The Bloated Dragon

January 12, 2011 10:09 AM
The Bloated Dragon

China’s central bank raised key interest rates recently in an effort to slow down the hottest economy the country has seen in years. As a result, investors scrambled to find a safe haven for their money, which they found in the U.S. dollar, and prices on commodities of all types tumbled.

The moves also set off fears that it could be the first in a series of rate increases as Beijing tries to tame inflation and curtail economic growth. Concern about what that would do to world commodity prices has been escalating ever since.

Fading impacts from an earlier economic stimulus package appear to have already helped moderate growth in the world’s most populous country (1.32 billion people). However, concerns about future interest rate hikes persist.

According to a recently released World Bank report, China’s gross domestic product (GDP) slowed from a 10.6% gain for the first half of 2010 to a still strong 9.6% increase for third-quarter 2010, compared with corresponding periods a year earlier.

The report’s lead author and World Bank senior economist Louis Kuijs expects China’s 2010 GDP to grow 10% but sees 2011 growth moderating to 8.7%, with possible easing in subsequent years.

China By the Numbers

The World Bank also recently decreased its 2010 projection for China’s consumer price index (CPI), a measure of inflation, to 3% from 3.7%. However, the World Bank raised its forecast for 2011 inflation to 3.3% from its earlier 2.8%.

Kuijs argues that a 3% to 5% rate of inflation in China is not all that worrisome. Other economists say they aren’t so certain.

“China would like to have inflation closer to 3%,” says Bill Lapp, former chief economist for ConAgra Foods and current president of Advanced Economic Solutions LLC in Omaha, Neb.

China’s October CPI figures (the latest available) rose 4.4% above year-earlier levels, but food prices rose 10.1%.

Currency Connection. One of the biggest issues causing mayhem in commodity markets today is the immediate link between the Chinese yuan and the U.S. dollar, which virtually move in lockstep.

Thus, Lapp compares the relationship between China’s monetary policy and U.S. economic policy to tandem bicycle riders, with one pedaling furiously to get ahead and the other slamming on the brakes.

“The challenge is, the U.S. is trying to escalate our economic growth through quantitative easing to get our economy moving,” Lapp says.

The Federal Reserve’s November decision to spend $600 billion on long-term Treasury bonds in the next few months is expected to keep downward pressure on the dollar.

“When the dollar weakens, the yuan weakens and China’s economy gets another boost,” Lapp adds.

If the U.S. Federal Reserve were to slow its bond purchases, commodity prices would relax and China would not work so hard to regulate inflation.

But is that likely? “One could make a case for it,” Lapp says.

If U.S. job growth, consumer confidence and manufacturing data were to improve substantially, the Federal Reserve could decide to moderate quantitative easing.

China GDP Growth Rate Chart

If that were to happen, Lapp says, there would be an immediate impact on commodity prices. “The dollar would strengthen, commodity prices would go down, gold prices would back off, crude oil would back off,” Lapp explains. “But if we continue down the path we are on, China will continue to put on the brakes.”

As a result, Lapp says, the yuan will weaken, the dollar will weaken and commodity prices will remain high—unless, of course, demand for commodities in China weakens substantially.

Is China Still Hungry?
Some worry a slowing economy or food price inflation in China could cut into demand for food products at the consumer level. “That would limit demand for agricultural products globally,” says economist Jason Henderson, vice president and Omaha Branch executive with the Federal Reserve Bank of Kansas City. As a result, the price of all food commodities as well as the price of other commodities would weaken, at least temporarily.

Soybeans would be particularly vulnerable to a demand slowdown. Chinese demand for soybeans occurred at record levels this year (49 million metric tons for the 2009/10 crop year), and demand from China continues to be the single most important factor in global oilseed prices, according to Rabobank’s latest quarterly report.

Short-term, China’s monetary policy is expected to slow food price inflation. In late November, demand for corn decelerated in China as processors and feed mills faced tighter credit conditions, which pressured farm prices lower. “It’s too early to tell how that will impact retail prices,” says Fred Gale, senior economist with USDA Economic Research Service’s China team. “But most people in China think any price declines will be temporary. Farmers in China are holding grain because they think prices will go up later.”

The Chinese government recently announced that support prices for wheat will be 6% to 8% higher this spring.

Chinese officials are trying to control food price increases by limiting who can buy food commodities, holding auctions of reserve supplies and stepping up price monitoring, Gale says.

With only 10% of the world’s cropland and 20% of its population, China has been surprisingly self-sufficient in food production until recently. In the past few years, China has not only dramatically stepped up its imports of soybeans and vegetable oils, it has stopped exporting corn. China has also imported more dairy products since the 2008 melamine crisis, in which the toxic industrial chemical was found in domestically produced infant formulas and other products made with dairy ingredients.

Can’t Ignore Supply. The global supply of commodities will also play a major role in commodity prices this year. Severe drought reduced Russia’s wheat crop and tightened global wheat supplies, Henderson says. Then USDA began cutting its corn production estimate for the 2010/11 U.S. crop, he says. Tight world supplies of several agricultural products will thus fight against any potential decrease in demand that comes from China.

No doubt, commodity prices will rise and fall with every move China makes during the next year, but the odds of a major economic slowdown in China is hard to fathom.

China Moves Toward GM Adoption
Unrest among Chinese soybean growers and record soybean imports are causing China to reassess its soybean policy. China does not allow its farmers to grow genetically modified (GM) soybeans but does allow imports of GM beans. The government has also approved field trials for more than 20 GM crops and this past year it approved its first strains of GM corn and rice, with production slated to begin in two to three years.

“Nearly all of the soybeans grown in China today are used for human consumption,” says Rob Joslin, chair of the American Soybean Association and 2010 president. “Imported GM beans are fed to livestock and aquaculture.” Chinese consumers have yet to embrace food made from GM crops because of perceived safety concerns.

Map of Chinas Soybean Growing Regions

Chinese farmers who want to grow GM soybeans, however, argue that the double standard makes them less competitive with their foreign counterparts. “The technology has allowed U.S. producers to produce soybeans with fewer inputs,” says Joslin, who believes China will eventually recognize the benefits and adopt the technology. “Worldwide demand for soybeans is going up every year,” he states. “Worldwide, we have to find ways to meet that demand.”

In 2000, when China joined the World Trade Organization (WTO), officials wanted to cap imports of soybeans at 110 million bushels, Joslin says, but import quotas were denied. For the 2009/10 crop year, China imported 1.8 billion bushels of soybeans, 825 million of them from U.S. growers. Prior to China joining the WTO, soybeans were subject to a 3% tariff, a 13% value-added tax and quota limits. Today, U.S. exporters still pay the 3% tariff and 13% tax, but the quota has been removed.

Top Producer, January 2011

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