Firstly, cycles.

The copper consumption has been strongly polarized in recent years. China uses more copper than North America and Europe combined. A drop in copper demand in China alone will signify a global crisis in industries pertaining to this natural raw material.

Despite the high and long-lasting economic growth of China (“despite” and “because of it”) one must remember that an economy develops in economic cycles, including long lasting ones. After the economic boom of the Middle Kingdom, there will be a deep recession. The financial system of China may prove to be a bubble and currency reserves, although they appear enormous, will lose their significance against the scale of outstanding credits which were used to finance, among other things, rushed government investments – all of it is still ahead of China.
Also, government statistics of China should raise some fears. The public debt is shown to be at the level of 20 percent of GDP (for the end of 2010), however, it does not take into consideration the creative accounting at the local Chinese governments, where the actual debt was delegated to financial vehicles which invested on behalf of local authorities, in fact the apparatus of authority of the Communist Party of China. According to the Chinese authorities, the debts of entities belonging to local governments are about 25% of GDP and according to many independent analysts they are at a level above 50% of GDP.  And thus the total public debt of China can be carefully assessed at the interval of 60-70% of GDP. A working paper by the Australian Treasury also estimates Chinese government debt in this range.

The driving force in China was and is export, which is responsible for about 40 per cent of GDP. The drop in global demand due to the recession, increasing protectionism used to protect jobs, based not only on duties but more frequently on quality standards, certificates, sanitary and ecological requirements does not favor optimistic prognoses for the Chinese exports.

Insisting on seeing a good market outlook for China in the internal demand may turn out to be an illusive assumption. It is export that generates primary capital including wages, without the export locomotive the cars further down will roll by inertia, not by the power of the drive. This speed means that the economy will stop at the “Recession” station. The increase in public expenses in China in order to improve the market outlook may cause the opposite effect from the one intended, the increase of investment risk and the withdrawal of foreign investors from the market.

In case of China, the inflation may destroy the economic relations in economy which were its last remaining healthy tissue. Despite the fact that the most of the public debt of China is in the hands of Chinese entities, it does not minimize the risk of a crash of the Chinese economy, it only diminishes the direct negative effects for the world. However, the indirect effects of the crash of the Chinese economy will definitely have global dimensions.

There is talk of the Chinese miracle, but it may be quite premature as the nature of miracles is such that they do not happen often, it would be even more strange if supernatural phenomena were to raise atheistic and regime authorities to the pedestal.

Perhaps, rather than a miracle, a ticking timed bomb will become a synonym of the Middle Kingdom over the millennia. The crash of "the Chinese model" is only a matter of time, keeping in mind the dynamics of economic processes, this perspective is shorter rather than longer. Crises come suddenly…right after the first symptoms.

Technological progress and the price of copper

The potential drop in the prices of copper, apart from the global recession, including in the Middle Kingdom, is in my opinion also influenced, paradoxically, by the technological progress, with the recycling of auto, electric and domestic equipment, etc. In addition, the equipment of previous generations being returned to be recycled, contains more metals than its newer counterparts, e.g. in case of an exchange of a PC computer for a laptop or a tablet PC (the very change from laptops to tablet PCs reflects with a crisis in the electronic circuits industry). Industrial technology is sensitive to the price of raw materials, which is reflected in the reduction of costs of materials or in the replacing of some raw materials with others, e.g. copper pipes with pipes made of synthetic materials. Copper competes with a few other conductors of electricity and heat, technological changes may favor the replacement of copper. Copper supply from recycling sources is also influenced by massive exchange of copper wires, “telephone” cables for data transmission by fiber optic cables.

The increase of economic efficiency (increased both by technology and by recession) means that more and more metals will be obtained from recycling processes. The amounts of copper mined at any time is growing, however, it is quite different in case of oil and natural gas where hydrocarbons subjected to the reaction of burning are not used again for energy purposes.

What came first – the chicken or the egg?

It is the prognosis of the economic market outlook in China that shapes the prices of copper in the spot and future markets. To express the same in a different way, that the price of copper is the marker of expected outlook in the Chinese economy, we make of the price of copper a very important figure for the Chinese authorities. It is thus probable that the authorities in Beijing may have been interested for some time in influencing the price of copper, and in particular after the September drop from 400 to 300 ¢/lb. Taking long positions in copper may be, in this case, treated not as an investment in a future market but as showing off the power of the Chinese economy – on the basis of the evaluation done by the “invisible hand of the market”, an thus an evaluation somewhat credible (as opposed to statistical data from the Chinese authorities).

The strategy of overstating copper prices performed by one super player may bring intended results for some time. However, within the longer perspective it leads to even deeper crashing of prices. Accepting the thesis that since October 2011 China influences the price of copper, this strategy would have to lead to physical supplies of “speculative” copper (or maybe more “surplus” copper).  The final destination of the transport of such copper would be most certainly China because over there it could disappear from the field of vision of market analysts. I bet dollars against nuts that China has been increasing its “stocks” of copper in the recent months, however, these are not “stocks” with economic expansion in mind, but rather with as long as possible image of such an expansion.

It is difficult to evaluate the scale of the operation. Also, the Chinese authorities must be aware that this strategy will last at most for a few months and it will eventually lead to a deeper crashing of the price in not-too-distant future (also because prices create supply which can be seen in investments in new copper mines, but also because the increased “artificial” demand will be one day compensated with lower orders – especially when the plot for the game of increase will be disclosed and weighed.)

Most probably China accepted, to some degree, the concept of influencing the prices of some commodities, counting on a soft landing of the Chinese economy. One can accept that the stocks of copper from the end of 2010 declared by China to be 2 million tones increased by at least a several dozen times by the end of 2011.

China has a kind of alibi – an alternative justification for the increase in copper stocks. The gathering of stocks of raw materials by China may be explained as a method of diversification of financial assets. Bonds and treasury bills of USA (as assets of Chinese currency reserves) are a bigger problem for the lender than for the borrower. If the borrower may finance the debt on a day to day basis by printing a few trillion USD under the graceful name of quantitative easing, then the value of bonds of such an issuer becomes questionable... The negative interest rate – is it really a safe haven? It is certainly a question that the helmsmen of the Chinese economy must be asking – well, we even know part of the answer that they worked out – the answer is visible in the significant decrease of the dynamics of the purchase of the American debt.

Into this kind of a justification, quite correct indeed, may be inscribed the official justification of the Chinese authorities for the increase in copper stocks. However, we think that it would be a position for the purpose of public opinion, when in fact China wanted more to maintain the opinion about the increase of the Chinese economy (on the basis of the market copper prices). Therefore we believe that the factual copper stocks are much higher than those shown in the official Chinese statistics.

It is worth noting that the prices of rare earth elements in recent times dropped significantly and they are also considered as an indicator of market outlook, in this case globally.  However, China tries to increase their prices by limiting exports of these metals, of course in this case most probably it is not at issue to deceive one of the barometers of world economy but rather a monopole premium due to the control over the majority of world resources of some rare earth metals.  However, we can see that China can manage the demand and supply in the metal market in order to shape pricing levels.

The increase of prices of rare earth metals may be also a compensation for China for maintaining high copper prices, and in addition, maintaining of mutual price relations in the metal market has a great significance in registering these prices and not registering the real strategy of China whose determinant is fostering the conviction of the good condition of the Chinese economy, particularly when this fostering is not too costly – for example 2 million tons of copper at present prices is equivalent to 15 billion dollars and thus quite little in relation to the Chinese currency reserves.

The alleged miracle

We hear about the Chinese miracle framed in the dynamics of growth of GDP, however when comparing GDP per capita, China places in a distant 90-100 place, depending on the ranking. Despite the miracle, we are dealing with a poor country, in addition extremely divided socially.

Taking into the consideration the dramatically low starting point GDP per capita from the beginning of the 1980s, no one should be really surprised by an average of 9 per cent annual dynamics of growth of GDP in the last 30 years, especially when the result of this dynamic is still a very remote position of China in the GDP ranking per capita.

The Chinese economy’s last two years of growth are due to the public spending. If we assume that the public debt of the government and the Chinese local governments is 60% of GDP, the question of when this debt was created should be asked. One can accept that the majority of public debt was made in the last 10 years. However, the peak of growth of the public debt falls on 2010-2011, unknown to us in exact figures because the majority of increase of public debt grew was made in local governments. However, without a severe assessment, the public debts grew in both past years by at least 5 percentage points annually.

If we consider that the public expenses generate a multiplier effect in the economy, then we know already what is the drive of the most recent growth of GDP in China, unfortunately it is a drive just a moment before the engine seizure. One needs not add that the public expenses administered by central and local functionaries means that to a large extent the money is wasted.

A hard landing awaits the Chinese miracle, considering the specific gravity of China we can expect a worldwide earthquake after its fall. Although we know that the sooner the better and the effects of the crash would be lesser, still, many interested parties who can influence the events prefers to defer this moment at the same time preparing to strike. Unfortunately, the tensions are so great at the moment that every crash of the Chinese empire will cause global effects to be calculated in years.

The prognosis of the copper market brought us to where it should have – to the prognosis of the overall situation in China. In both cases a crash is imminent but the crash in the copper market does not even need a recession or a crash of the Chinese economy – it is enough to get a weak market of 5 per cent and a lower growth of GDP.

And thus the prognosis of copper prices is a deep drop. I would expect that in 2012 we will see copper prices below 200 ¢/lb.

By Jaroslaw Suplacz
The author is an independent analyst.

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