With overcapacity and plunging prices, someone else picks up the tab

PUBLISHED : Monday, 15 May, 2006, 12:00am
UPDATED : Monday, 15 May, 2006, 12:00am

'China's producer prices rose at the slowest pace in more than two years last month as excess capacity led to plunging prices for many industrial products and raw materials.'

SCMP, May 12

'China's central bank said a report by accounting firm Ernst & Young which claimed that the mainland's bad loan ratio was almost six times higher than disclosed was 'ridiculous'.'

SCMP, May 12

NOW HOW MIGHT we make a connection between these two news items?

Let's try it with some numbers. Text is for Shakespeare. In matters of economics and finance, a story is told in facts and figures, which are best presented in charts and tables. That should mean I could end this column right here after introducing the first chart but the boss wouldn't like that.

The bars in the first chart show you that China's production of steel has tripled over the past six years to almost 33 million tonnes a month. This is a lot of steel. It is about four times as much as the United States produces and, at latest exchange rates, the US has an economy almost six times as large as China's.

We certainly have an indication here of excess capacity and, as our first news item asserts, we also have evidence of plunging prices. Look at the blue line on the chart. It represents the year over year inflation rate for smelted and pressed steel on China's producer price index.

Now notice the minus signs on the bottom of the right-hand axis. The latest figures say steel prices in China are down 9.2 per cent from the same period last year. There was a spike in those prices two years ago, but it is over now.

What this suggests to me is that China's steelmakers are paying no attention to whether they make money. They have state permission to go for growth and that's that. The bosses are just employees with little or no personal stake in their firms. If they lose money, someone else has to pick up the tab.

And who might that someone else be? The ravenous appetite of China's banks in tapping the Hong Kong market for cash already suggests the banks smell trouble. The story in steel tells what shape that trouble may take.

Thus, if the People's Bank of China protests that Ernst & Young's figure of US$911 billion in bad loans is ridiculous, well, it may not be a fully accurate figure at the moment, but I can see how it quickly could become one. The story in steel can be told in many other industries at the moment.

Now for another metal prices story. China's internal steel market is out of sync with prices for other metals. Copper prices on the London Metals Exchange have risen fivefold in the past three years and it is a general trend in most metals. I cannot rationalise it with what is happening in China's internal market and I am not the only one to be dismayed by the trend. Noble Group, a Singapore-listed commodities trader and supplier with a big presence in China, also took note of it in a first-quarter results announcement.

I shall quote chairman Richard Elman's comments about it at length here because he adopted a growing practice from the US of talking about his company's performance in everyday speech, leaving the jargon that securities authorities require to follow underneath. 'We have never, ever seen such a disconnect between reality and the pricing of raw materials as that which we observe today. Ladies and gentlemen, this is fairyland.

'It is a fairyland defined by hundreds of patently ridiculous apartment blocks, vacant shopping malls, and never to be occupied factories lining a road, with overpasses to nowhere, stretching between two cities that you have never heard of in China.

'If we have drunk too much coffee and are having a really bad dream, we don't drive between the two cities you have never heard of in China counting all the shrines to misallocated capital, we ride a massive, super slick, steel hungry, maglev train that is 95 per cent empty and operates only sporadically.'

And so on. Yes indeed, overinvestment, overcapacity, overbuilding, prices askew and who will pick up the tab in the end? I might use the word 'ridiculous' about it, too, but not in the way the PBOC does.