China's New Normal: Less Stimulus for Commodity Producers

What China's new normal of slower growth means for commodity prices in the near term.

May 17, 2014 at 1:14PM

Many economists believe that growth rates are revert to the mean in the long run. This is because it becomes harder to grow as one becomes larger.

For over three decades, China managed to grow significantly faster than the mean growth rate. In good times, the nation's economy grew by double digits. In bad times, China grew by 7%. 

As a result of great growth rates, China's economy grew from $2 trillion a decade ago to $8 trillion today.  

Many commodity producers like Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BBL), and Freeport-McMoRan Copper & Gold (NYSE:FCX) benefited enormously from China's growth. Because China needed commodities to build infrastructure, the Chinese economy consumed nearly half of the world's total commodity production. That enormous demand swelled the bottom lines of many of the world's leading commodity companies and led to a commodity rally from 2002 to 2007. 

Many commodity investors were hoping that China could continue to grow like it did a decade ago. Their hope is now less probable than before. China's president, Xi Jinping, recently said that China needed to adjust to the new normal of slower growth in its future.    

New normal for China
The old normal for China was for the economy to grow faster than 7% on an annualized basis. The 7% growth rate was basically the lower bound for full employment for China's economy. If China's economy grew less than 7%, rising unemployment could potentially have led to instability.

Due to the global financial crisis, China's government instituted a massive credit expansion and fiscal stimulus program in late 2008 to help its economy grow faster than 7%. The resulting stimulus led to a significant increase in commodity demand and a rise in commodity producer share prices. Five years later, however, that stimulus has worn off and China has to contend with the downsides of injecting so much credit into its economy as bad loans come due.

China now has two choices: it can kick the proverbial can down the road by doing another round of fiscal and monetary stimulus or it can aim for a soft landing. With President Xi Jingping's new normal remarks, it seems that China wants to do the latter. China's economy may still grow faster than 7% in the near future, but the central government will no longer do whatever it takes to hit that figure. This means the chance for another meaningful stimulus is now significantly lower.

With no additional Chinese stimulus on the horizon, it's hard to see commodity prices rising significantly over the next couple of years.

The bottom line
It's not all bad news. The market has already discounted slower Chinese growth. In fact, share prices of BHP Billiton, Rio Tinto and Freeport-McMoRan Copper & Gold all rallied higher after President Xi Jingping made his new normal remarks. 

Even though commodity prices may be sluggish in the near future, leading commodity producers are still in good position. Rio Tinto and BHP Billiton are both diversified, low-cost producers that remain profitable even in slow times. The two companies are both cutting costs and using their operating cash flow to raise dividends. The rising dividends should support their share prices even if commodity prices remain range-bound. 

China's new normal means that a 2002-2007 type rally in commodity prices is less likely. Due to their low production costs and efficient capital allocation, however, leading commodity producers can still do well in the long run.

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Jay Yao has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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