Container traffic is the proverbial canary in the coalmine of international trade, and at Shenzhen in China, the port that serves key high value export industries, volumes fell in June by 0.6 per cent from the previous month and grew only 3.5 per cent against the same month last year; in H1 2008 volumes were up 7 per cent against 14% during the same period last year. At Shanghai, the country’s largest port, container throughput has also halved, and these figures are all the more ominous given that June is the peak month for container traffic; exports are now slowing fast. The domestic situation doesn’t look great either; China’s stockpile of unsold new vehicles rose about 50 percent in the six months ended June, hitting a four-year high, as sales growth slowed. I have argued for many months that China’s growth model was fundamentally unsustainable, and that the country would see slumping growth as its terms of trade deteriorated. The Communist Party apparently agrees, because at last Friday’s Politburo meeting they decided to backslide on fighting inflation and prioritise growth. Among the implications will be to delay a revaluation of the Renmbini, at least for a few months more. But there is a deeper problem looming than just a cyclical growth slowdown; recent rapid and contradictory economic and security policies and rising social tensions are signs of a system in crisis and a leadership gripped by paranoia. We have seen a stream of reactionary policies (the latest being a bizarre pre-Olympics restriction on visas for foreign visitors, meant to target human rights activists but affecting businessmen too) from a central leadership trying to preserve its authority, stabilize social stability and postpone an economic crisis. Aggressive nationalist sentiment has been officially stoked up against ’splittist’ forces ranging from Tibetan nationalists to religious groups like the Falun Gong, but may prove difficult to control once unleashed. There is much anecdotal evidence that local governments, and even organs of the central government, are actively resisting directives from Beijing. So too are key state enterprises like China National Petroleum Corp., China Petroleum & Chemical Corp. and the state banks. The political situation is far more unstable that most foreign observers appreciate. Chinese history since 1949 (and all the way back to the First Emperor) indicates that the central bureaucratic leadership is willing to sacrifice social and economic stability to preserve power. The Great Leap Forward and Cultural Revolution under Mao or the crackdown at Tiananmen Square under Deng offer clear evidence of this. Maintaining centralised control and fighting centrifugal pressures from the provinces have always been paramount in Beijing. The risks of a major political upheaval in China are higher than they have been in decades. The implications for commodities are potentially devastating, particularly as there has been substantial official stockpiling ahead of the Olympics (particularly of fuel) and speculative stockpiling ahead of a hoped for revaluation. In fact, copper offers an instructive view of the Alice in Wonderland world that is the Chinese economy. Globally, copper consumption is falling, yet known stocks are mysteriously low. What gives? China has over 200 seaports, 128 of which are open to foreign vessels. Even copper producing giants like Codelco admit to not knowing where their exports are ending up; many shipments just don’t show up in official Chinese customs data, as the copper is being shipped into free trade zones where it can be warehoused in bond. Since the metal doesn’t pass through customs, it doesn’t show up in official trade data. This provides an ideal way to store the copper out of the public gaze for an unlimited period of time. Duty is only paid if the metal is imported, but not if it stays in a bonded warehouse or is shipped to another country, even if its ownership changes. So we have a massive speculative hoard of copper lying in bonded warehouses all over China (a total area equivalent to roughly 12 football pitches would be needed). The financing cost would run into the hundreds of millions, but as I suspect state owned banks are financing all this, perhaps unwittingly under the direction of corrupt officials, that’s not a big problem. In the 1990’s, a Japanese trader at Sumitomo tried to corner the copper market, ultimately blowing up in 1996 with losses of $2.6bn (like the Hunt brothers in Silver in the 1980’s), leading to a market collapse and massive losses for his company. The copper market should be in a surplus of 2 million tons by the end of 2008, yet official data lead to consensus forecasts of a surplus of sub 100k tons this year. Those naive pensions funds diversifying into commodities as ‘uncorrelated assets’ are in for a rude awakening if I’m right in suspecting the biggest manipulation in the history of the metal markets is set to implode in coming months. The speculators attempting to disguise or misrepresent the growing but hidden surplus are going to have to purchase and finance more and more physical inventory. Eventually, this Ponzi scheme will collapse under its own weight, taking mining stocks with it. The Chinese government’s implicit decision to delay any revaluation will hasten this inevitable crisis, as it will encourage the flood of speculative money washing through the current account to move on, but will be just one element in a broader crisis that may shake international markets in coming months.

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Commodities, Market Commentary