Will a Residential Construction Bubble in China Weigh Down Industrial Metals?
China is the world's largest consumer of copper, zinc and nickel and also among the leading consumers of other base metals. The country has one of the fastest growing auto sector (which has overtaken the US in size) and has plans for rapid expansion of railroads and other infrastructure segments. Not surprisingly, China's demand growth is expected to be the single most important factor in determining the direction of metal prices.
With a substantial emphasis on infrastructure and construction, the health of the construction sector in China is worth a look to corroborate future prospects of industrial metals. In the present report, we have analyzed China's construction sector and its likely impact on industrial metals in the medium to long-term. We have divided the construction sector report into two parts to avoid overkill. In this part we will analyze the shape of the residential construction segment, which is allegedly slowing down after a phase of tremendous expansion. In the subsequent part we will emphasize on the more significant sectors of non-residential construction and infrastructure.
China's residential construction sector comprises approximately 21% of the total construction in the country. China's residential construction market has grown rapidly to about 186 million square meters of new building per annum since the privatization of over 70% of the housing inventory in the last decade. Construction levels in Beijing alone have outpaced construction levels in entire Europe – a testimony to the magnitude of building activities happening in China.
A momentous climb in middle class income levels has led to higher demand for modern day luxury buildings. The swelling population in cities such as Shanghai necessitates higher requirements of new buildings every year. China also has plans to build a number of satellite cities and townships to cope with the massive expansion in the upcoming years. With Japan and the US stagnating, China remains the global hotspot spurring construction investments.
The massive Chinese stimulus with emphasis on infrastructure saw the power and enormity of China's ability to drag metal prices out of any potential downside. Copper and other industrial metal's solid performance in the midst of the global recession is evidence of how influential China's infrastructure spending could be. The impact of the stimulus is yet to wear off and we expect infrastructure activities initiated as part of the stimulus plan to continue pulling up metal demand for some more time yet. Also, China's emphasis on infrastructure is not a new stand – it only underlines the continuing growth happening in the region. Much of these factors will remain a key driver of metal prices in the upcoming years as well.
After rallying in 2009, industrial metals have had a mixed year so far in 2010 as the global economic scenario remained weak in the first half. China's metal imports, a key driver of the rally in the second half of 2009, lost pace leading to speculations that demand for metals in the developing markets is drying up. Although metal prices have picked up over the past few months, the withdrawal of Chinese purchase plans is likely to affect metal prices in the upcoming months.
The World Bank and IMF's revised global economic growth outlook indicates a marginal improvement in 2011; but the bias is toward a more protracted and muted development. Macroeconomic data from the major economies also indicate a pause in metal prices. The unemployment data from the U.S., Europe and Japan dampen the prospects of metals in the short term. However, the role of developed economies in shaping metal prices is expected to be nominal in the next few years with developing economies accounting for a clear majority of the demand. The silver lining is that the developing nations are continuing to grow at an impressive pace to keep metals supported.
Despite the host of negativity in the metals market, LME and Shanghai copper inventories have witnessed a drastic reduction this year. The supply side has also been showing signs of fatigue – new exploration activities have stalled and ore grades have started to deteriorate. The dollar has also not been strong and that has helped prices of dollar denominated metals. It is evident that demand is a less important factor now in determining copper prices. Nonetheless, investors looking to gain in the long term should be prepared for a correction because of a perceived lull in Chinese demand.
Impressive growth for residential construction in China
China's construction sector has demonstrated impressive growth in the past few years. In fact, contribution of the sector to the country's economic growth has increased from a mere 3% in the 1990s to 17% in 2009. The total construction expenditure in 2008 was estimated at approximately USD 1.2 trillion making China the second largest housing market in the world, after the U.S. In addition, China's construction sector witnessed double-digit growth (compound annual growth rate) during the past decade. That's a whopping number given that the global growth was in the range of 5-6% during the same period.
Despite signs of a slowdown in property prices and buying in the short term due to overheating of the residential sector, China looks poised to dominate the world's construction sector leading a healthy demand for base metals. The Chinese construction sector contributes approximately 40% to the domestic consumption of aluminum, copper, nickel and zinc – about 8-10% of the global consumption.
The share of residential construction in China is significantly lower than in the US because of its emphasis on infrastructure spending. However, it still contributes significantly to the growth story in China. In order to gauge the state of residential construction in China, we have analyzed a few critical indicators that give us an insight into the condition of the sector.
Regardless of claims of a slowdown in residential construction, residential real estate investment data from the National Bureau of Statistics of China shows that the y-o-y YTD growth has been up by close to 35%, even marginally better than the growth in commercial investments. This is well above the global average and clearly better than investment in real estate in most of the developed regions post recession.
Buildings completed data also displays a robust growth in the past two years. This is primarily a government stimulated recovery through fiscal support and considerable easing in lending. Such a measure is not a long term support for construction – a slowdown in residential construction is impending. However, the palpable difference in the growth rates of China and other developed economies ensures that even in the event of a correction, China's growth rate will be sufficiently superior to support metals demand. Other indicators such as the FDI investment in the construction sector, house prices index and the "Residential Real Estate Climate Index" also demonstrate that the construction sector had bottomed out by 2H08, and movements in the residential market could only be upward.
Drop in prices possible but growth in construction to continue
One of the primary concerns engulfing the residential market in China currently is an impending correction in property prices. The subtle but steady drop in housing prices in 2010 indicates that the overvalued residential market has scope for price corrections. The Sales Price Indices of New Buildings in 70 Medium-Large Sized Cities, a measure of residential house prices in China, has been hovering around the 110 mark (on a y-o-y basis) throughout 2010. This index highlights that while the sector is still growing y-o-y, the m-o-m growth in prices has not been able to replicate the augmentation levels observed in 2008-09.
Additionally, the "Real Estate Climate Index" has been dipping consistently over the past few months on an m-o-m basis. These indexes point to a long-drawn-out growth in the residential housing sector as opposed to a sharp one. However, while stagnation in prices of housing property does not augur well for construction activity, under the circumstances it is not indicative of drop in construction (and hence demand of metals).
Much of the correction in prices that analysts anticipate can be attributed to the government's efforts to restrict speculation in the real estate market by encouraging higher down payments and mortgage rates for buyers, encouraging construction of affordable houses and restricting purchases by non-residents. China's housing prices to income ratio is at a historical high and a pressure on prices is imminent. However, there has not been a let up in sales. If at all, lower prices and stricter government controls has been attractive for residential property from the retail buyer's point of view. The amount of assets being built is not slowing-the volume of construction starts was up 55% from a year earlier in June. Total investments in real estate are also up from a year earlier.
New trends in urban housing to need more metals
A lot of talk about the residential construction sector, but what about metals? Metals will not only gain from the overall growth in residential construction in China but also from the fact that new activities will be led by urban housing, which is now witnessing a paradigm shift – furnished apartments instead of ordinary homes. New housing units data in China over the past decade shows a clear trend of rising luxury homes in comparison to affordable housing.
The use of metals in a typical Chinese home has been steadily increasing over the past few years as a result of emphasis on the luxury segment. A common Chinese home requires 33 kg of copper and 45 kg of aluminum, while the average furnished luxury home requires 180 and 200 kg of the two metals, respectively. The anticipated housing bubble may dent the growth of the luxury segment in the next few years, but even at reduced levels, this segment is likely to far outweigh the affordable segment in size.
No housing bubble – residential construction in China still strong
Finally, why should China's march in residential construction continue? The key word is affordability. Household incomes are significantly higher in China than that indicated by official statistics. The average house price in 2008 is believed to be around four times the average disposable household income, after taking "grey income" into consideration. This is similar to numbers in the US in the same year.
However, there is a huge difference between the US bubble and the purported Chinese bubble. In the United States the bubble was all encompassing and drove up prices across all income groups and building segments. In China, housing construction is largely concentrated in the luxury high-end segment and it is this segment that is experiencing a drag in prices. In that sense, the bubble is restricted to the top income group. Prices will come down as the government promotes affordable housing instead of luxury buildings (overall construction is not impacted) but from a metals demand perspective, the fundamentals are still intact.
Moderate growth estimates in China suggest that base metals will likely witness an average 0.5-1.5% increment in demand. If the 10-15% growth witnessed in the past few months sustains, it would revive the global demand for base metals by approximately 2 percent. In the current scenario, we believe that a moderate growth in the residential sector is certainly plausible and this supports medium to long-term prospects for industrial metals.
The primary dilemma of investing in metals is that they more closely follow market and economic conditions than precious metals. This makes metals susceptible to wide corrections – for superior returns, it is essential to time the markets well. Be well armed with proper entry points and expert advice to extend gains likely from the key support from China. To put the above analysis into proper perspective – please remember to that precious metals outperformed industrial metals at the final stage of the bull market of 70's – 80's, so while diversification between various commodities might be a good thing to do, forgetting about precious metals at all is definitely not recommended.
Thank you for reading.
Sunshine Profits Contributing Author
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