Copper prices have fallen by a little over 12.1%(in dollar terms) since the beginning of this year. Interestingly, a substantial portion of this fall has come since the beginning of this month. Analysts often refer to copper as Dr Copper, given that the demand for copper is often a reliable indicator of economic health.
How is that? Copper is widely used across different sectors of the economy. It has uses in sectors as varied as electronics, homes, factories and even power generation and transmission. Given this, demand for copper is often a very good lead indicator of the economic health of the global economy. This demand is reflected in the market price of copper.
Hence, rising copper prices indicate strong demand for copper, which in turn indicates a growing global economy. Vice versa, falling copper prices indicate low demand for the metal and hence, an imminent economic slowdown.
As Albert Edwards of Societe Generale writes in a note dated March 13, 2014, titled We are repeating 2008- just backwards? Ignore copper meltdown at your peril “Copper and iron ore prices have slumped almost 10% over the last week. Interpreting this move may prove crucial for global investors who traditionally have looked to Dr Copper specifically, and industrial commodity prices in general, to give an early warning to any changing direction of the global economy.”
In fact, there has been a lot of talk in the recent past about a worldwide economic recovery. But that doesn’t seem to be reflected in the price of copper, or other industrial metals for that matter. As a recent column in The Economist points out “It is not just copper this time; the aluminium price is down 10% over the last 12 months, nickel 7.9% and lead 6.3%. Compared with a year ago, metals prices are down 10.2 per cent. With the important exception of oil, commodity prices in general have been weak over the past year.”
What this tells us is that all the talk about a global economic recovery should not to be taken very seriously. In fact, other data suggests the same. The core personal consumption expenditure deflator, a measure of inflation closely tracked by the Federal Reserve of United States, the American central bank, rose by just 1.1% in January 2014. This is well below the Federal Reserve’s benchmark of 2%.
In fact, if housing is excluded from this index, the inflation comes in at 0.7%. Housing prices in the United States have been rising at a fast pace because of the low interest rates maintained by the Federal Reserve.
What this tells us is that consumer demand is rising at a very slow pace in the United States. And there can be no economic recovery without an up-tick in consumer demand. And how are things in Europe? The inflation in the Euro Zone (18 countries which use euro as their currency) fell to the lowest level of 0.7% in February 2014. It was at 0.8% in January 2014.
What these numbers clearly tell us is that most of the Western world is close to deflation. Deflation is the opposite of inflation and is a scenario where prices are falling. In a scenario where prices are falling (or even in a prospective scenario where people start to believe that prices will fall) people tend to postpone consumption in the hope of getting a better deal. And this lack of consumer demand essentially ends up killing the possibility of economic growth.
In fact, the inflation numbers in China are not looking good either. As Edwards writes “Indeed the widely ignored RPI (retail price index)…is rising by only 0.8% year on year, confirming that China is closer to outright deflation than widely appreciated.”
What is interesting is that falling copper prices also tell us clearly that the demand for the base metal is falling in China. Estimates suggest that Chinese demand comprises 40% of the world’s demand for copper. Nevertheless, the thing is that all the demand for copper in China is not genuine industrial demand.
A lot of copper demand is due to a practice known as “cash for copper”. The way this works is as follows. A Chinese speculator manages to raise money in dollars. These dollars he then uses to buy copper. He then sells the copper and gets Chinese yuan in return. He then invests the Chinese yuan in wealth management products, which promise huge returns. The money invested in wealth management products is typically lent to borrowers like property developers to whom the banks are reluctant to lend.
As Lucy Hornby and Paul J Davies point out in The Financial Times “The trick works best for copper because of the red metal’s liquidity and easy storage. Importers have also tried zinc, rubber, plastics and – least successfully – palm oil, which turned out to be bulky, difficult to store and perishable.”
The cash for copper scheme works as long as the the Chinese yuan remains stable against the dollar or appreciates. As on March 19, 2013, one dollar was worth around 6.21 Chinese yuan. Since then the yuan has gradually appreciated against the dollar and by January 13, 2014, one dollar was worth 6.04 yuan.
But since January 13, 2014, the yuan has started depreciating against the dollar, and one dollar is now worth around 6.15 Chinese yuan. A depreciating yuan makes the cash for copper scheme unviable simply because the speculators need more yuan in order to repay their dollar loan. Given this, as things stand currently, the cash for copper scheme doesn’t really work.
What this means is that a huge section of the Chinese economy which was borrowing through this route has effectively been cut off. As Horny and Davies write “Import financing is one of the few sources of cash flow left for companies that are already cut off from loans by state banks at official interest rates. Many have already exhausted their ability to fund themselves through high interest rate trust products.”
Also, an important part of this trick is that borrowers to whom yuan loans are given return the money. In the second week of March the solar equipment producer Chaori Solar missed a $14.7 million interest payment. This was first case of a Chinese company defaulting on a bond payment. What is interesting here is whether China will allow the yuan to continue to depreciate against the dollar. If it does that then the cash for copper scheme will automatically get killed. Also, it will be a recognition of the fact that the government is taking the deflationary fears in China seriously.
By allowing the yuan to depreciate it will make Chinese exporters more competitive internationally. A Chinese exporter will make much more money when one dollar is worth 6.5 yuan vis a vis when one dollar is worth 6.15 yuan, as it currently is. If this were to happen, Chinese exporters will get more competitive internationally and cut the prices of their products. In order to stay competitive manufacturers from other countries will also have to cut their prices (or source their products from China) and in the process, China can effectively end up exporting deflation to large parts of the world.
The article originally appeared on www.FirstBiz.com on March 20, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)