China consumes half of the world’s base metal supply. Its housing market is the most metal-intensive large sector. A new quantitative study shows that China housing has been a key determinant of global metal prices during the boom of the 2000s and the bust since 2014. It is a crucial ingredient of forecasting models for directional commodity trading.

Kruger, Mark, Kun Mo and Benjamin Sawatzky (2016), “The Evolution of the Chinese Housing Market and Its Impact on Base Metal Prices”, Bank of Canada, Staff Discussion Paper, 2016-7.

This post ties relates to the importance of macro trends for predicting asset prices (view summary here)
Previous reviews of the subject dealt with other channels of influence of China on commodity markets, which include in particular the use of commodities as collateral (view post here).  Also, previous posts dealt with the risks to China’s housing boom (view post here).

The below are excerpts from the paper. Headings, links and cursive text have been added.

Evolution and size of China’s housing market

“Until the late 1980s, all Chinese residential real estate was essentially state-owned. Liberalization began in the 1980s, but markets remained relatively small until 1998 when the Chinese government relieved firms of the burden of providing housing for their workers. The market became the primary method of obtaining housing, and new home sales increased 10-fold between 2003 and 2013. Over this period, the Chinese housing market became extremely large by global standards. By 2015 it was over six times the size of the U.S. new home market.”

CNY_HM01

“To help anchor our medium-term view of the Chinese housing market, we have constructed a bottom-up estimate of fundamental demand based on urbanization, replacement and upgrading demand. Based on these calculations, we estimate that fundamental demand for floor space in China has plateaued and is not expected to pick up substantially going forward.”

CNY_HM03

“While limited alternative investment opportunities and artificially low deposit rates likely contributed substantially to strong investment demand during the boom period, liberalization of deposit rates, increased investment opportunities and the expected implementation of a property tax should reduce the incentive for Chinese households to use housing as an investment vehicle going forward.”

Why China’s housing market dominates base metal prices

“China’s demand for base metals rose at a meteoric pace over the 2000s, and in recent years China has become by far the world’s largest consumer of base metals.”

“The high base metal content of economic growth in China reflects an economic structure that has been geared toward metal-intensive sectors such as real estate. Data from the input-output tables suggest that for every dollar of housing output, roughly 16 cents’ worth of base metals are used as inputs, compared to about half that for the economy overall.”

Unlike housing markets in North America and Japan that involve lumber-based structures, housing units in Chinese urban areas are nearly all found in high-rise buildings. Taller buildings require much more concrete and reinforced steel to stay upright: a 32-floor building consumes twice the steel per unit of floor area as a shorter, eight-floor structure…China’s ongoing urbanization given its still-large rural population [necessitates]…high levels of construction and demand for base metals. In the past, when Japan and Korea were at China’s current level of real per capita income, they were largely urbanized (around 80%), whereas nearly half of China’s population still resides in rural areas.”

‘The unexpected nature of the rapid demand growth in China led to sustained supply shortages and exerted substantial upward pressure on prices. Work by Bank of Canada staff suggests that repeated upward revisions to growth prospects for emerging Asia played an important role in explaining price movements for base metals between 2003 and 2008.”

Some quantitative estimates

“We estimate that the level of Chinese GDP would have been about 9% lower at the end of 2010 in a counterfactual scenario where the housing market did not grow after 2002.”

“Our model suggests that base metal prices would have been close to 20% lower by the end of 2010 in the absence of the Chinese housing market boom. This represents a significant portion of the 85% increase observed in base metal prices from 2002 to 2010. There are also reasons to believe that the true impact of the housing boom on prices may have been larger. In particular, the impact of stronger demand on base metal prices may become non-linear when supply constraints are tested, as was likely the case during the 2000s.”

“Since 2014, however, a substantial inventory overhang has led to a steep correction in the housing market…While official data suggest that the level of inventories only stands at 4–5 months of sales, other data point to a much more acute problem.”

CNY_HM02

“Chinese base metal import volumes, which grew at a double-digit pace for most of the past decade, have essentially flatlined over the past two years. In particular, we note that the slowdown in import growth has been especially pronounced in the case of iron ore, which is the base metal that is most intensely used for construction. This unexpected slowdown in demand growth has likely amplified downward pressure on base metal prices stemming from increasingly abundant production capacity at low-cost mines around the world.”

CNY_HM04

“Specifically, we assume in a counterfactual scenario that investment and activity in the Chinese housing market would have continued to expand at their previous pace, instead of declining in 2014. In such a scenario, the level of Chinese GDP would have been around 2% higher by the end of 2015. After accounting for the fact that these additional economic activities are more metal intensive than the economy overall, we find that base metal prices could have been 5 to 10% higher had there been no correction in the Chinese housing market. This estimate represents up to a third of the actual decline in prices observed.”

“[The 2014] downturn has been driven primarily by market forces, in particular:[1] a significant build-up of unsold inventories; [2] slowing economic growth; [3] financial innovation that offers households alternative investment opportunities; and [4] expectations of the future implementation of a property tax. After growth of close to 20% in 2013, the volume of sales fell by 9% in 2014. While they recovered by 7% in 2015, they did not re-attain their 2013 levels.”

“Despite stronger housing market indicators such as buoyant sales growth in 2015H2 and relatively low financing costs, we expect investment growth to remain subdued in the near term. The remaining inventory overhang likely necessitates a more prolonged adjustment in investment, while the recent strength in sales growth may have been driven by temporary factors.”

SHARE
Previous articleInsurance companies and systemic risk
Next articleThe term premium of interest rate swaps
Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.