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BOTTOMLINE: Tight credit in China may deflate commodity prices, even equities


The runaway rise in commodity prices could be at risk with China putting the brakes on credit expansion

BOTTOMLINE: Tight credit in China may deflate commodity prices, even equities
Commodities, hard and soft, have seen a big surge over the past year with the S&P World Commodity Index up 64 percent. That’s huge. Metals like copper and steel have been flashing red hot, with Chinese demand surging on the back of its rebuilding exercise post the pandemic. But China has recently started moving to quell the rise. It removed incentives for steel exports after its plan to become carbon neutral by 2060 led to shuttering of many steel units. More and more Chinese leaders are now talking of the risk to the economy from rising input costs and pointing to the need to curb prices. What’s more important, though, is that China has already started tightening credit lines, some months back. And that’s the big one.
China’s credit impulse relates credit growth to GDP, and this metric has been on a decline since the start of the year. What this suggests is that China is tightening credit to keep unbridled expansion in check. However, this is not yet showing up in the global growth numbers, but it likely will, with a lag.
Since I don’t understand the Chinese economy enough to offer a view on its significance, I borrowed knowledge on the subject. I share some of the relevant bits from a few readings here. These first nuggets are from a PIMCO piece in March.
China’s central bank announced it has begun to reduce coronavirus-related stimulus early – a decision that may be far more relevant for policy evolution in developed economies than presently perceived... People’s Bank of China (PBOC) – mindful of the country’s high debt-to-GDP ratio and fast-developing financial markets – places a higher weight on financial stability risks than most central banks, and liquidity is often managed to mitigate the risk of asset price bubbles alongside traditional inflation and exchange-rate-stability objectives.
The important point to note in the above extract is the use of monetary policy to control asset prices. And here, the recent divergence of commodity prices and credit growth in China seems to suggest there could be a possibility of trend correction—given that credit impulse and iron ore and copper prices have tended to move in sync historically.
But let’s get in some more expert views. Below are a few excerpts from a piece in the Financial Times on the subject.
Mike Riddell, a lead fund manager at Allianz Global Investors, warned that China’s credit cycle is "the main global growth dynamic to watch" because it had "driven a lot of global reflation” so far. Any further tightening would drag on global growth as it recovers from the pandemic, he said. "Already China's been the first major economy to tighten policy," said Julian Evans-Pritchard, senior China economist at Capital Economics. The latest signs of a deceleration in credit growth come after the central bank asked lenders to rein in their activity in February. Policymakers have targeted the property sector through the so-called "three red lines" policy, which aims to limit major developers’ leverage as measured by three balance sheet metrics. The approach is designed to constrain their access to credit, which has helped drive a construction boom that pushed steel production to its highest ever level last year...
While global attention has focused on the US, where President Joe Biden’s fiscal stimulus package has boosted global economic growth forecasts, some investors point to the shift in China’s lending patterns as an under-regarded indicator for the trajectory of the global recovery. "The US fiscal spend completely dominates the inflation debate," said Bhanu Baweja, chief strategist at UBS investment bank. "I'm surprised by the extent to which people are not talking about the Chinese credit impulse."
This indeed is a worry. China is the world’s second-largest economy, and to think a trimming of credit flow to the economy will be without repercussions is being naïve. And while the $2 trillion infrastructure stimulus in the US is expected to be a big tailwind for commodities, much of this is factored in. What’s not, is the crimping of Chinese demand. Simple math reveals that every 1% change in the US economy can be offset by a 1.5% change in the Chinese economy.
Source: World Bank
So, if US growth does not surprise on the upside, but China's growth trends down, the impact on global growth and hence commodity demand is likely to be of some significance.
The big question that arises from this is: is the commodity boom nearing its peak? If so, this could hurt other asset classes too.
Commodities and equities have had a significant positive correlation since 2015, as exhibited by the S&P World Commodity Index and the S&P-500. So, if the commodity run falters, the equity run could too.
But here, the traditionally tracked commodity, crude may not be the best indicator. This because after 2019, the correlation between crude and equities has weakened to a level below significance. Is this an aberration and will it revert to the earlier strong synchronic trend between 2015 and 2019? That, only time will tell. But for equities, a turn in the trend for most metals and soft commodities could well spell a turn in trend as well.
So, keep a sharp eye on China and what it does to keep prices in check. That could well be an early pointer to where commodity prices and equity values may be headed.