The “sound and fury” of new China stimulus and PE and PP spreads

CHEMICALS MARKETS are abuzz with last week’s insertion of the words “moderately loose” into Beijing’s description of its monetary policy for the first time since the 2009 credit explosion. Moderately loose replaces “prudent”.

Confidence that Chinese growth will rebound next year has been further boosted by China’s subsequent pledges to allow a bigger budget deficit, borrow more and cut interest rates.

I wouldn’t be surprised if, in response, we see a rally in chemicals pricing over the next few weeks.

But we should take a deep breath and put this short-term noise into the right long-term context. Let’s start with this useful 11 December article from the Australian Financial Review article.

“The most pressing concern is the dramatic erosion of consumer confidence, battered by falling house prices, double-digit youth unemployment and broader job insecurity,” wrote author Jessica Sler.

“Sentiment is down to levels last seen during the 2022 Shanghai lockdowns, reflecting a deep-seated anxiety among Chinese households,” she added.

A sharp decline in house prices because of oversupply and softening demand had wiped an estimated 25 trillion yuan [$3.4 trillion} off household wealth – equivalent to about a third of annual household income, she added.

One of the often-repeated “facts” about China’s economy is that its high savings rates means that there are large amounts of untapped consumption waiting to be unlocked once the right policies are adopted.

But a July 2024 Rhodium Group report, appropriately entitled “No Quick Fixes”, said: “Around 60-65% of China’s total savings may still be held by the top 10% of households. This leaves significant proportions of China’s households vulnerable to consumption downgrades during periods of slower economic growth, such as what is occurring now.”

“The primary issue is that Chinese households have experienced their first sustained loss of wealth in a generation,” the AFR quoted Ernan Cui, China consumer analyst at Gavekal Dragonomics as saying.

The top 10% or so of Chinese households benefited the most from the property bubble. This tells us that the 10% is suffering the most from the end of the bubble, making it unlikely that these people will go on a spending spree, regardless of government policies.

“China’s official urban unemployment rate edged up to 5.1 per cent this year, from 4.7 per cent last year, but the youth jobless rate has been stuck in double digits for years. Alternative indicators of the broader jobs market also paint a bleaker picture than official data,” the AFR continued.

Can China, realistically, significantly boost its domestic consumption?

Another challenge identified by the AFR was intensifying deflation because of sustained weakness in both consumer and producer prices. November consumer prices were up by up just 0.2 per cent year-on-year – below analyst expectations – while producer prices fell 2.5 per cent. Producer prices have been falling for 26 consecutive months.

And despite last week’s excitement, can China afford another bazooka of stimulus on the scale that we saw from 2009 onwards? The AFR said that the IMF expected China’s budget deficit to reach 7.5% in 2024.

Let’s assume that Beijing can afford the type of “root and branch” reforms of weak healthcare and pensions, and reforms to the Hukou residency system, that might rebalance the economy towards more domestic spending.

Such reforms would require a change of political mindset and would, of course, take considerable time. You don’t build new and better healthcare and pension systems in the space of a year or so.

“To promote common prosperity, we cannot engage in ‘welfarism.’ In the past, high welfare in some populist Latin American countries fostered a group of ‘lazy people’ who got something for nothing,” said Xi Jinping in 2022.

“As a result, their national finances were overwhelmed, and these countries fell into the ‘middle-income trap’ for a long time. Once welfare benefits go up, they cannot come down. It is unsustainable to engage in ‘welfarism’ that exceeds our capabilities. It will inevitably bring about serious economic and political problems,” he added.

Perhaps there has been a shift in thinking. But this would still, as I said, leave questions over whether China can afford a major reform programme, and whether people have the money to spend much more given the collapse of the property bubble.

“With consumption growing at roughly 4% a year before the pandemic (and much less since), is 6–7% growth in consumption possible?” asked Michael Pettis, professor of finance at Peking University in a December 2023 article for the Carnegie Endowment for International Peace.

He said that 6-7% per year consumption growth was necessary for China to achieve its target of maintaining GDP growth at 4-5%.

“With consumption growing at roughly 4% a year before the pandemic (and much less since), is 6–7% growth in consumption possible?” asked Pettis.

“No country in history at this stage of the development model has been able to prevent consumption from dropping, let alone cause it to surge, but that doesn’t mean it’s impossible,” he said.

Consumption growth at 6-7% per year would require businesses to pay higher wages and higher taxes. China’s currency might also have to be strengthened in order to reduce China’s dependency on exports (exports being the same as manufacturing investments) as a driver of growth.

But Pettis said that China’s manufacturing competitiveness was based mainly on the very low share of income Chinese workers retained relative to their productivity. Making businesses pay more would seriously undermine China’s manufacturing competitiveness.

If government financing was reformed, however, Pettis said it was possible that local governments could foot the bill.

He warned, though, that transferring such a large share of local governments’ assets would be politically contentious and require “a transformation of a wide range of elite business, financial, and political institutions at the local and regional level”.

China’s economy had been structured for four decades on direct and indirect transfers from households to subsidise manufacturing and investment, he added.

This took the form of easy and cheap credit, weak wage growth, an undervalued currency, excess infrastructure spending, a weak social safety net, and other explicit and implicit transfers, wrote Pettis.

There is a further reason to question whether China can significantly boost its domestic spending which is demographics.

“The United Nations expects China’s population to fall to 1.26 billion in 2050 and 767 million by 2100. These are down 53 million and 134 million, respectively, from earlier UN projections,” wrote Kevin Swift, the ICIS economist, in this 30 August 2024 blog post.

“Recent analyses by demographers (Shanghai Academy of Sciences, Victoria University of Australia, etc) question the demographic assumptions behind these projections and expect China’s population could fall to as low as 1.22 billion in 2050 and 525 million in 2100.”

Kevin added that Demographer Yi Fuxian at the University of Wisconsin has questioned assumptions about current Chinese population and the likely path forward. He examined China’s demographic data and found clear and frequent discrepancies, such as the inconsistencies between reported births and the number of childhood vaccines administered and with primary school enrolment.

“These should parallel each other, and they do not. Analysts see that there are strong incentives for local governments to inflate data. Reflecting Occam’s Razor, the simplest explanation is that the births never happened,” continued Kevin

“Yi posits that China population in 2020 was 1.29 billion, not 1.42 billion, an undercount of over 130 million. The situation is most acute in northeast China where the economic engine has stalled. Yi speculated that with low fertility rates – 0.8 versus replacement level of 2.1 – China’s population will fall to 1.10 billion in 2050 and 390 million in 2100. Note that he has another even more pessimistic projection.”

“We have seen other estimates that China’s population could be 250 million less than what is currently reported. China accounts for roughly 40% of global plastic resins demand and as such, alternative futures concerning population and other factors significantly influence global plastic resins demand dynamics.”

Protectionism and the risks for China’s exports in 2025

“Globally, according to the World Bank, investment represents on average 25% of each country’s GDP. But China’s investment share of GDP has never been below 40% during the past 20 years,” wrote Pettis in the same Carnegie Endowment for International Peace article.

Under a scenario where China continued to focus on investment-led growth, the rest of the world would have to agree to reduce the investment share of its GDP by roughly 1 full percentage point to 19% of GDP, well under half of the Chinese level, Pettis added.

But this accommodation seems unlikely to happen as other countries, including not just the US, push back against China’s growing dominance of exports.

While China’s 12-month trade balance with the US had risen by $49 billion since 2019, it was $72 billion with the European Union, $74 billion with Japan and Asia’s newly industrialised economies, and about $240 billion with the rest of the world, according to data compiled by Brad Setser of the Council on Foreign Relations.

Logan Wright, head of China research at the Rhodium Group said China accounted for just 13% of the world’s consumption but 28% of its investment. That investment only makes sense if China takes market share away from other countries, rendering their own manufacturing investment unviable, he said.

“Even as China targets advanced products such as electric vehicles and semiconductors, it refuses to surrender market share in lower-value products,” wrote the Wall Street Journal in a 29 August article.

The Financial Times, in a 6 December article, said the following:

• Most scholars agree that China’s rapid rise in manufacturing has no parallel since the US overtook Britain early in the 20th century.
• It is now the world’s “sole manufacturing superpower”, according to Richard Baldwin, professor of international economics at IMD Business School in Lausanne, who estimated in January that China’s share of global gross production had risen from 5 per cent in 1995 to 35 per cent by 2020 — three times that of the US and more than the next nine countries combined.
• China’s share of global manufactured exports was 20 per cent in 2020, up from 3 per cent in 1995 and dwarfing the US, Japan and Germany. Out of a total of about 5,000 products, China held a dominant position in exports for almost 600 in 2019, at least six times greater than for the US or Japan and more than double that of the EU, a paper by economists Sébastien Jean, Ariell Reshef, Gianluca Santoni and Vincent Vicard last year showed.
• Since then, China’s exports have roared further ahead and are expected to rise by 12 per cent in volume terms this year, according to Goldman Sachs.

As I discussed in my 2 December post, something may have to give next year. Because of the increased pressure from Chinese direct and indirect chemicals exports (as components of finished goods or as packaging for finished goods) since the Evergrande Turning Point, we could see an increase in trade protection measures against China.

No significant recovery in PE and PP price spreads in 2025

To paraphrase William Shakespeare, I see last week’s fuss about China’s new economic stimulus as being full of sound and fury, signifying hardly anything. The hard reality is that China is undergoing a period of a much lower GDP and therefore chemicals demand growth. Nothing can change this trajectory.

During 2025, the problem will remain far too much global capacity chasing weaker-than-expected demand up and down all the chemicals value chains because the consensus on China was wrong.

So, to add to my five forecasts for 2025 which I published last week, here is a sixth: There will be no significant improvements during next year in Chins CFR PE and PP price spreads over CFR Japan naphtha costs.

The 2024 final numbers are almost in. We can see that the downturn in spreads that followed the Evergrande Turning Point continues.

Let’s start with PE where 2022-2024 spreads for three grades were just $300/tonne. This compares with spreads during in 1993-2021, during the Chemicals Supercycle, that averaged $532/tonne.

The table below the chart below shows the percentage recoveries required before PE spreads return to their Supercycle levels.

Let us repeat the exercise for PP. Average 2022-2024 spreads were just $240/tonne as against $562/tonne during the Supercycle.

Please don’t be distracted by unhelpful noise. Instead, place all your focus on retooling your tactics and strategies to deal with the post-Supercycle chemicals world.

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