INFRASTRUCTURE AND COMMODITY DEMAND
Emerging markets are often characterized as primarily exporters of commodities. This is an over-simplification. On an aggregate basis, they are both exporters and importers of raw materials. India and China are net importers of commodities, while Australia and Canada are important exporters of commodities, including to customers in emerging markets.
These days, numbers of interplanetary magnitudes are published, illustrating projected “infrastructure development” in the emerging markets. These are staggering figures. Of the $22 trillion earmarked for infrastructure spending over the next decade, some $1.3 trillion is being disbursed this year. Beyond Brazil, Russia, India and Russia, the main multi-billion infrastructure investors will be Indonesia, Mexico, Saudi Arabia, South Africa and United Arab Emirates. Despite of all the wailing about a “bubble”, this infrastructure expenditure has so far proved largely price insensitive.
A closer look at these projects reveals that “only” slightly above 30% of the overall expenditure will transform into commercial and industrial infrastructure. The rest will be spent on what mankind always had to fork out – shelter. And for a good reason. In China, which comprises 34% of all new urban residents among these economies, as much as 63% of all construction is residential. During the next decade 11% of all Chinese, 10% of all Brazilians and 9% of all Indians will relocate to the cities. Only Russia has a negative urbanization rate, offset by the gradual replacement of old Soviet building inventory. All together, the world will experience relocation of 2.4bn people into the cities of Asia, Latin America and Africa. The move dwarfs the magnitude of Western and Japanese urbanization of the 1950s and 1960s which involved one tenth of that number.
IS THIS REALISTIC?
Although they are still minnows in terms of final consumer demand, emerging markets now represent some 30% of the world’s economy and 60% of incremental growth. The massive infrastructure spending plans have connected these economies more strongly among themselves. As the global trade flows have registered the lowest growth in several years, the trade among the emerging market economies has been booming. In the process, the US-centric supply chain pattern of the 1990s has given way to a new structure in global trade. These shifts are illustrated by unprecedented spreads between commodity indexes (up) and industrial production in the developed economies (down).
How was this massive realignment possible?
After the 1998 debacle, most governments in emerging markets dodged the pressure to develop internal consumer and financial markets. Instead, since at least 2002, these nations have embarked on major developments of infrastructure, in part to serve new export markets, and in part to address the needs of modern urbanism. This, in turn, reinforced the trade networks among these countries, making them less directly vulnerable to periodic economic slowdown in the US and other developed economies. Not surprisingly, in the early 2008, their overall export growth was maintained, despite falling demand in the US. With 80% of its commodity demand destined for the domestic consumption, China, rather than US, often emerged as the ultimate destination of exports from other Asian and African countries.
Following several years of capital accumulation through trade account surpluses, emerging market nations are now holding 75% of the world’s foreign reserves. Over the last five years, they have been growing annually by 39% in China, 57% in Russia, 32% in India and 33% in Brazil. China has a closed capital account and export earnings are essentially trapped within the Chinese economy. Owing to appreciation pressure on Chinese renminbi, there has been little incentive for illegal capital flight since at least 2001. The Chinese State continues to control not only interest rates and cross border capital flows. It controls asset supply and asset transfers. And it remains the chief banker for infrastructure and property development in the country. Only in the first half o this year, additional $52bn flew into China in the form of foreign investment. This wealth has been largely re-directed into urbanization and re-industrialization of these economies.
The common misconception is that the infrastructure spending (and, by extension) commodity demand will collapse the moment the export industry stumbles. This is misguided for at least two reasons.
First, the contribution of net exports to Chinese gross domestic product, while growing in the recent years, has not exceeded 7%. This is dwarfed by 43% ratio of investment (both public and private) to gross domestic product and the ratio of consumption (46%). Even if the American consumers turned their backs tomorrow on Chinese goods, the impact on China’s growth would be limited. Most of Chinese exports go to Asia (46%), followed by Europe (24%). Only 21% of Chinese exports are destined for North America. And that is less than 1.5% of China’s gross domestic product. At a recent Canton Fair, order volumes were dominated by Europe, followed by the Gulf countries, and only then US. This is understandable given that Chinese currency has actually depreciated 4.4% versus Euro over the last year.
Secondly, the slowdown in Chinese exports will not defeat the building and infrastructure boom because it has occurred already. Since the beginning of the year, roughly 20% of Taiwanese and Hong Kong-invested businesses have closed in Pearl River Delta. While the new French-style Labor Law was the final straw, the maquiladora-type of operations had already been losing competitiveness for some 18 months. Friends in the region are telling me about the same Taiwanese businesses opening in Vietnam (60% of China’s wage level) or Cambodia (40%). While there could be a lagging impact on the local property market, the deceleration in maquiladora activity is unlikely to have a lasting impact on China’s infrastructure spending ambitions.
All this will require materials necessary for property development (aluminum, copper, cement and steel, i.e. iron ore and metallurgical coal), power generation (thermal coal, natural gas, uranium, cement, steel), power transmission (aluminum, copper, steel) and transportation (oil, steel, cement). But what may slow down this urbanization process, is a phenomenon unthinkable just several years ago – insufficient supply of basic commodities.
NO SUPPLY TO THE RESCUE
The main reason for the stubbornly high commodity prices should be sought in their inelastic supply. All the four groups of commodities – agricultural, energy and industrial – have been affected by several, mutually reinforcing factors that bottlenecked supply to the market. The most important among these are access to capital and technology, physical constraints, volatile weather conditions and explosion in capital costs.
Regardless of the potential return, capital and technology find it much more difficult to flow towards the sources of raw material wealth in the conditions of the progressive erosion of what the Western Culture labels “the rule of law”. With long-term security of tenure under threat, resource nationalism on the rise, bureaucratic rent-seeking behavior, ideologically motivated support for social and industrial disturbances – it is not surprising that both risk-averse debt and allegedly risk-tolerant equity markets appear reluctant to lock in capital for considerable periods of time in far-flung, inherently unstable destinations. Despite all the self-satisfied and politically palatable blabber that “the world is flat” the hurdles for capital flows are often insurmountable. Examples are aplenty. Equity investors are unable to prop up the world’s largest copper company. The most technologically advanced oil companies may no longer access bookable reserves in the ground. In turn, Arab oil sheiks are not allowed to invest their resources in North America’s agricultural land, instead of artificial ski slopes in the Persian Gulf. In these cases, and many others, capital will lie fallow, or will be redirected into lower return projects elsewhere.
Nor can resource companies fully leverage the potential of tax arbitrage. Most major companies now have their emerging market subsidiaries attached to holding companies in tax-free jurisdictions, but the subsidiaries themselves are taxed more aggressively by host governments. This has taken an extreme form in upstream industries, where a combination of royalties, export quotas, domestic pricing, equity transfers, beneficiation levies and windfall taxes has reduced incentives to pursue investments. In extreme cases (as in Africa), this is due to state bank-backed competition from China (mostly Exim Bank) which carries promises of large-scale infrastructure projects and local power perpetuation, neither of which are acceptable to Western shareholders.
In one Latin American country, I once assisted in a meeting of “stakeholders” – colorfully clad activists interested more in robust projection of their agendas rather than dialogue with potential employers and tax payers. As much of the increasingly acrimonious debate was couched in terms of racial self-victimization (“Spaniards came here 500 years ago, brought us shards of glass and took our gold”), the most interesting moment came when the attention of the attacks was redirected from the well-trodden path of anti-Western and anti-Anglo Saxon bashing. To rowdy ovation from the class-conscious crowd, a speaker lashed out again a dangerous new beast – “las Multilatinas”, successful Latin American companies in search of growth opportunities in neighboring countries. Latin “capitalists” were deemed unwelcome, just as other “foreigners” and their local allies.
Physical constraints are gradually becoming a barrier to capital flows as well. In agriculture, mining and energy, the low-hanging fruit has been largely harvested. The available agricultural land in South America and Eastern Europe is not adequately linked to major market thoroughfares and it will take years before adequate infrastructure is developed. In the US, much of the protected federal land could be released, but due to soil quality, it cannot be instantly transformed into fertile corn or soybeans acreage. Meanwhile, oil, gas and metal exploration efforts are forced move to increasingly remote locations in the Arctic Circle, sudorific jungles or off the continental shelf, only to tap into deposits of lower quality than those that are currently being depleted.
It is extremely difficult to attract and maintain a committed workforce in those inhospitable, boring and often dangerous places. The fact that so few schools prepare new generations of geologists and engineers further exacerbates this problem. And although the global transportation links may have spread out a single company’s asset web around the planet, the increased transportation costs make even these value chain decisions questionable. The strain on international logistics contributes to increased costs as too few sources with too few linkages carry massive volumes of products to too few end-point destinations. The resulting costly delays lead to further dislocations in the trade system.
All commodity production is, to certain extent, dependent on weather conditions. As the recent floods in Eastern Australia have proved, a global 850mt seaborne coal market may suffer disproportionately from a knock-on effect caused by excessive downpour in one, key region. But more surprises may be on the horizon. The unusually cold winter over a landmass stretching from Iran to Korea, wet weather conditions in Japan, floods in Southern Africa and North America and cooler, wetter summers in Europe, have all an impact on economic activity, and nowhere is this influence stronger than in the agricultural markets. It just could be that the sun spot activity cycle will usher the planet into several cooler years. It could also be that the melting Arctic ice cap has poured so much fresh water into the North Atlantic that the Gulf Stream is trapped much further to the south, leaving American northeast and European west colder than usual. It could also be that we are entering an uncharted era in which anthropogenic factors begin to interact with (poorly understood) climate effects of ultraviolet and cosmic rays. Whatever the causes, the weather volatility at this new stage of Holocene will continue to impact the already tight global commodity markets and the low inventories.
Finally, the illiquid debt markets and the underperforming stock markets do not make it any easier for resource companies to increase the supply of raw materials. Huge delays in permitting process deserve part of the blame. It now takes up to 4 years to finalize a feasibility study, up to 10 years to obtain the necessary permitting in certain Western countries, and up to 48 months to have the critical equipment delivered. Even if some of these periods overlap – it does go a long way in explaining why the commodity boom has NOT been followed by a swift production response.
Because of exploding capital costs and expensive, but chronic delays, mining companies are not developing brand new “greenfields” projects, nor can they enter profitably many countries due to the afore-mentioned resource nationalism. They can and do redeploy their cash either in mergers and acquisitions, which are supply-neutral, or in “brownfields” developments nearby their existing operations. The latter choice may actually be supply negative – the mining companies move to lower grades, extending the life of the mines and improving their net asset value, often effectively lowering the volumes of payable product.
21st CENTURY'S ZENO PARADOX
With the supply side so constrained – the only solution lies in the adjustment of global demand patterns. But the much-talked about “demand destruction” could be a short-term phenomenon. In any case, it has not occurred yet. Unfortunately, the main emerging market economies carry a statist legacy, are not fully market-driven and often introduce various price distortions that make price transmission more opaque. Regulated energy prices in China and in India reallocated capital away from utilities and pushed energy demand too high, now leading to accelerated energy imports of oil and coal. Similarly, India froze cement prices between 2006-07, leading to shortages and increased imports. Last May, despite 59% increase in the prices of raw materials and energy imports, China increased the volume of key imports of resources by another 13%.
It appears that neither conservation nor substitution offer a durable demand solution and more radical technological solution should be sought – both on the demand- and supply side.
In 5th c BC, Greek philosopher Zeno formulated a notorious paradox. If the tortoise is given a head start over Achilles, the Greek warrior will never catch up with the turtle if he always halves the distance between the carapaced reptile and himself. It took 24 centuries for human thought to solve this paradox.
We are slowly reaching the conclusion that, at the current level of technological advancement, this planet’s resources will not allow China and India to reach the level of wealth attained by the Western economies and Japan. This is a sobering thought for the world and a challenge for non-linear technological breakthroughs in alternative energy, agribusiness and material science. Let us hope that mankind’s cerebral power finds solutions before we enter a collision course with these new players’ frustrated ambitions.
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