The Malaysian Insider

LONDON, Feb 9 — After New Year cheer, reality is starting to bite.

Several factors have doused the rallies in some key basic resources this year, including dollar strength and concern about regulation, but most noticeable are the steps taken by commodity consuming giant China to curb excessive loan growth.

While the moves made so far are relatively small, the prospect of higher borrowing costs is proving hard to digest and looms large over sentiment.

“There are natural concerns when central banks start to raise rates: how much are they going to do, how quickly are they going to do it, and how does it affect growth expectations?” said Michael Lewis, analyst at Deutsche Bank in London.

Key commodities, excluding red-hot sugar, swerved off track in mid January on news that People’s Bank of China would raise the reserve requirements for banks, draining money out of the economy after a year in which lose money helped pump it up.

Prices have struggled to recover since that point, with benchmark base metal copper having shed some 14 per cent, while crude oil and gold have lost almost 10 per cent and nearly 6 per cent respectively.

And with a lack of real traction in demand from OECD countries, investors have a lot pinned on China — as the world’s biggest consumer of copper and other industrial metals and a hard to satisfy appetite for energy.

“The Chinese gamble is that by allowing some expansion of credit, but at a sharply reduced pace from last year, that they can keep all the plates spinning in the air,” said Sean Corrigan, chief investment strategist at Diapason Commodities Management in Switzerland.

China’s loosening of credit and stockpiling was seen as the key factor behind a 140 percent rise in copper prices in 2009, while the country’s industrial revolution has been the kernel of reasons to hold high hopes for other raw materials.

And where China led, other leading nations were expected to follow as the global economy started to stabilise from crisis.

But while investors have been happy to jump on the commodity bandwagon, concerns about the nature of demand, particularly in metals, have lingered as stockpiling does not equal real order flow.

“Last year — where was all the demand? It was apparent demand into China,” Diapason’s Corrigan said.

“Apparent” consumption is the sum of production plus imports minus exports. “Real” consumption also recognises changes in stock levels.

A Reuters poll published in January concluded Asian Central banks would raise interest rates by September as growth and inflation in most economies, notably China, are picking up faster than predicted three months earlier.

The picture ex-Asia is looking less clear. Recovery in the euro zone faces a severe test from fiscal troubles in Greece, Portugal, Spain and Ireland, while the US struggles to contain unemployment — a factor that many see as a requirement for higher borrowing costs.

Nonetheless, a Reuters poll of primary dealers found that the US Federal Reserve would start raising rates in the fourth quarter of this year.

Two key questions arise from a higher rate environment: what happens to growth and investments made by borrowing money at near zero interest rates and both have potentially bearish results.

“Looking at the net longs in oil; and copper for example, in absolute terms they are giants in terms of money,” said Jonathan Compton, managing director of London-based long-only equity investment group Bedlam Asset Management.

“Not only has the world never been longer, but the rate of change has never been higher,” he added.

Compton argued that a lot of commodity market purchases had been done using “carry trades”.

“We all have free money now if we are borrowing. I think you will see a fantastic unwinding of the speculative longs the moment rates move up,” he added.

For growth, of course the traditional argument would be that it must be on track or running ahead of projections for central banks to consider tightening, leaving demand for commodities intact once the dust settles from any initial moves.

Scotia Capital looked back to previous Chinese tightening in 2003, where reaction to bank reserve ratio tightening was muted, and 2004 when commodities markets and local Chinese stock markets suffered a very severe pullback.

“The experience of China’s last tightening cycles taught us a simple lesson: if the market ignores the initial tightening, it will trigger another tightening that could not be ignored any more,” Scotia Capital said.

“If the market takes the initial tightening seriously, eventually it should prove to be a good buying opportunity.” — Reuters