As China’s economy slows, the pain hits home

Hong Kong –  Piles of unsold coal line rural roads in north-central China. Some iron ore mines near Beijing are operating at a fraction of capacity. Chinese farm products are even increasingly scorned by the Chinese consumer.

While China remains nearly self-sufficient in all these categories, it is importing more from other emerging markets. Economists and investors around the world have been fretting in recent days about the effects on smaller emerging markets if China’s economic slowdown worsens. Those concerns have driven down share prices and currencies from Jakarta to Istanbul to Buenos Aires, although emerging markets staged a partial recovery Wednesday. They helped to prod the central banks of Turkey and India to raise benchmark interest rates unexpectedly Tuesday.

Yet the most vulnerable producers these days may not be the coal mines in Indonesia, palm oil plantations in Malaysia or soybean farms in Brazil, but the farms and particularly the mines in China itself.

China’s role as the largest buyer of a long list of commodities, from iron ore to palm oil, means that emerging markets are heavily exposed to any economic slowdown. But their ability to capture ever-larger shares of the Chinese market at the expense of China’s commodity producers has limited at least somewhat the exposure of emerging markets.

China’s steadily strengthening renminbi, persistent inflation and soaring blue-collar wages have combined to erase much or all of the cost advantage of domestic production for a long list of commodities. At the same time, tightened pollution regulations have made it harder for steel mills to use China’s low-grade iron ore reserves or for power plants to burn China’s low-quality coal.

“With the increasing focus on the environment and high costs in some industries in China, China seems to be importing more of the key commodities they need,” said Bruce Diesen, an analyst at the Oslo, Norway-based investment bank Carnegie.

Another profound change in Chinese society is also having an impact. Hundreds of millions of Chinese are eating more meat and drinking more milk. The extra animal feed, as well as chicken, beef and dairy products, for that shift is coming increasingly from farms as distant as Uruguay and Argentina. Chinese farms have grown uncompetitive because they tend to be small and inefficient and have a reputation for contaminated food.

Charter rates for bulk freighters, often a good leading indicator of China’s commodity imports, have stayed strong. The shipping industry is betting that even when long-distance freight charges are included, new mines opening in Brazil and Australia will outcompete mines in China.

“That new capacity will probably squeeze out more expensive domestic capacity for iron ore and coal,” said Timothy Huxley, the chief executive of Wah Kwong Maritime Transport Holdings, a Hong Kong shipping company.

Emerging markets face many more pressures right now than the strength of China’s demand for commodities. A gradual tapering in the pace of monetary stimulus by the U.S. Federal Reserve, where policymakers were concluding a two-day meeting Wednesday, has sent interest rates drifting higher in America, drawing in investment dollars that might have previously gone to Bangkok or Rio de Janeiro.

Rising exports to China by emerging markets also mean that if a downturn in China is severe enough, emerging market exporters will be affected along with Chinese producers. China could also adopt a variety of measures to keep out imports during a downturn, like providing government subsidies to domestic producers – although many of these possible steps would violate China’s commitments to the World Trade Organization.

Many emerging markets, including India, have fought losing battles with inflation for years and are now struggling to maintain the value of their currencies. After announcing this month a two-year plan to slow inflation in consumer prices, the Reserve Bank of India announced Tuesday that it was pushing up its benchmark short-term interest rates by a quarter of a percentage point.

Raghuram G. Rajan, the central bank’s governor, acted even though his country’s manufacturing sector, heavily dependent on borrowing and sensitive to any increase in rates, is already slowing. “It is only by bringing down inflation to a low and stable level that monetary policy can contribute to reviving consumption and investment in a sustainable way,” he said in a statement.

The Turkish central bank raised its benchmark interest rate a surprisingly steep 4.25 percentage points on Tuesday in an attempt to defend the nation’s currency.

If China’s economy slows further in the coming months, that would not just hurt demand and world prices for raw materials. It would also reduce demand and prices for a wide range of industrial materials, like steel, produced in many emerging markets.

An HSBC survey last week found considerable gloom among many Chinese manufacturers. Some wholesalers and retailers in China say that they also see signs of weakness in the crucial shopping period ahead of Lunar New Year celebrations beginning Friday. The period is nearly as important for Chinese retailers as Christmas is for many Western retailers.

“Business this month is down 20 percent over the previous few months. I don’t really know why, but people’s desire for spending is just not there,” said Michael Liu, a wholesaler of photo frames, bangles and other crafts in Guangzhou.

Yet the prospects for emerging markets are not entirely grim. Many economists have focused on slowing growth in the value of Chinese imports, and warned about troubles in emerging markets. That partly reflects that commodity prices have been falling. But the tonnage of Chinese commodity imports has kept rising. In December, China’s imports were up only 4.3 percent in dollar terms compared with a year earlier. But they were up nearly twice as much, 7.8 percent, in terms of tonnage, according to China’s General Administration of Customs.

The rising tonnage of imports has been hurting domestic production. China’s coal imports have doubled in the last three years, even as many new open-pit mines have begun production in Inner Mongolia and Xinjiang. That is causing considerable hardship and closings at underground coal mines in traditional mining provinces like Shanxi and Shaanxi, just as many underground coal mines closed in Wales and Appalachia in the 1970s and 1980s when they could not compete with open-pit mines in emerging markets or Montana.

The iron ore industry in Hebei province, near Beijing, has also been struggling as growth in steel production has stalled even as iron ore imports pour in from South Africa, Iran, Brazil and Australia.

Chinese statistics show that annual growth in the mined tonnage of iron ore slowed to 6 percent last year after hovering around 20 per cent for a decade. Even the modest increase last year overstates the actual increase in iron extracted, because China is having to shift to lower-grade ore reserves as high-grade reserves are exhausted.

“You’re moving more dirt to get the same amount of useful product,” said Ephrem Ravi, the head of Asian metals research at Barclays.

The weakening value of iron ore production, together with low prices and costly pollution controls in the steel sector, is affecting the entire economy in Hebei.

“Business has not been good during the past few months, it is down 20 percent compared to the same period a year ago,” said Yi Jinwei, the marketing manager of a construction materials wholesaler in Handan City. “The economy is just not what it used to be.”