China's monetary policy - no drop in copper demand

The two hikes of the minimum reserve ratio by the Chinese central bank (the Peoples Bank of China) by 0.5%-points each in mid-January and in the past week, and the brakes on lending by commercial banks does not mean the demand for copper at the largest consumer is going to collapse. Overall, despite a tightening of credit policy, copper consumption in China should develop better than the International Copper Study Group estimated in its forecast from early October 2009. The supply surplus could be lower in our view. This does not mean, however, that the price of copper will not suffer under greater burdens in the year 2010. These possible pressures, however, are more likely to come from those factors that have driven the price of copper strongly higher in 2009, although the LME inventories had increased significantly.

The net-lending of Chinese banks in the first 20 days of 2010 was around 151 billion euro. Given the objective of China's central bank, to limit the volume of new loans to around 781 billion euro, it comes as no surprise that the PBoC has twice raised the minimum reserve requirement ratio by 0.5% points and the commercial banks put on hold the granting of new loans during the last third of January. Even as the target of the PBoC is to reduce volume of new loans in this year to the equivalent of 999 billion euro, this volume would still be well above the amount of new loans in 2008. Therefore, China is far away from pursuing a restrictive monetary and credit policy, but it will not be as expansionary as in the previous year. However this is not surprising, given the recent growth figures for GDP of 10.7% in the 4th Quarter of 2009. The development of inflation in China suggests that China's central bank takes his foot off the accelerator, too. Although the inflation rate for consumer prices in January, after a surprise fall to 1.6%, is at a moderate level, but it has accelerated considerably for producer prices, which rather sooner than later would spill over to consumer prices.

The fears in the markets, not only for copper, seem to be based on the fact that some analysts and traders confuse acceleration and speed. In the 1st Quarter of 2009, the growth of China's GDP was still at 6.1% yoy. It has steadily accelerated to 10.7% in the last quarter. While one could still argue that the basis for comparison in the 2nd and 3 Quarter was distorted by the prescribed production stoppage with respect to the Olympic Games in Beijing, but this applies no longer to the 4th Quarter. The accelerated GDP growth has been due to the expansionary monetary and credit policy. In China, as the central bank takes the foot off the accelerator, the monetary and credit policy as a whole is less expansionary, but is still far from acting restrictively. For the growth rates, this means that they will not rise much further. But the Chinese economy is likely to be far away from a drop in growth rates. In yoy-comparison China's GDP could still grow by a double-digit rate this year.

For the demand for copper, this implies it should grow strongly again. The International Copper Study Group estimates that much of the Chinese consumption would be satisfied by supplies from the strategic reserve, which was strongly increased in 2009. We do not share this assumption. On the one hand, a strategic reserve is not used to compensate for short-term fluctuations. Secondly, the copper stocks in the warehouses of the metal exchanges have increased and copper is not scarce. In order to provide copper to the market from China’s strategic reserve, probably a significant plunge of the copper stocks in LME, SFE and CME warehouses would be required.

Overall, we consider the impact of actions by the Chinese central bank on the recent development of the copper price is far overdone. This does not imply that the price of copper is unlikely to suffer under various burdens this year. Many analysts and traders expressed surprise that the price of copper has risen almost to $ 7,800 per tonne, although the stocks in warehouses have steadily risen. Our econometric model for the fair value of copper shows other factors, which also have a significant impact on copper prices, have more than offset the negative impact of rising stocks. But in the course of 2010 these factors are likely to lose more and more their positive influence and could even become a burden. The OECD leading indicator could still rise further, but the further increase is likely to lose momentum, which is negative for copper. Also in the equity markets, the gains over the previous year are expected to decline. The Fed is likely to begin in the second half to adopt a less expansionary monetary policy. This would then also lead to rising yields of 10yr. US Treasury bonds and thus also impact on the price of copper negatively. Also we do not expect oil prices - as an indicator of expected inflation risks – to drop significantly, which would then also draw copper prices down. But a robust rally as in 2009 is not expected as well. The US dollar is already having a negative impact on the price of copper. After the weakness of the US dollar in 2009, when it served as the funding currency for carry trades, the greenback has gained strength in the foreign exchange markets, as the fear of state bankruptcy of Greece and breakup of the euro dominated sentiment. This scenario is absurd, as ECB President Trichet has rightly observed, but the irrationality leads to a flight into the safe-haven of US dollar denominated assets. Not only the precious, but also the base metals suffer under the flight into the US dollar.

After the strong upward trend in the previous year, copper could trade this year in a wide sideways range. In this scenario, Copper is for buy-and-hold investors not interesting, but should offer still attractive trading opportunities for more flexible investors.