-focused jobs that were at risk as a result of the global financial crisis.

In effect, the instruction from Beijing to the state-owned banks was: “Go out and lend for the sake of lending and do not worry about the long-term supply and demand fundamentals of the projects you lend to.” This led to overcapacity across many industrial sectors and a sharp rise in China’s polypropylene (PP) self-sufficiency, along with a major real-estate bubble.

The credit bubble also resulted in the growth of the shadow banking sector. This involves highly speculative and complex – and so very risky – lending practices.

Lending was an astonishing $18tr higher by 2013 when China’s president, Xi Jinping, came to power. He then reversed policy from early 2014, causing lending to fall $4tr by 2015. However, last year saw lending take off again.

XI IN CONTROL

What happens next? Xi Jinping, who leads the reformist political faction within China’s senior political leadership team, appears to be back in full control of the government.

Last year, Prime Minister Li Keqiang, who leads the group of politicians that prefer short-term stimulus measures to tackling China’s debt problems, seemed to have had more influence. Hence, the reinflation of the credit bubble.

And so with Xi back in control – and with his political influence likely to increase after this October’s important 19th National Party Congress meeting – it seems likely that lending will once again become harder to come by in China during the rest of 2017 and in 2018.

Why this matters so much for Chinese economic growth is because this extraordinary rise in credit since 2009 has had a huge, beneficial effect on key end-use markets for polyolefins. Take autos as a good example, which is a major end-use market for PP:

• In Q1 2017, Total Social Financing (TSF) averaged Chinese yuan (CNY) 2.4 tr/month, 2.2x the CNY700bn/month level in Q1 2008. TSF is a measure of total credit creation in the economy, including lending from both the state-owned banks and the private, shadow lenders.
• Auto sales in Q1 2017 averaged 1.9m, 2.06x the 733,000/month average for Q1 2008.

MIDDLE CLASS MYTH

“Hold on, though,” I can hear you saying. “The growth in Chinese income levels is also behind the rise in consumption of all the finished goods made from polyolefins. This is not just about excessive credit creation”. This is an argument very often used by the CEOs of polyolefins companies, particularly in the US, where the industry is on the cusp of major polyethylene (PE) expansions. The often-repeated comment is that the “growth of China’s middle classes” guarantees a very strong economy, even if lending was to decline again.

The problem is that the official government data on income level does not back up this argument. According to the Chinese government’s National Bureau of Statistics, average urban incomes were at $5,061 in 2016, while in rural areas it averaged only $1,861. This would represent extreme poverty in the west.

There was thus no way that autos, housing and other sales could have grown at the levels we have seen in China in recent years without a massive credit bubble. If this bubble is again deflated, this has to mean lower demand growth for many of the finished goods made from polylolefins.

IMPACT ON OIL PRICES

As we said, we have been here before. From early 2014, as Xi took control of the economy, month-by-month growth in TSF began to contract compared with 2013.

But it was not until around September 2014 that global consensus opinion recognised this pivotal change in China’s economic direction. Recognition that China was slowing down was one of the factors behind the subsequent fall in oil prices – and so of course polyolefins prices – and the prices of other commodities, such as iron ore. Global economic growth also weakened.

So far this year, the evidence on lending is mixed. In January-February, TSF was sharply down compared with the same two months in 2016, but it then bounced back in March.

However, March saw a sharp fall in the growth of lending from the state-owned banks with the surge in that month’s TSF the result of consumer lending, via the highly speculative and risky shadow-banking system.

But our ICIS China team believes that later this year, economic growth will moderate on reduced credit creation. This is one of the reasons why we are forecasting just a 5% increase in China’s oil imports in 2017 compared with 13.6% in 2016.

There are three other reasons for this forecast of much-lower growth in oil imports:

1. China’s teapot, or independent, refiners will import less crude this year than 2016’s record amount of 87.6m tonnes.
2. Demand from the bigger state-owned refiners – Sinopec and PetroChina – will be stable, rather than spectacular, this year. This will be the result of oversupplied local fuels markets.
3. China wants to prevent its foreign reserves from falling below the $2.66tr level, below which its economy may struggle to function normally. It is thus much more carefully monitoring the flow of funds overseas, including offshore oil purchases. China is also worried that excessive yuan depreciation could trigger a trade war with the US – another reason for controlling the outflow of funds.

This matters like just about nothing else for global crude markets because China is in major deficit on oil, and has been the number one driver of global incremental demand growth for many years.

Lower Chinese crude imports will not automatically, of course, translate into lower global oil prices. But if the economy does indeed slow on lower credit growth later in 2017, there is a good chance that this will happen. Global sentiment in crude markets may again turn negative, as it also did in 2014 – especially if at the same time US shale oil production continues to rise.

ALTERNATIVE SCENARIOS

The current high levels of uncertainty surrounding oil prices and the global economy make it even more important to include alternative scenarios when attempting to forecast polyolefins prices. ICIS monthly PE and PP Asia price forecast reports include alternative scenarios based on different assumptions on crude prices and naphtha costs. Crude could surprise everyone on the downside, leading to lower-than-anticipated naphtha feedstock costs. Equally, of course, the opposite might happen if today’s very fraught geopolitical environment further deteriorates. Crude prices, and so naphtha costs, could go through the roof.

For example, in its April PP Asia price forecast report, the consulting team at ICIS predicted a base case for average monthly Brent crude prices for the forecast period April 2017-March 2018 of $57/bbl. This led us to forecast naphtha at an average of $489/tonne CFR Japan and raffia-grade PP at $1,057/tonne CFR China. The alternative outlook took crude down to an average of $47/bbl and naphtha at $419/tonne CFR Japan. This left raffia-grade PP at $935/tonne CFR China.

IMPACT ON GLOBAL ECONOMY

Leading economists, including those who work for the International Monetary Fund (IMF), have recently been upgrading their forecasts for global growth. In the case of the IMF, its April decision to raise its annual forecast for global growth was the first time it had done this since 2011.

But we believe that by the time this article is published, or soon afterwards, the global economy may well be showing signs of cooling again because the recovery we have seen since mid-2016 is largely down to China. And, as we said, China will soon be slowing down again.

As UBS wrote in an April 2017 report:

“The economy at the epicentre of the most significant growth impulse for the global economy has actually been China. Its [total] import volumes rose by just under 15% over the last 12 months, providing a solid boost to global growth. By comparison, US import volumes grew by 3.5%, while Europe’s were nearly flat over the same period.”

History does not have to repeat itself for polyolefins companies if they have the right planning in place to deal with a repeat of 2014. During that time, some companies were caught out by extreme pricing volatility and weaker-than-expected demand.

ICIS PRICE FORECAST REPORTS

The price forecast reports are produced by the consulting team at ICIS, and are available for the PP and PE markets in Asia, Europe and the US. Price forecast reports are also available covering the global benzene market and the European styrenics market. Find out more: