China: From accelerator to brake?

Continuing today's Asian theme, Mark Thoma brings our attention to an Economist piece on China and commodity prices, From accelerator to brake. It argues that "the Chinese economy has driven a boom in commodity markets. It may be turning into a drag".

The country's enormous appetite for base metals, minerals and fuels has pushed their prices to new highs and created record profits for the companies that extract and process them. With China swallowing raw materials as fast as they can be dug up, some observers even talk of a “super-cycle” of extended high commodity prices.

However, the popular perception of China as an insatiable commodity-guzzler is now too simple. As the Chinese authorities have attempted to cool overheated parts of their economy, from construction to cars, consumption of some commodities has slowed sharply or even fallen.

Of course its not a simple slowdown story. Demand for some commodity imports, like coal, remains strong. "In other raw-material markets, the recent weakness reflects inventory corrections." And  for some commodities "a new wave of demand may be gathering, as construction ..appears to be accelerating again". So what's new? Well, Chinese aluminium, steel and cement exports have grown rapidly, and there appears to be "massive excess capacity" building up in those two metals (the classic Asian over-investment story).

All of this will cause political headaches for the Chinese as well as economic upset for their trading partners. Until now, China's surging exports of manufactured goods have at least partly been balanced by its strong imports of raw materials. If it now starts to export commodities and basic goods as well, trade tensions can only worsen. Steel could follow textiles as the next flashpoint.

There are signs already. On October 3rd, America's International Trade Commission agreed that rising steel-pipe imports from China were causing “market disruption”, a victory for American pipe producers who have been lobbying for protection. Recently, POSCO, South Korea's largest steelmaker, gave warning of China “turning into a threat” as South Korean shipyards develop an appetite for cheap mainland steel. And at the Seoul conference, Guy Dolle, chief executive of Arcelor, the world's second-largest steelmaker, painted a terrifying picture - for him, anyway - of a gigantic Chinese steelmaker, pushing out 150m tonnes a year.

Whether China's government will manage to consolidate the sector to this extent is questionable, given the strength of vested local interests. But that is not the point. The bogeymen are already being conjured. Both China and the rest of the world will find an end to the long commodities boom hard to handle.

I have two problems with this thesis. First, why would the end of the long commodities boom - if indeed that is occurring - be such a bad thing? Surely cheaper commodities are (1) to be expected after such a strong rally, and (2) a good thing for world inflation?

Second, what is wrong with China becoming a major exporter of steel, aluminium and other simply transformed manufactured goods? Of course, that might trigger a protectionist response, but I'm surprised the normally free-trade Economist would give any credence to such vested interests. Mark Thoma also takes a dim view:

I understand why I should be concerned if central planning or some other inefficiency in China is causing excess capacity and affecting world markets for steel and other commodities. But that is not the argument. I don't understand why I should be concerned with an outward shift in the world supply of commodities resulting in lower prices for key inputs to production. Why is that a problem?

If Chinese industry can produce steel cheaper than other countries, then let them. We will all benefit.

Comments

[brad setser]

a couple of notes of caution:

a) china's exchange rate is decidely not free, so more exports/ import substitution (barring offsetting demand surges) = larger trade surpluses, and bigger imbalances. some of China's competitive advantage derives from an exchange rate that is sustained by massive central bank intervention. if metal bashing was moving to China in the face of (additional) RMB appreciation, I would be more comfortable.

b) China subsidizes domestic energy -- and energy is a big input into steel. not sure how big the subsidy is, but it is significant. today's WSJ reported china uses 50% more energy per unit of steel than Japan. korea is more like japan.

c) lots of steel plants are owned by local governments and financed by banks that are partly owned by local governments, and overall, credit in china is both cheap and hardly allocated on the basis of price. there are i think legitimate concerns about production increases stemming from non-market decisions about credit allocation in 03-04. there is a reason why the PBoC slapped on administrative controls to try to limit investment in new steel capacity.

there are lots of potential distortions here.

[Steve]

Yes, China is a managed economy and the hand is always visible at least for now but we must bear in mind that China has entered WTO and very soon China has to loat RMB but for now, if CHina opens the exchange rate system and let RMB competes in the international market, China may not be ready for that given China's backward banking system and the financial market is still at the infant stage but in time, China must open it currency market completely when it is ready for that.

It is true that the Chinese economy appears to be cooling given the need to cool the Real Estate Market as well as ensuring a soft landing. Therefore, we may be seeing that China could start supplying commodities for the World Market instead of sourcing them in the global market years ago. Moreover, China is playing a fair game and does not subsidies any commodities that are geared for export.Otherwise, China would suffer too much every time if it has to supply base metal for export.
I guess we do not have to be too jealous of China's economi progress because China plays the game fairly and not squarely to compete just for the sake of export. Otherwise, China would definitely be in great trouble and stripping its owners'earnings for the sake of just exporting.

As such, we must not be too hysterical as to the modernization of China and as a matter of fact, China has to open its door to free trade beginning this year as it has promised WTO in 2001 that China would open its market directly to overseas investors and not for long, Chinese Currency RMB would have to be floated in order to survive competition in the Worldwide Circus.

Steve

[Edward Hugh]

"there are lots of potential distortions here"

Yep. Sure. But remember that in Korea and Japan - if they are the central reference points of comparison - there are plenty of potential distortions too. Eg the differences between internal market productivity in Japan the export sector, as, incidentally highlighted in the BIS productivity post above.

[brad setser]

China does not subsidize commodity exports, but it does in some ways subsidize imported commodity imports, by holding down domestic prices for something like oil. that facilitates certain kinds of exports. of course, by keeping the rmb's value down, china also makes certain imported inputs more expensive than they need to be.

Edward -- Korea and Japan have smaller current account surpluses now than china does now, and generally ran smaller surpluses (korea even had a deficit for a while) during their fast growth period. an analogy can be made between china's banking system now and korea/ japan's banks in their catch up phase, but i think the extent of China's fx intervention is unprecedented. Japan's current account surplus at the peak of the 80s was under 5% of its GDP i think (in part b/c the US CAD was smaller then than it is now). I do not think Korea or Japan ever intervened in the fx market to the tune of 15% of their GDP to support their export sectors. directed credit -- sure. cheap credit (perhaps too cheap) -- sure. but this kind of support via the central bank's balance sheet? No.

[Edward Hugh]

"but i think the extent of China's fx intervention is unprecedented."

Yes, surely it is, I don't think we really disagree about this. But then just about everything relating to China from now on is going to be unprecedented.

Obviously I'm not saying that Japan and Korea have the same distortions as China, just that there are important 'distortions' (even when compared with a European economy like France say. Incidentally, is the US the only economy that isn't 'distorted' apart from Finland and Singapore?). The thing is structural management distortions in Japan (this is why people talk about financial socialism) and S Korea. The system of interlaced business networks is obviously hugely different from anything we know.

"but this kind of support via the central bank's balance sheet? No"

Agreed, in Japan it has been mainly through the Ministry of Finance: viz the notorious 'convoy' system.

BTW, I don't know if you'll come back and read this, but you'll just *love* the latest rendering from Kotlikoff:

http://econ.bu.edu/kotlikoff/China.pdf

"Will China Eat Our Lunch or Take Us to Dinner?"

It's overlapping generations, lifelong savings stuff of the kind which interests me, even if I don't quite buy what he's saying:

"This paper develops a dynamic, life-cycle, general equilibrium model to study the interdependent demographic, fiscal, and economic transition paths of China, Japan, the U.S.,and the EU. Each of these countries/regions is entering a period of rapid and significant aging that will require major fiscal adjustments. But the aging of these societies may be a cloud with a silver lining coming, in this case, in the form of capital deepening that will raise real wages."

"Adding China to the model further alters, indeed, dramatically alters, the model’s predictions. Even though China is aging rapidly, its saving behavior, growth rate, and fiscal policies are currently very different from those of developed countries. If successive cohorts of Chinese continue to save like current cohorts, if the Chinese government can restrain growth in expenditures, and if Chinese technology and education levels ultimately catch up with those of the West and Japan, the model’s long run looks much brighter. China eventually becomes the world’s saver and, thereby, the developed world’s savoir with respect to its long-run supply of capital and long-run general equilibrium prospects. And, rather than seeing the real wage per unit of human capital fall, the West and Japan see it rise by one fifth percent by 2030 and by three fifths by 2100. These wage increases are over and above those associated with technical progress, which we model as increasing the human capital endowments of successive cohorts."

So China *saves* the world. Not quite your cup of tea I imagine :).

I don't think he's quite got it either (I smell something fishy in the way he uses 'effective labour' for a start, but there is more).

Otoh I definitely think that there is a certain symmetry through artificial demographic shocks in both cases: in the US a demographic jump-start through immigration, and in China through administratively imposed low fertility. This is why the two of you seem to be tied together so, and I do think it is worth *starting* the analysis here.

Also, one more for your reading list if you haven't seen it:

Modigliani, F, and Shi Larry Cao (2004), The Chinese Saving Puzzle and the Life-Cycle Hypothesis, Journal of Economic Literature, Vol XLII (March 2004) pp. 145-170.