Morgan Stanley: Caution! Price drop ahead

Morgan Stanley Asia chief presages a commodity knock

Andy Xie, managing director at Morgan Stanley Dean Witter Asia Ltd, says that commodity prices will drop sharply next year.

He points out that while the Chinese authorities had curbed credit earlier this year, local governments have been pushing for growth, and loan growth has been strong since September. This, says Xie, is what is responsible for the current rise in commodity prices.

Xie believes that this rise is temporary, because the Chinese government is likely to raise interest rates again next year. At the same time, rising interest rates in the US should slow consumption growth there, leading to lower exports from China.

This slowing of investment and export growth will cool the Chinese economy, and there'll be a big drop in commodity prices. Although commodity producers like Australia and South Africa will be hit the most, India too will feel the heat because it too is exposed to commodity prices.

But won't the slowdown be a blip rather than a steep dive? Xie thinks not, pointing out that Chinese energy consumption has been growing at 16 per cent per annum, double the historical rate of 8 per cent.

He expects energy consumption to revert to its historical rate, and the Commodities Research Bureau (CRB) index is closely correlated to Chinese electricity consumption.

What's more, Chinese growth has been pretty cyclical, with sharp rises and falls "" in earlier cycles, growth in electricity consumption has slowed to below 5 per cent, and the CRB index has followed.

Keep a sharp eye out for inventory build-ups in China, because Xie says that's what happens initially to commodities, before prices drop. What are the turning points to watch out for?

One, rising Chinese interest rates; two, the supply of property in China overwhelms demand and the Chinese property bubble bursts; three, US consumption slows down; and finally, a change in sentiment which leads to speculative capital withdrawing from China.

Till that happens, however, will foreign inflows into emerging markets continue? Xie points out that interest in India among fund managers has never been stronger, and the government should seize the moment to create an "investment machine" to fund infrastructure.

In China, local governments formed investment companies and listed them on the stock market to fund infrastructure. India could do the same. "Over investment", points out Xie, "is far better than underinvestment", because even when the bubble bursts, the country is left with the physical infrastructure.

Foreign inflows will continue, says Xie, till US interest rates exceed inflation, which could happen sometime in the middle of next year, and when the US authorities stop trying to talk down the value of the dollar.

Depreciating the dollar is a dangerous policy because the US is acting like a small emerging market economy. Instead, a lower dollar will hurt Japan and Europe, which in turn will lead to lower imports by these regions, impacting US growth.

Despite a 20 per cent depreciation of the dollar in the last two years, US exports have not picked up. The US's soft dollar policy, therefore, says Xie, is very dangerous. Rather, the remedy for the US should be to raise interest rates and taxes.

Hindustan Lever

Hindustan Lever has sought shareholder approval to hive-off one its soap manufacturing facilities and its functionalised biopolymers business. The biopolymers business is what's left of the company's speciality chemicals business, and its hive-off is in line with HLL's strategy to dispose non-core businesses.

But what's intriguing is the plans with the soap manufacturing facility, which is part of the company's core operations. HLL's soap manufacturing facility at Sewri, Mumbai has significant cost disadvantages, and according to the company "its unviability is further aggravated by unproductive and antiquated labour practices... and high wage rates payable to workmen."

The proposed transfer will make the unit transparent in terms of costs and productivity and will enable a fair comparison of the unit as a sourcing location with other available alternatives.

But given the plethora of problems at the Sewri plant - incidence of octroi on all raw materials, high incidence of rates/taxes for water and power, higher lease rentals, high power tariffs and other infrastructure costs - it doesn't seem very likely that it would stand up against alternative sources of production even if it is run as a subsidiary.

One alternate source is HLL's upcoming soaps and detergents facility at Himachal Pradesh, whose fiscal benefits alone would make production there much more viable. According to HLL, however, there is no plan to shift production to the new plant, which will service only incremental demand.

Incidentally, fiscal benefits at the new plant is available only for incremental production. In other words, if production is merely shifted from an existing plant (run by HLL) to the new plant, the fiscal benefits won't be available.

According to analysts, if the Sewri plant gets transferred to a subsidiary, it will no longer remain an HLL plant and hence the production at the new plant would qualify for tax breaks even for the extent of the existing production at Sewri (approximately 20,000 tonne).

With contributions from Mobis Philipose