Michael Pettis — By 2015 hard commodity prices will have collapsed

Michael Pettis joins Randy Wray in predicting a commodity collapse in the works.

China Financial Markets
By 2015 hard commodity prices will have collapsed
Michael Pettis

This has created a selection process that favors accumulation. Companies that prefer to hold more, rather than less, inventory of commodities and goods in which commodities are a high cost component have outperformed their rivals, and so the whole market has moved towards a preference for stockpiling, much in the same way that, according to Hyman Minsky, periods of stable or rising asset prices force the financial system into taking on excessive risk. [emphasis added]

Since overstocking has always been a winning strategy until very recently, it is a pretty safe bet to assume that Chinese traders, speculators, end-users and investors have a built-in prejudice towards being long or longer inventory.

The overstocking problem in part has also had to do with financing constraints. In late 2010 and early 2011 in this newsletter I wrote often about commodity inventory financing as a popular tactic among Chinese businesses and banks aimed at getting around regulatory constraints on lending.

By importing commodities that were funded through trade financing and then using inventory receipts to borrow domestically, banks and borrowers could get around lending restrictions.　 We have never been able to figure out exactly how much of this was going on, but there was plenty of anecdotal evidence to suggest that this was a pretty wide-spread scheme and it involved a variety of commodities – copper, most famously, but also soy, magnesium, cotton, rubber and several others.

Finally, I should add that in China there is, more than in any other country I know, a sense that physical ownership of commodities or of commodity producing facilities creates substantial intangible benefits.　This may be a legacy of Maoist perceptions of self-sufficiency, or it may have to do with a history of unstable political and monetary arrangements, but whatever the reason Chinese are often obsessed with the need for physical control of commodities.

The result has been a tendency to hold much larger commodity inventories than can be justified by business needs and risk management concerns.