Why is China buying up copper?

PORTFOLIO POINT: A 70% rise in the copper price since late December, largely driven by Chinese buying, has important implications for investors.
China has taken a new step to reshape the world economy. If it continues down this new path the ramifications will be just as dramatic as the other major steps China has taken over the past two decades and will require a revision of many investment strategies.

In essence, China's State Reserves Bureau is investing in copper rather than US dollar paper. Several global commentators have isolated this new trend, which follows copper’s stunning 70% price rise since hitting a bottom on December 26 last year.

Today I will set out the investment strategy implications of this new and important development. (And this will be explored further by Alan Kohler in tomorrow’s Weekend Briefing email.)

Although copper is the main game, China's State Reserves Bureau is also reported to be accumulating aluminium, zinc, nickel, titanium and perhaps rare metals including indium (used in thin-film technology), rhodium (for catalytic converters) and praseodymium (glass).

China has not been a major buyer of gold, at least to date, preferring minerals it can use operationally. (To read more on China’s revived commodity demand, see China trader cautiously hopeful.)

If you are feeling bad about not picking this new trend then you will be comforted that very few global experts picked it until this week. For example, BHP was so fearful about the resources outlook it abandoned its bid for Rio Tinto. With the benefit of hindsight it was a mistake.

Rio Tinto responded to the BHP rejection by signing a deal with Chinalco, which sets purchase prices that look low given the new world reality. But even Chinalco itself, with its close links to China, did not play the game well. It negotiated a wonderful deal in terms of price but it attached to that deal some 600 pages of agreements that effectively passed long term control of Rio Tinto to China.

They were too greedy and exploited a wounded Rio Tinto. By contrast China’s Valin group did a deal with Fortescue that didn’t carry the same morass of agreements and was therefore able to get quick approval from the Foreign Investment Review Board.

Given the Fortescue precedent, it is unlikely that Canberra will want to agree with the almost outrageous Chinalco terms and, following this week’s successful bond issue, it is clear Rio Tinto no longer has any need of Chinalco for its solvency.

In assessing strategic investment alternatives we need to put the Chinese actions into context.

These recent deals have to be put into context when assessing the impact on your investment portfolio of the new trend in China for putting reserves into hard assets – specifically commodities as an alternative to paper assets such as US dollars.

China has been able to buy hundreds of thousands of tonnes of cheap copper, effectively removing the big global stockpiles. Although China’s fundamental demand is picking up after the big slump, it is buying copper at a rate that is well ahead of likely demand.

Of course, as it became known in the market that the Chinese were stockpiling copper so the traders came in and pushed the price higher. I obviously don’t know the detail of the Chinese plan but I would still be stunned if it drove the copper price back up to the old levels.

China now has a substantial strategic resource base so it is able to move the market either way.

If the traders push the price too high, the Chinese can sell metal to bring it down again. However, we can now see that there is a base level of buying under the copper price that is substantially above its low point at the end of 2008, and that buying is not related to current global economic events.

Looking longer term, an enormous amount of the world’s infrastructure expenditure over the next five to 10 years will revolve around copper. We are going to re-engineer much of the world’s power generation to lower carbon emissions, and that will require copper. The communications revolution might have a strong optic-fibre content, but a large amount of the facilities will require copper. We are going to re-engineer our cars either via the hybrid movement or via electric cars and that will also involve large amounts of copper.

So China’s longer-term view is that now is the time to secure a substantial foothold in copper to ensure the country will not be exploited in the same way it was with oil, iron ore and other materials in the last boom.

At the heart of this China policy change is frustration with the US and a falling US dollar. Against this background there is new attention to alternative concepts of global currency. Among the most interesting of these is Bancor.

To understand the possible significance of what is happening and to prepare you for the investment strategies required, I want to go back to the remarks made last month by Zhou Xiaochuan, the governor of the People's Bank of China.

As a leading banking authority, Zhou is in charge of clearing up some $US865 billion bad loans in the Chinese banking system. Recently he has been under pressure from the finance ministers and central bankers of the G7 countries to revalue the Chinese currency, the Renminbi, and change its exchange rate-setting mechanism.

Although he has yet to reach the highest rungs of decision-making within the State Council, Zhou Xiaochuan has been called "China's most able technocrat".

On March 24, Zhou gave a speech entitled 'Reform the International Monetary System’, which covered many issues but in one segment he argued that it was regrettable that John Maynard Keynes’ "far-sighted" Bancor global currency proposal was not adopted at Bretton Woods in the 1940s The Bancor was to be anchored on 30 commodities – a broader base than the Gold Standard that had caused so much grief in the 1930s.

Zhou said such a currency would prevent the sort of "credit-based" excess that has brought the global finance to its knees.

I don’t think the world is anywhere near adopting Bancor at the moment, but as we look at our investment strategies ahead it is important to understand some of the fundamental long-term thinking taking place in China at the moment and China’s concern about the value of the US dollar. Obviously if you have a portfolio that has a large resource base, particularly in copper, then you are feeling good. If you are weak in resources you will be wondering what to do next.

But there is plenty of time to get things right: China’s policy is only slowly becoming clear. The advantage of copper is that it can be stored easily unlike, say, oil or iron ore. So long-term portfolios need to have a copper-oriented resource base but there are going to be big price fluctuations given the Chinese control over the market.

And so below I have brought together some research material that isolates some of the high copper content stocks.

nMetal stocks
Company	Code	% of gross revenue FY08		P/E	Price ($)	Mkt cap ($)
BHP Billiton	BHP	Copper	15.9	11.26	33.21	184.81 billion
		Aluminium	9.7
		Nickel	8.5
		Zinc	8.1
Rio Tinto	RIO	Copper	7.7	12.09	58.05	74.53 billion
		Aluminium	41.0
OZ Minerals	OZL	Copper	41.4	N/A	0.62	1.98 billion
		Zinc	43.8
Equinox Minerals	EQN	Copper	100.0	6.13	2.44	1.47 billion
Anvil Mining	AVM	Copper	100.0	N/A	1.41	100 million
PanAust	PNA	Copper	80.0	N/A	0.37	617 million

Source: Eureka Report

As China pours more money into copper and resources the Australian dollar will tend to rise, particularly against the US dollar. In the short to medium term the Chinese will be anxious to avoid any American crisis that will disturb the fragile global banking equilibrium.

Longer term they know that the massive printing machine that US President Barack Obama has switched on will reduce the value of the American dollar and the Chinese holdings of treasury bonds. The Chinese are effectively locked into the existing holdings but are able to use new money in different directions, subject to wanting to keep stability in the US.

Over time, the strengthening of the Australian dollar (which will come with the Chinese purchase of copper and other minerals) will make it much easier to fund Australian assets and some of the depressed asset positions that still have strong income will improve in price.

I must emphasise that we will need to follow this Chinese trend very closely because I suspect we are going to see some wild fluctuations as the Chinese play on both sides of the market. But longer-term portfolios need to be adjusted to have a resource content that recognises this fundamental shift in the game.

– With additional reporting by Supratim Adhikari.