Monday, May 16, 2011

A Penny Saved Is Not a Penny Earned: Copper Pricing and China

"A penny saved is a penny earned" is a famous quote from American Founding Father, Benjamin Franklin. However, this maxim is hardly true today - the modern penny having been diluted by a 97.5% base of zinc and a thin copper covering of 2.5% after prices had become too expensive.

Copper is an industrial metals bellwether and more importantly, a risk on trade bellwether (dollar down/risk on assets up). Unlike oil, which has a substantial political volatility premium built into its pricing, copper's output is constrained by mining difficulties. Both commodities take years for efficient resource extraction, but base metals had been comparatively neglected in the past 2 decades compared to energy.

Consequently, any fall in copper prices are likely to be due to falling demand as opposed to speculative swings in prices. Technicians can see this trend outlook in the MACD in the above charts.

Compare copper to the volatile price swings in other risk on assets such as gold and silver. While precious metals retain intrinsic value in preserving wealth they had also taken on bubble like characteristics in recent months - just look at silver's dramatic rise to near $50/ounce before its violent 1 week correction earlier this month. Of course, no discussion about copper would not be complete without mentioning China.

China has been the biggest source of demand for copper with anecdotal reports of manufacturers stockpiling the shiny metal in warehouses. But authorities have been on a decidedly hawkish stance since last year with persistent interest rate increases and bank reserve requirements. The renminbi has also been allowed to appreciate the most in its history - by differing accounts from between 3.5% - 4.5%. This rate rise may sound small compared to swings in other currencies but remember that China's exchange rate remains tightly controlled for political and economic reasons.

An appreciation on the order of AT LEAST 5% is needed to be effective in constraining runaway inflation. Official inflation rates for April 2011 were 5.3%. Real inflation rates are estimated to be much, much higher - on an order in the double digits. Volatile food and energy costs are estimated to comprise much of this increase. To be truly effective in constraining price pressures, Chinese authorities would have to allow the renminbi to appreciate to double digit percentage levels. Of course, this will never happen. Allowing the currency to appreciate to such levels would devastate the export manufacturing sector and lead to a massive loss of jobs.

The Chinese government is left w/alternative policy controls such as raising bank reserve requirements, hiking margin on stock exchanges, loosening currency flow restrictions (e.g. allowing renminbi denominated accounts to be opened elsewhere outside Hong Kong), and allowing wage increases among broad swathes of the employment sector (more on this topic in the next post). These methods have had varying levels of success in cooling the economy. One thing is certain though: as inflationary pressures continue to rise, Chinese authorities will ultimately be forced to allow the renmimbi to appreciate to higher levels.

The bottom line:
Bulls on risk on assets are now engaged in a fight w/the Chinese central banking authorities.
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