The China effect

If global growth is going to slow down this year, which seems to be the consensus, then commodity prices too should start cooling off.

That logic seemed to be working last month, when commodity prices were headed downwards, thanks to concerns about the strength of the Chinese economy and worries that the government's move to slow it down was working.

A look at the BSE Metals index tells the story""the index has risen by a mere 0.8 per cent since the beginning of May, in contrast to a 15 per cent rise in the Sensex.

Reductions in local steel and aluminium prices have hurt sentiment towards the metal stocks. And it's not only in India that steel prices are under pressure""prices of hot-rolled coils in Europe, the US and China have plunged in recent months.

The reason for the fall is simple""there has been a massive ramp-up of production in China. The main reason for the rise in commodity prices in the last couple of years has been China's extraordinary appetite, thanks to huge amounts being spent on developing infrastructure in China.

What seems to have been underestimated, however, was the rapidity with which China would be able to increase metal production. Steel production, for instance, was at an annualised rate of 343 million tonnes in April, compared to 274 million tonnes in 2004.

This rapid rise in Chinese production, together with some amount of destocking, has led to a fall in steel prices. And what has happened in steel could very well happen in other metals as well.

There has been concern, for example, about overinvestment in aluminium, and analysts are pointing out that high copper prices have led to a spurt of investment in new smelters.

At the same time, raw materials needed by China to fuel its metals production, such as iron ore and coke, should continue to do well. In short, the impact of the rise of the Chinese economy is not merely that finished goods prices worldwide fall while commodity prices rise.

It's also increasingly becoming apparent that metals prices too could fall as Chinese production rises, and the only long-term gainers will be raw materials.

That is also the reason why crude oil prices have been unaffected by perceptions of a slowdown in China. The China story, of course, is completely unpredictable.

Recent data show that industrial production has rebounded, investment in fixed assets has grown and inflation is low, removing much of the incentive for the government to clamp down on overinvestment. In fact, analysts now expect steel prices to recover by the fourth quarter.

The other factor influencing commodity prices is the weight of money going into commodity funds. US mutual funds investing in commodities have grown to $10 billion from a mere $200 million three years ago.

Overall, funds invested in commodities amount to $50 billion, five times the level in 2000. With that kind of money chasing commodities, it's no wonder that volatility is so high.