China Research

A discussion forum on emerging markets, mainly China – from a macro, micro, institutional and corporate angle.

The Rise of China and its Influence on Commodity Prices

October 3, 2012

Commodity price indices had been in a broad decline in real terms since mid-1800s. The falling real price for commodities was the product of ongoing global economic development and demand growth, but also a positive commodity supply response and ongoing increases in productivity and innovation in the use of resources.

Oil prices were an obvious exception in 1970s, with two sharp upward oil price shocks – but oil prices then fell back to earth in the 1980s and 1990s.

What has changed? The principal difference has been the Chinese growth miracle since early 1980s, which has added a new source of global commodity demand beyond the normal growth pattern in industrial countries. Other emerging markets also caught the policy reform wave, saw their sustainable growth rates and incomes rise, and the demand for commodities followed in tandem.

The rise of the middle class in China and a growing number of other emerging markets was thus the core driver of increased commodity demand and in real prices (that is, with the impact of inflation removed) Since the early 2000s, there has been a structural upward shift in the global prices for energy, metals, food and related key inputs like fertilizer.

Recent global economic developments have had a negative feedback effect on many commodity prices. Global turbulence due to the ongoing euro crisis, the slow US recovery, and slower related economic growth in emerging markets has placed downward pressure on commodity prices as global demand slowed. However, although commodity prices in aggregate have declined over the past 18 months, they generally remain well above the levels of a decade ago. There are, of course, differences among the various commodities – pulp, iron ore and natural gas prices are all facing their own special downward forces.

But in general, each time there is a drop in perceived global economic risk, energy and key metals prices (like copper) rise again, which reinforces the strength of the underlying demand for resources from China and other major emerging markets. Commodity prices in aggregate may not return to the highs of 2007 any time soon, and they may even decline a bit in real terms going forward. But they are also unlikely to return to the historic downward path. Structurally higher commodity prices are the new normal, thanks to the rise of the middle class in China and many other emerging markets.

 

 

 

 

Glen Hodgson

Chief Economist, The Conference Board of Canada

 

Back to Start Page

How the Euro Connection could Boost Russian Asset Prices

One of today’s puzzles is the low valuation of Russian equities. On average, these cost just 6 times the expected profits of 2012, while Canadian stocks trade at 15 times earnings and Norwegian stocks at 12 times, to mention just the two commodity producing countries which lie in the same climate zone. The message from the price-to-book ratios is similar: if a company is attractive for investors, the ratio should be well above 1. But Russian stocks average only 0.85 whereas Canadian and Norwegian stocks trade at 1.85 and 1.58.

Creating conditions that bring valuations on par with those of other stock markets would do wonders for the country’s spending on capital goods, including foreign direct investment, the growth rate of real GDP and thus for the standard of living.

One way to achieve this is to create an institutional framework similar to that of the democracies of Western Europe. This is just as important as broadening Russia’s production base and reducing its dependency on raw materials. Indeed, a comprehensive and state-of-the-art institutional framework is probably the precondition for that sort of structural change. Economists emphasize more and more the role of institutions in development, such as independent courts, media, regulators and central banks, a fair and efficient tax system, genuine opposition parties which have a reasonable chance to oust the existing government in secret ballots, an incorruptible bureaucracy, good and affordable kindergartens, schools and universities, a well-maintained infrastructure, and so on.

Russia has serious deficiencies in all these areas and pays the price in the form of undervalued equities and real estate. In spite of its enviable endowment with natural resources it is an unnecessarily poor country.

One approach to improve things is to use the European Union’s “Acquis communautaire” as a guide for institutional reform. Norway and Turkey, very successful economies for some years now, have done this – without being members of the EU. The Acquis covers the EU Treaty, the whole body of laws, decrees and guidelines passed by EU institutions as well as the judgments of the European courts. These are binding for all 27 countries, and new members have to fully adopt them. Dauntingly, the complete edition of the text comprises 31 volumes and more than 85,000 pages. Cyprus and Malta have been able to do it, so Russia’s civil service could certainly do it as well.

For years, Russians did not care much about institutional reform. They were able to increase their spending at a higher rate than production, as export prices have outpaced import prices. The general feeling is that the standard of life continues to improve. Since this is not accompanied by political and institutional progress, the rising middle classes are getting restive, demanding a bigger say in the country’s decision making process.

To rely on ever higher commodity prices is not a sustainable growth model in any case – prices will certainly not go up all the time. Every so often they crash and cause havoc in the rest of the economy. The 8 per cent decline of Russian GDP in 2009, the 80 per cent fall of stock prices between mid and end-2008, the 36 per cent depreciation of the rouble against the dollar during that time, and the collapse of the real estate market were direct consequences of the crash of raw material prices, in particular the oil price which imploded from $146 to $35 in just half a year. To this day, markets are not yet back to pre-crisis levels.

If Russia had more robust institutions and took the rule of law seriously, investors would demand lower risk premiums for holding shares of companies and government and corporate bonds – which is another way of saying that asset prices could be much higher, and the cost of capital correspondingly lower. A big increase in capital spending is needed to wean the country from its reliance on commodities. China’s impressive growth model has at its core very high saving and investment ratios. Anything that helps to boost these must have top priority for policy makers. Right now, the value of Russia’s firms that are traded at the stock exchange is about 19 trillion roubles (€465bn).

If the government could credibly show that it will launch an institutional reform process on the basis of EU standards, this number could easily double, cutting the cost of capital expenditures by one half. Perhaps more importantly, Russia would become a more normal country where people like to live, rather than trying to emigrate.

 

 

 

 

 

Dieter Wermuth
Chief Economist & Partner, Wermuth Asset Management

 

Back to Start Page

The Chinese Currency Conundrum

Recent informal talks with business managers from both the industry and the financial sector in a number of developed countries have led me to the conclusion that general knowledge about the Chinese currency (renminbi = RMB or yuan = CNY, official) still is very limited. This is the case despite China’s great – and still growing – importance to the global economy and many globalized companies.

There are different reasons for this shortcoming. Many executive practitioners in the corporate world are not really interested in details of exchange rate policy. Furthermore – which may be an even more important reason for the lagging interest – the Chinese exchange rate policy is still extremely opaque for outsiders, i.e. for everybody outside the Chinese Communist Party leadership.

Some knowledge about Chinese exchange rate policy, however, exists. We know that China had an 8.3 RMB fixed link to the American dollar (USD) until 22 July, 2005. On this day, this fixed exchange rate regime (more or less) was abandoned and replaced by a limited floating policy which allowed for a sizeable appreciation until today all the same – the Chinese answer after many years of American complaints about an undervalued Chinese currency when considering China’s dynamically rising surpluses in foreign trade.

We also know that China is linking the RMB to a kind of currency basket that consists of about 20 different currencies. But what we do not know are the weights of these 20 different currencies in the Chinese basket despite the obvious dominance of the USD in this basket. In an interesting empirical study (“Re-pegging the renminbi to a basket: issues and implications”, Crawford School of Economics and Government, 2012, Asian Pacific Economic Literature), Heikki Oksanen from Helsinki University found that the RMB may be linked by up to 90 per cent to the USD. The consequence of this is that not very much influence is left to the other currencies – not even to the Euro – which means that predictability of the CNY vis-à-vis other currencies tends to be even more difficult.

Having said that the Chinese exchange rate policy is closely linked to the USD does not, however, rule out that China’s political leaders in recent years having been going for a cautious, but visible appreciation policy with slightly varying speed of this policy in relation to the USD (around 25 percent since July 25, 2005). Sometimes, we also have seen intermissions in this appreciation process – obviously in times when Chinese exports have been/are suffering from difficulties because of dampened global demand. This could be observed during the American subprime crisis in the latter part of the past decade and in 2012 when the European crisis was the seen as the main obstacle for Chinese exports.

Despite the fact that two thirds of the huge Chinese currency reserves are invested in USD, it would be beneficial to China to gradually decrease the weight of the USD in its currency basket which I have been pointing at before in different articles. The predominance of the USD is too strong in this respect, also from a (Chinese) risk perspective. The current Chinese foreign investment strategy makes China too dependent on financial markets’ confidence in the dollar. The U.S. economy will have major challenges in the forthcoming decade, too, and nobody can rule out that the USD may suffer from sizeable downward pressure at some point in the future.

Altogether, the composition of the Chinese currency basket should have much more hedging elements. This is another reason why China really dislikes the ongoing European crisis since only the Euro has the theoretical and practical capacity to become a real alternative to the USD for Chinese currency investors. Therefore, China is definitely not interested in a weak Euro.

However, there is only way for the Chinese exchange rate policy to get closer to the Euro, i.e. the very gradual one. Really fast moves in such a direction would cause turmoil on global currency markets at the expense of the dollar – but also when it comes to the development of the real economy of China, the U.S. and many other countries (exports, imports, GDP). China most certainly wants the survival of the Euro.

If we assume a positive outcome of the current Euro/European crisis, the Euro will gain a lot of importance in the longer run, maybe 10 years ahead or even more. This would “automatically” incline a weakening status of the USD as a reserve currency with unpredictable consequences for both the U.S. and the whole global economy. We really should hope that the U.S. will be successful in restoring fiscal stability and sustainability during this probable process.

Otherwise, the global economy will become even more unstable. China will – without doubt -have an increasing impact on this development, also by its exchange rate policy. However, the “global house” cannot be put in order during the next decade or so without major positive contributions from both Europe and the U.S. – also for the avoidance of (temporarily) chaotic conditions on global currency markets.

In the meanwhile, there should be room enough for China to make its exchange rate much more transparent and also for substantial changes in exchange rate policy. Such a change could mean a more trade-related basket in line with the Swedish model from the 1980s (which failed because of major macroeconomic imbalances in Sweden, not because of its composition of currencies) or – according to Oksanen’s second suggestion – a linkage to Special Drawing Rights (SDR, which contains USD, Euro, yen and the British Pound Sterling – a composition that has to be checked up/revised by the IMF every fifth year).

But even if these technical changes in Chinese exchange rate policy will occur in the forthcoming years, the road to a fully convertible currency will be very, very bumpy for the renminbi. It may take 10 years or even much longer to get there.

 

Hubert Fromlet
Professor of International Economics
Editorial board

Back to Start Page