The sudden reversal in fortunes for China’s beleaguered steel mills and Australian miners has been remarkable.
Since February, Chinese steel prices have risen by more than 50 per cent as government agencies and state supported banks and financiers started pulling as many fiscal and monetary levers as possible to get a listing economy upright again.
Around 6 trillion renminbi ($1.25 trillion) has been injected into China’s financial system to stem an ongoing deterioration of credit, while increased government spending has blown the fiscal deficit out to around 3 per cent of GDP – or an additional 650 billion renminbi ($140 billion).
The vast amount of the stimulus has been funnelled into a construction industry which has been decidedly wobbly since the boom swung to bust between 2014 and 2105.
NAB’s senior Asia economist Gerard Burg has crunched the numbers and found the weak trend in property that flowed into the start of 2016 has suddenly reversed, with construction starts growing by almost 20 per cent in the first quarter, returning near to the levels recorded in the same period of 2014.
However, Mr Burg said there is little to suggest that a wholesale recovery in property markets has underpinned this result.
Mr Burg found that, while property prices in China’s largest tier one cities – Beijing, Shanghai, Shenzhen and Guangzhou – have recovered and are now almost 20 per cent above their previous peak in 2014, tier two cities are still around 5 per cent below their peak, and tier three (and below) cities are around 4 per cent below.
“At a fundamental level, little has changed in China’s property markets – with excess supply persisting in many locations,” Mr Burg noted, given the tier one cities house just 5 per cent of the population.
Debt driven recovery likely to make next cycle worse: RBC
This boom in activity is reminiscent of 2009, when the Chinese government fired up an industrial and construction boom in the face of the Global Financial Crisis.
However, this time, the foundations seem even less stable.
RBC Capital Markets mining analyst Tyler Broda said, compared to 2009, this time around debt levels are far higher, inventory levels – especially in property – are worse, and divergent medium term global monetary policy is likely to cap a recovery.
“This debt-driven recovery in itself is likely to add to the structural downside for the next cycle,” Mr Broda wrote in a note to clients.
“Longer term, demographics and falling metal intensity as a share of GDP are also likely to pressure the sustainability of the recovery (of metal prices).”
Mr Broda points out that the burden on China’s structurally challenged property market, which accounts for around half of internal steel demand, should not be overlooked.
“Just being able to keep up with 2009-2014 demand levels will likely be a large task for an economy that is moving through structural change,” he added.
However, in the short term, booming construction activity has driven a surge in demand for, among other things, steel, which in turn has driven up the value of Australian iron ore producers.
In lockstep with the accelerating steel prices since the start of the February stimulus, Rio Tinto shares have jumped almost 10 per cent, BHP Billiton 14 per cent and Fortescue Metals Group an extraordinary 60 per cent.
Chinese steel mill profits at seven-year highs
While steel prices have bounced back from almost 20-year lows of RMB (Renimbi) 2,000 a tonne in February to more than RMB3,000 a tonne late last month, profitability in steel mills has improved just as dramatically to seven-year highs.
However this appears to be masking much deeper problems in the Chinese steelmaking industry.
Despite recent efforts to throttle back production and close unprofitable mills, China’s capacity of 1.1 billion tonnes per annum is now 300 million tonnes higher than a year ago.
As NAB’s Gerard Burg said, “By comparison, the entire steel output of Japan – the world’s second largest producer – was 105 million tonnes in 2015”.
This is hardly in keeping with the plans to eliminate overcapacity and bankrupt “zombie” companies from the industrial landscape.
Under a policy endorsed at the National Peoples’ Congress in February, steelmaking is to be reined in by 100 to 150 million tonnes – or around 13 per cent – over the next three to five years.
“However this alone will not be enough to eliminate spare production capacity,” Mr Burg said.
“Previously announced cuts have had a limited impact on total capacity – with older plants removed often simply replaced with new production facilities.
“There is limited upside to China’s steel consumption – with the China Iron and Steel Association suggesting that consumption has already peaked and will now enter a long term declining trend.”
Mr Burg said there is little hope saturated export markets will offer much support in coming years, with Chinese producers already stretching the limit.
“Rising Chinese steel exports add to trade tensions – limiting further upside,” he explained.
Another ‘false dawn’ for the miners?
Overall Mr Burg’s prognosis is grim.
“The sudden improvement in conditions in China’s steel sector – with profitability back to multi-year highs – could draw idle capacity back into production,” he cautioned.
“Such a move could impact both the short term – through worsening trade relationships and further pollution – and the longer term, if it is allowed to derail much needed reform to the sector.”
RBC’s Tyler Broda said the current situation lends itself to the potential for “false dawns” because of the cyclical nature of commodity markets and the potential for changes in Chinese policies or even US interest rate expectations.
“What we did not appreciate was the magnitude of the Chinese policy response coupled with the shift in Fed positioning, which is creating perhaps the potential for this false dawn to extend for some time,” he explained.
A pick in Chinese inflation, leading to a throttling back in fiscal stimulus, or in the US, which could to lead to a resumption of interest rate rises, might be all it takes to prick the current steel bubble.
“We have already seen some signs in China of a tempering of stimulus and some intervention into commodities trading, suggesting policy makers are more proactive than they were in 2009,” Mr Broda observed.
The RBC house view is that metal prices will likely stay firm – or even appreciate – until the market anticipates a tightening of Chinese financial policy or the US looks like raising rates.
Mr Broda argued this more positive environment could persist for another three to six months before inflation worries begin to force a change in conditions.
But that will only provide temporary respite for the miners.
“Longer-term structural challenges remain and could well be made worse by any extension of this short-term cycle,” Mr Broda concluded.
Given that commodity prices were bumping along near post-GFC lows when the liquidity taps were turned on, the next dive could well be far deeper.
That in turn could well lead to another round of stimulus, trapping China in a cycle of weak recoveries and slowdowns with diminishing effectiveness and harsher outcomes.