Rare Earth Prices Partly Hinge On China’s Economic Health

China’s spectacular economic growth and transformation into an industrial power house has made it the first or second largest consumer of a range of industrial commodities, therefore its economic health has a very large bearing on commodity prices, including those of rare earths.

And clearly the pace of economic expansion in China is slowing and this begs the question over whether it will have a hard landing or will be able to orchestrate a managed slowdown.

A hard landing scenario, brought on by for example the banking system imploding under the weight of dubious real estate loans, would likely send prices of most industrial commodities, such as oil, coal, gas, steel and copper along with many minor metals into free fall

On the face of it, the same should apply to rare earths, prices of these materials are already lower on reduced consumer buying. However, China controls over 95% of world rare earth supplies and is determined to ration exports and could apply even more stringent measures to reduce output if rare earth prices went into free fall.

How effective those measures would be in a crisis situation where companies would try and sell stocks by any means in a desperate bid to build cash balances is another matter.

Therefore cash strapped producers faced with declining domestic demand and credit issues with local buyers could still try and export rare earths through any means possible and prices would consequently weaken on world markets.

But what are the chances of a hard landing in China?

It’s probably one of the biggest questions that divides opinion among investors and economists right now and both sides can make strong arguments for their case.

This division is exemplified by two very successful British fund managers, Anthony Bolton of Fidelity who is a China bull and the very outspoken and contrarian investor Hugh Hendry of Ecletica who is bearish on the country’s economic prospects.

The bulls argue that China has reserves of around $3.2 trillion, has relatively low national debt, a very competitive economy and can deploy vast fire power to pump up flagging economic activity. It is rebalancing its economy from exports towards domestic consumption where there is very considerable growth potential. Also, the Chinese authorities have anyway orchestrated the current slowdown by forcing banks to carry higher reserves – measures, which could be reversed if the economy was to seriously deteriorate.

And besides GDP growth of around 9% is still impressive and by not having to please voters, China can take whatever measures it deems necessary to stimulate the economy

But the China bears are having none of it. They point to China’s vast investments in infrastructure as unsustainable in the long run. Over investment leads to ever lower returns and wasted capital, they argue. Boosting fixed asset investment in the face of a downturn will actually delay the necessary rebalancing of the economy towards consumers, they say. And whereas debt ratios of the country look fine, argue bearish economists, those of local government are a different story and if their debts are included China has a GDP to debt ratio of around 74-75% and possibly a 100% if loans to state enterprises are included, many of which are poorly run.

But maybe the biggest elephant in the room is the real estate bubble often characterised by China’s empty cities. Watch these two extraordinary short documentaries: China’s ghost cities and Ordos.

Economists reckon over a quarter of China’s GDP could be tied up in real estate and prices are falling. JPMorgan estimates they could fall 5-10% over the next 18 months and by 20% in some major cities, though other economists think it could be far worse.

A big fall in real estate prices would hit the banking system hard through direct loans to the sector and indirect exposure via the shadow banking system, which has boomed on the back of government actions to curb bank lending. Many local governments would be hurt as they get a lot of funding from land sales, which would dry up.

Credit Suisse analysts recently said that loan losses at Chinese banks could hit the equivalent of 60% of their equity capital if real-estate companies and local governments fail to repay debts.

If there was a widespread real estate crash its hard to quantify the magnitude of the domino effect that would have on the country’s banking system and it could be severe, say the bears

The China bulls response to this is that a correction in real estate prices is healthy and that China has long used banks and accepts bad bank debt as a way of stimulating economic growth. Also, Chinese consumers, unlike their western counterparts, tend to be far less indebted.

Clearly this is a story that is still playing out, but so far Hendry is reported to be up some 40% on his bets against China, while Bolton has had to publicly admit that returns in China have been disappointing.

It does appear that real estate speculation has got out of hand in China, but should it turn into a full blown crash, the country’s authorities do at least have some pretty formidable fiscal and monetary capacity at their disposal to deal with it.

For buyers of rare earths that still leaves a very uncertain situation as even a relatively mild Chinese economic slowdown could result in lower prices and much depends on the success of the country’s authorities in clamping down on smuggling and illegal production.

Though there have been high profile cases of illegal rare earth mines being put out of operation in China, many rare earth prices in Europe remain significantly down from their highs.

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