China’s Grey Swan Could Turn Black as Coal

Guest Author: Jack H. Barnes, who writes at jackhbarnes.com.  Jack is retired founder and portfolio manager of a small hedge fund shop. He was named in the “Best of the Web” as the Top Stock Picker of 2005 by Forbes. His two funds returned double digit positive returns in 2008. I retired in 2009 to the beach where I now write random comments about the global markets.

The Chinese economy is heading toward an economic hard landing; it will overshoot to the downside and become the economic Black Swan event of 2011-2012.  Inflation, yes both types, will be the story in China in the coming months.

The steps necessary for an economic black swan landing have all happened, what is next is just the crash landing.  The rains in Australia have cemented China’s economic slowdown.  The rains will have longer lasting implications for both economies.

(Click here for larger image of the graph below.)

• China is about to have its steel mills shut down due to a lack of available high BTU coal.  This has always been the weak link in the Chinese export model.  A reliance on imported raw commodities.
• China is about to have its electrical grid under perform during the peak winter months as it uses Australian high-grade coal to “sweeten” local Chinese sourced low-grade low BTU coal for their power plants.  While these plants will work using the local coal, they will not produce the same Megawatt load they did.
• China will have to import emergency supplies of Diesel to help the local factories to continue to run on their own independently powered generators.
• China will end up paying at least 100% increase in high-grade coal prices, year over year.  This will have to be pushed into their cost structure, it is too large to absorb.

The Chinese are going to be shopping the worlds markets for any available coal with BTU content higher than their own average domestic coal.  They have no choices.  They are going to be buying coal from the US east coast terminals in size before this is over.

The need to import high-grade coal ore & iron ore are the two Achilles heel of their export based economy.  China is going to be pushing up coal prices around the world, making locally sourced steel profitable again in the US.

The Chinese are also looking at an increase in iron ore, the primary input for steel mills.  Vale has raised rates by 8.8% for the 1^st Quarter of 2011.  BHP is reported to have raised rates by 40% this year.  In the future, BHP is now negotiating quarterly rates.  The inflation in iron ore for the 1^st Q of 2011 is reported to be 7% higher than last Q2010.

The last time that Australian coal fields were flooded, the price of high grade coal reached $300 per ton.  The price for Australian coal for 1st quarter 2011 was $225 per ton, and this was before Force Majeure was declared.  It was an increase of 75% over the price negotiated in March 2010.

A rescue boat in Rockhampton, Queensland, on Tuesday, from The New York Times (1/4/11).  See GEI News Brief.

The new flooding is going to push prices of high-grade coal to $300+ this time.  The flooding is more extensive, with the damage to the local Australian infrastructure worse this time.  This is not going to be a quick or easy repair job in Queensland.  This is going to be a longer lasting event than the main stream media is giving it.

In simple terms, there are two types of inflation.

• There is cost push inflation where a producer is able to increase prices, because of an increase in raw costs.
• There is the expectation of inflation type. This is the source of all past hyperinflationary events!

The second type is the dangerous type.  Expectations of inflation infected the US economy when Paul Volcker took charge of the US Federal Reserve.  He raised interest rates in the US, until he killed the expectation that there would inflation.   It was a gutsy call at the time, and is what provided the fuel for the historic bull market of 1982 -2000 to grow.

Today, the media pundits are talking about a slowdown to the mid-single digits because of Chinese government attempts to slow down inflation, or said better the expectations of inflation.  It is the second type of inflation that the Chinese leaders fear.

Once it’s infected a nation’s population, it does not go silently away.  It takes Volcker type actions to stop it dead in its tracks.  To do that, China would have to put their economy into a negative growth period, something they can’t afford to do.

The Chinese manufacturing base is not going to able to absorb the inflation, and will have to use cost push inflation at this point. This should boost the nations with steel export capacity, and locally sourced coal.  The US steel industry, with locally sourced iron ore and coal, is going to be competitive again.

This is going to push expectations of inflation into the China economy as hard import costs continue to rise in a slow global economy.  Their ability to continue to raise the Yuan against the US Dollar will be further stressed.  Let the Yuan rise, and watch all competitive edge bleed away, or stay fixed and watch inflation rage internally through their economy.

The ongoing economic war between the US & China is driving up the cost of food for the average Chinese citizen. This will hit the Chinese hard, as they import a food staples for a growing middle class.  There are already reports that basic food staples are more expensive on an equal basis in the US, compared to US food supermarkets.

“On a recent Friday, the balding 33-year-old, who runs a breakfast stand with his wife, wheeled a shopping cart into the aisle of a C.P. Lotus Corp. superstore in northern Shanghai, eying only prices. In seconds, his wife emptied the shelves of its 11 remaining bottles of Cofco Ltd. “Five Lakes” soybean oil, the discount choice at 47.90 yuan, or about $7.20, for five liters (1.32 gallons).

At the checkout, Mr. Liu separated their $79 purchase into three batches to sidestep the store’s four-bottle maximum and government bans on hoarding. To transport the provisions to their food stand, Mr. Liu placed two bottles into the basket of his blue electric scooter and balanced nine more on the running board. His wife plopped on back.

Mr. Liu’s livelihood is now just as precariously balanced. He reckons his cooking-oil costs shot up 27% in 2010.”

WSJ

The Chinese have exported deflation to the US for the last decade.  The US for the last few years using Q.E. has exported inflation to China.  This two-way exchange is now hitting the Chinese consumer in the wallet.  It is affecting their ability to put expected food staples on the table at dinner time.  This is also about the only way you can destabilize the Chinese government. The implications of that are farther reaching then this article…

Note:  The Guardian has an interactive map showing the extent of flooding in Australia.