China PMI eases slowdown fears: Clyde Russell

SINGAPORE Mon Apr 23, 2012 5:38am EDT

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SINGAPORE (Reuters) - It may be a touch early to be definitive but it looks like Western investors' fears about a sharper slowdown in China have been overstated.

The flash HSBC China Purchasing Managers Index, released on Monday, rose in April to 49.1 from March's final 48.3. Though not quite in expansionary territory, it's enough of a recovery to suggest the downtrend is over.

Combined with ongoing solid demand for commodities, the gradual easing of some monetary restrictions, and a somewhat brighter picture from the rest of the world economy, it seems China is achieving exactly what it set out to do: slow the economy enough to temper inflation but not so much that it causes a hard landing.

Some investors have yet to wrap their heads around the fact that China is no longer going to deliver double-digit growth rates for the economy, or for imports of key bulk commodities like oil, iron ore and copper - and that this may be a good thing.

A slower economic growth rate in China would benefit commodity consumers in the rest of the world, as it would help keep supplies more in line with demand.

Western investors who constantly look for strong growth numbers out of China as a reason to push equity prices higher should be careful. If they get their wish, they won't like the consequences for commodity prices, and for their own economies.

It is puzzling that equity investors appear to go into sell mode as soon as growth shows signs of moderating in China, even though this is exactly what is necessary and desirable.

Many seem to ignore the simple economics of base effects, or put another way, how a steady growth rate still delivers ever-higher volumes, which in turn make it impossible to carry on achieving growth rates of 10 percent and above indefinitely.

If an economy expands at 10 percent annually, it takes seven years for it to double in size, and while China started from a low base in the 1990s, it is by no measure a small economy anymore, so shouldn't be growing at double-digit pace.

Nothing illustrates base effects more clearly than demand for key commodities.

Using 2007 as a base, crude oil imports have risen at a compound annual growth rate (CAGR) of 9.1 percent while those of iron ore have gained at 12.3 percent.

Copper imports are more tricky because they have fluctuated more in the past five years, but they still have a CAGR of 13.6 percent between 2007 and 2011.

Over the same five years, China's gross domestic product has actually done better than a 10 percent CAGR, expanding at 15.8 percent to more than double from $3.5 trillion in 2007 to $7.3 trillion last year.

Looking at the relationship between imports of the three key commodities and economic growth, it appears inbound shipments of crude, iron ore and copper trail GDP growth, but not by a huge margin.

This isn't unusual, as economies generally get more efficient in using energy and commodities the further they travel down the path of development.

However, for the sake of this argument, let's assume that China's GDP slows to a CAGR of 7.5 percent over the next five years.

Let's also assume that the relationship between commodity imports and GDP growth is maintained, implying a halving of the rates of growth for purchases of crude, iron ore and copper.

That would imply growth in crude imports dropping to about 4.6 percent a year, implying for 2012 they would total about 264.1 million metric tonnes (291.1 million tons), or about 5.28 million barrels a day.

Based on the first three months of this year, this figure already looks conservative, given that China imported crude at a rate of 5.66 million barrels a day in the first quarter.

This is up from 5.05 million barrels a day in 2011 and just 3.26 million in 2007.

Even working with a CAGR of 4.6 percent for crude, it works out to Chinese imports of 316.1 million tonnes by 2016, or about 6.3 million barrels a day.

That translates to extra demand of a whopping three million barrels a day over a 10-year period, and I would argue that a CAGR of 4.6 percent for oil over 2012-16 would be on the conservative side, given the rapid build-up of China's private car fleet.

It's much the same story for iron ore, assuming the CAGR is halved to 6.2 percent for 2012-16.

By 2016 China would be importing 928 million tonnes of iron ore, or 2.8 times more than it did in 2007.

It also means iron ore producers have to expand output by 545 million tonnes in the space of a decade, and that's assuming no net growth in demand from the rest of the world or no net loss in export supply - something that's already happening with India limiting its shipments of the steel-making ingredient.

It also doubtful that the world's copper producers could keep up with a Chinese import CAGR of 6.8 percent over the next five years, which would take imports of refined copper to 3.8 million tonnes a year by 2016, or 2.6 times the level of 2007.

The numbers show that even if the rate of growth in commodity imports slows dramatically, the amount of oil and metals that China buys and uses will still increase greatly.

There are of course risks to the scenario outlined above, the main ones being that China's GDP growth won't expand by as much as 7.5 percent a year between now and 2016, or that the rates of growth in commodity imports slow more quickly than does GDP as the economy re-weights to domestic consumption.

But the main risk is that investors fail to realize that China's economic growth is finally shifting to a lower gear, and that this is a good thing.

They must also realize that the rule of base effects means that commodity import volumes will rise strongly, even as growth rates slow.

(Clyde Russell is a Reuters market analyst. The views expressed are his own.)

(Editing by Daniel Magnowski)

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