BackStumbling dragon, crumbling commodities
Slowing growth in China up to 2017, as recommended by the IMF, would keep a lid on commodity prices
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Commodity prices fell sharply last week as China devalued the yuan. But a depreciation of 3-4% is unlikely to affect the demand for commodities in China. Instead, the way to look at it is that both yuan depreciation and low commodity prices are the outcome of low Chinese growth. What matters for commodity prices is, therefore, the outlook on Chinese growth. Clues about that are available from the International Monetary Fund’s (IMF’s) annual consultations with the Chinese authorities, the report on which was made available last Friday.
The IMF forecasts a slowing down of Chinese growth, with its gross domestic product, or GDP, predicted to increase 6.8% this year, 6.3% in 2016 and 6% in 2017. This is substantially below the consensus estimates for 2016 and 2017. The IMF says this slowdown is essential for China so as to remove the imbalances built up in the economy as a result of runaway credit growth and over-reliance on investment demand. Structural reform, such as more reliance on the market and the reform of state-owned enterprises, are also essential to improve productivity. The transition will mean lower growth rates in the near term, but it will be more sustainable growth. The IMF describes it as “Moving to slower yet safer growth". Once the transition is done and the productivity gains from structural reform kick in, growth will pick up, so goes the argument.
Slowing growth in China up to 2017, as recommended by the IMF, would keep a lid on commodity prices. Indeed, the report’s appendix on a Global Risk Assessment Matrix says there’s a decent likelihood in the next one to five years of a “sustained decline in commodity prices".
Even more interesting is the reaction of the Chinese authorities to the growth rates put forward by the IMF. The staff report says that while the authorities realize the need to change the current Chinese growth model, they also believe “growth may stay close to the current level without jeopardizing long-term sustainability". In other words, they would like growth to stay at the current level of around 7%.
What would happen if the Chinese want to keep growth at current levels in the next couple of years, rather than allow it to slip to 6%? Here’s what the IMF staff appraisal note says: “A no-reform scenario is constructed that assumes the authorities attempt to stabilize growth at around 7%. This strategy will eventually fail as growth would slow as the marginal product of capital falls and productivity growth stagnates." Further, they say, “Without reforms, growth would gradually fall to around 5% in 2020, with steeply increasing debt ratios." They’re saying that trying to keep growth high will backfire, resulting in imbalances in the economy building up further and, ultimately, lead to even lower growth in future. In short, growth in China will slow, whether the authorities like it or not.
The impact on commodity prices would depend on the extent to which a substantial slowdown in Chinese growth has already been discounted by the markets. As Chinese growth drops further, it is likely to lead to even lower commodity prices, though the IMF says its has run simulations that suggest it would not have a major deflationary impact on the world economy, given the cushioning effect of lower commodity prices on global demand and “solid medium-term growth prospects in China".
But there are two other clues in the Global Risks Assessment Matrix. One of them states that the likelihood of persistent dollar strength in the next one to five years is high. Indeed, it says that China’s policy response to a strong dollar should be a more flexible market-determined exchange rate, which is exactly what the Chinese authorities claim the yuan devaluation is aimed at achieving. A stronger dollar will mean lower commodity prices.
The report also says that there’s a high probability of lower-than-anticipated growth and persistently low inflation in advanced economies continuing. In that case, the impact on the Chinese economy would be substantial as exports are affected. This would mean “Capacity utilization rates in export sectors would decline, leading to a fall in profitability, rising unemployment, and diminished ability to service corporate debt. A deterioration in banks’ asset quality, together with tighter financing conditions, would further slow investment and growth." In other words, the “solid medium-term growth prospects in China" are by no means assured. Given the size of China’s credit and investment bubbles, and given the history of pricked bubbles, growth is going to be a challenge.
That means commodity prices could stay low for a considerable period of time. Commodity prices move in very long cycles—the accompanying chart of the IMF’s metals index shows the index levels in 1988 were surpassed only in 2005. In fact, the current level of the metals index (for July 2015) is lower than its level in 2006. The IMF projections for this index not only show a substantial fall this year but a smaller fall in 2016 as well, followed by a rise so gradual that the index will be lower in 2020 than in 2015.
That should benefit an importer of natural resources like India. And unless the rupee falls sharply, it should also mean lower inflation and therefore lower interest rates.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at
capitalaccount@livemint.com
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