Fundamental analysis

Commodity Currencies Await Green Light from Beijing

fundamental analysis commodity currencies

14 Jun 2013

Yi fang jiu luan, yi luan jiu shou, yi shou jiu jiao, yi jiao jiu fang, yi fang jiu luan.
When policy is relaxed there is chaos; when there is chaos policy is tightened; when it is tightened people complain; when they complain policy is relaxed; when it is relaxed there is chaos.
Chinese saying

Over the past two months, short commodity currencies/long USD positions have begun to pay off. As of June 13, the Canadian dollar was down 1% from its recent high on May 8. The Australian dollar, New Zealand dollar, and Chilean peso saw much steeper declines, falling 10%, 8%, and 6%, respectively, from highs in mid-April.

One of the main reasons for this weakness is slow Chinese investment growth, which has continued despite expectations of a pickup following last November’s National Party Congress. The Congress’s emphasis on ‘urbanization’ was expected to have set the stage for large numbers of new projects to be launched throughout the country. Over the next ten years, some 40 trillion Yuan (6.5 trillion US dollars) are supposed to be invested in the expansion of China’s cities and towns.

Yet so far the Congress seems to have been a false start. After a brief move to 21.2% in February, FAI growth is now back below 21%. Trends in the bellwether steel industry make it clear that few urbanization projects have gone ahead so far. Chinese steel prices are down about 12 percent since late February, after having risen by some 15 percent during the preceding five months.

Socialist booms and busts

You might think that central planning would make China’s “socialist market economy” largely immune to investment booms and busts. In fact, however, Chinese investment has always been highly cyclical, with peaks in investment growth typically occurring approximately every five years.

Unlike cycles in capitalist economies, Chinese booms and busts originate in the state-sector. Booms are generally led by local government officials, who rely on investment projects to boost GDP growth within their jurisdictions. Busts are imposed by Beijing, which must periodically intervene for the sake of preserving macroeconomic stability.

Year-on-year growth in Chinese fixed asset investment (FAI) last peaked at 33.6% in June, 2009. Subsequently, this statistic trended steadily downwards, reaching a low of 20.1% in May of last year. Since then, it has remained in a range of 20.0% to 21.2%. For the first five months of this year FAI was up 20.4%.

Given that FAI growth has been moving down or sideways for almost four years, history suggests that we are now overdue for an upturn. Yet so far there have been few signs of any strengthening in investment demand.

Urbanization as property  development

For local government officials, whose careers depend more on GDP growth within their jurisdictions than anything else, launching investment projects has always been essential for promotion. They would thus like to turn Beijing’s urbanization policy into an excuse to start grandiose construction schemes. For them, urbanization would ideally be mainly about building new apartments, shops, and offices and the associated infrastructure of roads, subways, power lines, and sewer systems.

Interpreting urbanization as a mandate for real estate development also makes sense from the point of view of local government finances. Most localities depend heavily on land sales to cover their operating expenses and service debt. In fact, no matter how urbanization is defined, without healthy land-sales revenues the local governments will be unable to pay for it.

The problem with the local governments’ idea of urbanization is that China is already facing a glut of unoccupied commercial and residential space. In some places, entire ghost cities have been built—New Ordos, Inner Mongolia, which has enough unoccupied apartments to accommodate almost a million people, being perhaps the most famous example. Such space is typically in the hands of investors, who tend to hold it as a store of value rather than a source of rental income. Much of China’s real estate development thus consists of little more than turning land into empty buildings.

Same bed, different dreams

Beijing’s economic planners naturally have a different view of urbanization. For them, it’s about ‘rebalancing’ the Chinese economy by moving rural residents into cities. This is not only supposed to make them more productive but also to turn them into middle-class consumers, thereby facilitating a transition from investment to consumption-led growth. Unlike local officials, who are mainly interested in urbanizing rural land by replacing farms with cityscapes, Beijing’s goal is to urbanize China’s population.

A logical first step would be to remove the legal distinction between rural and urban residents. Under the current system, the approximately 200 million rural migrants now living in China’s cities continue to be considered as residents of their places of origin. This makes them ineligible for social welfare benefits like medical insurance and K-12 public education that are provided by city governments.

Beijing would also like to see local governments build more affordable housing for the newly urbanized population. A high share of China’s residential development typically consists of luxury apartments and ‘villas’ that ordinary families cannot afford. Local governments can get high prices for the land on which such projects are built, so can developers because they generate high margins, and speculators find them easy to flip. But they do nothing to address the needs of rural migrants, who generally work low-wage factory and construction jobs.

Beijing and the local governments thus find themselves in the “same bed with different dreams,” as the Chinese saying has it. The former would like to see reforms that would facilitate the integration of rural residents into urban society. But the latter would prefer to preserve the status quo for the sake of balancing their budgets and keeping growth rates up.

It is thus unsurprising that the first draft of the urbanization plan drawn up by the National Development and Reform Commission, China’s top planning body, was reportedly rejected by Premier Li Keqiang. The plan apparently was long on ideas for infrastructure spending but short on the kind of detailed economic reforms that Beijing is looking for.

Resolving the standoff

The current slowdown in the Chinese economy is primarily the result of this standoff between Beijing and the local governments. As long as the former is insisting on real reform, investment growth is not going to pick up. But as long as the latter are able to keep reforms from going forward, consumption is not going to emerge as an alternative driver for China’s economic growth.

This standoff cannot continue indefinitely. Sometime later this year, a compromise between Beijing and the local governments is likely to be reached. Once this happens, the latter will give a green light to go ahead with many of the projects they have already planned. Even though these will undoubtedly, tend to be on a smaller scale than originally envisaged and have a variety of conditions attached, a new Chinese investment boom will finally be underway.

That might be a good time to think about covering some of those short commodity-currency positions.

Mark A. DeWeaver