China Infrastructure Spending Won’t Prop Up Metals as Housing Slows

Bond-Market Troubles Dim Outlook for Financing of Projects

By Nathaniel Taplin

   A newly completed bridge in southwest China opened to traffic last week. Photo: Associated Press

Global commodities producers are hoping that China will order big lumps of iron, coal and copper in the new year to send prices higher.

The miners are banking on a boost in infrastructure spending, which they believe would offset the price declines caused by slowing growth in housing. China is the marginal buyer of every big commodity, but the idea that Chinese infrastructure can itself drive prices much beyond recent highs looks misplaced.

There are two main reasons to be skeptical. First, with the exception of certain categories like power lines, infrastructure is, on average, less metal-intensive than offices or homes. Real estate accounts for around 20% of fixed-asset investment in China but nearly 40% of steel demand, notes CRU, the London-based metals consultancy. Although infrastructure accounts for a quarter of investment, it sucks up only 13% to 14% of Chinese steel output. In other words, infrastructure investment likely needs to rise around 3% to offset every 1% fall in real estate to replace lost iron-ore demand.

For copper, investment in the most important type of infrastructure—electric power—has also slowed sharply since mid-year. Higher coal prices in mid-2016 pushed down growth in grid investment to around 5% on the year in October and November, down sharply from the 40% gains in early 2016.

The recent convulsions in China’s bond market could cause substantial problems for infrastructure funding. Most infrastructure in China is financed through municipal bonds or so-called local government financing vehicles (LGFVs), off-balance-sheet entities cities use to circumvent restrictions on local borrowing.

The sell-off in Chinese government bonds has particularly punished both of these types of quasi-sovereign debt.

Demand for official municipal bonds, meanwhile, could be dented by the recent troubles in the money market. Chinese banks like munies in part because they are widely accepted as collateral for money-market transactions, notes Frances Cheung, head of rates for Asia, excluding Japan, at Société Générale. With money markets in full deleveraging mode now after the U.S. Federal Reserve’s rate increase, bank demand for municipal bonds could weaken. That means higher funding costs for local governments.

The slowdown in Chinese real-estate construction next year is unlikely to be catastrophic, and there is little reason to expect carnage in the commodities markets on the scale of 2014 or 2015, particularly if miners hold the line on further capacity expansions.

But by the same token, investors shouldn’t count on Chinese infrastructure spending to push commodities higher, unless the central government steps in with much more aggressive direct stimulus.

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