A Double Hit for Chinese Steel Makers Brings Pressure to the Baltic Dry Index
Over the past thirty days, the Baltic Dry Index (BDI) has shed over 40% of its value, and has many now questioning if the move in this leading indicator is a forewarning of what is to come in the global economy. To answer this, one has to look at what has been driving the index lower during the month, and take it in context of broader cyclical moves and the relatively high levels of volatility and speculation.
Although some of the weakness undoubtedly comes as the broader global economy is slowing down, I believe the reasoning behind the majority of the move can be summed up in one word: China. During the past thirty days, China has given its national steel makers a double hit on the exports front, firstly announcing it will be removing current subsidies on steel exports, and secondly, a more recent move to decouple the Yuan from the US dollar. The raw materials needed for steel (such as iron ore and coking coal) make up a large weight in the BDI, and the knock on effect of contracting steel exports in China, ripples down the entire shipping chain.
The first move on China’s part was the announced reduction in its subsidies to domestic steel producers, specifically, removing steel export rebates which had been hiked in July last year. The Chinese Ministry of Finance announced that starting July 16 this year, steel export rebates will be removed from hot rolled coil exports as well as some cold rolled coil and galvanized product exports (rebate for hot rolled coils is currently 9%, for cold rolled coils it is currently 13%).
Market estimates are that the removal of the rebate from hot rolled coil for example, will add around $50 per ton to the current price of around $600/t, and in doing so, reducing Chinese steel makers’ competitiveness in the global market. Although these rebates are still in place, Chinese steel makers are already slowing down their raw material intake in preparation for the anticipated softening in downstream demand. It is worth noting that this contraction in demand also comes amid a general slow down in demand for steel products, with China already implementing some constriction measures on the property market (a key user of steel) earlier this year.
As previously highlighted, dry shipping of the raw materials needed for steel production, such as iron ore and coking coal, are heavily weighted in the Baltic Dry Index (also know as the Dry Bulk Index), and have been responsible for the majority of its declines over the past month or so.
We can evaluate this specifically, because the index is in fact a composite of three sub-indexes that measure different sizes of dry bulk carriers; Capesize, Supramax and Panamax (simply speaking, ‘large’, ‘medium’ and ‘small’ size carriers respectively).
During this recent sell off in the index, the cost of the largest class of vessel, Capesize, which is mainly used to transport iron ore to China, has seen a faster pace of decline than that of the smaller Panamax vessels, which are used mainly for the transport of other commodities such as grains. Again, although a certain lag time is in the nature of shipping raw materials and downstream demand moves, and here undoubtedly a broader contraction in Chinese steel demand has been leading to a contraction in raw material shipping for some months now, the more recent removal of the rebate will likely exacerbate the fall, and as such markets are already factoring in these declines, which is translating to a more immediate move for the BDI.
The second move by China, and one which is seeing many more headlines, is the recent announcement from Peoples Bank of China, that it will be allowing the Yuan (also know as the renminbi) to trade more freely within the previously defined 0.5% band surrounding the currency’s daily peg to the US Dollar. This is the first step from the Peoples Republic towards a much anticipated free floatation of their currency. Although current moves in the Yuan-Dollar rate are expected to have little immediate impact on exports, again it is speculation in the forex markets and some attempts by Chinese producers (steel producers particularly relevant to BDI) to pre-empt the coming fall in exports from China, that is helping to push the fall in the BDI. In effect, many steel producers and market speculators are at least partially pricing in, to one extent or another, a free floating Yuan.
A simple evaluation can show us the impact this is having on the Baltic Dry Index. Although the full impact on the Yuan if it does indeed become free floating, is well beyond the scope of this article, it is general consensus that the currency will strengthen against the dollar when China does not actively depreciate it. This is mainly due to trade imbalances between the two countries, and also more recently on the back of an influx of dollars into China amid both foreign investment, and as the government continues to maintain strong dollar reserves.
As a basic economics lesson would tell you, if a currency appreciates, imports into that country become comparatively cheaper, while at the same time exports from the country become comparatively more expensive for the rest of the world. Naturally, this will lead to a fall in exports from the country and a rise in imports (certis paribus).
China is a powerhouse when it comes to the commodity markets, both in terms of global production and global demand. In recent years, its massive consumption of raw materials has sky rocketed on the back of the double digit economic growth it has been undergoing. At the same time, its massive commodity production capacity has been fuelling global supply of raw materials and resources. Never is this more so the case than with steel, of which China is the largest steel producer in the world.
As discussed previously, any strengthening of the Yuan against global currencies will make Chinese exports, in this case steel, less competitive in the global market and therefore reduce global demand for Chinese goods. This fall in steel exports will, in a similar vein to the removal of the subsidies, filter through the supply chain and end in less raw materials being required on the back of lower downstream demand. As with the removal of the rebate for steel exports, this will lead to a reduction in demand for those materials, such as iron ore and coking coal, which are needed in for steel production, reducing the shipping of these goods to China.
This again brings us to the moves in the Baltic Dry Index. The direct impact of the currency change will take some time to come through, not just because of the normal lag between end demand and raw material requirements, but in this case also because as of yet, appreciation in the renminbi is still limited, and actively managed by the Chinese government. That said however, the BDI has been feeling the effects of the move as speculation and players in the steel market, already take account of the potential future moves in the currency and begin to price in a stronger Yuan. Once again we see the potential impact of a move, itself leading direction a long time before a direct impact comes through.
As a final thought, it is worth noting that the speculation driven pressure on the back of the subsidy removal and currency move, may yet prove to be unfounded, or at least overplayed. It is almost impossible to accurately measure the impact on Chinese steel exports these measures will have, and as time goes on it is likely that the current effect they are having on Chinese demand for raw steel making materials (and therefore the BDI) will reach more of an equilibrium. It is also important to take the current move in context of what is a normal seasonal lull in shipping, such as slowing industrial activity going into the summer and the Indian monsoon season impacting demand for shipments.
Whether the index is truly forecasting an economic slow down is yet to be seen. One thing is for certain however, the impact of China on this key measurement of commodity supply and demand is strong, and any reduced demand for raw material shipments into the Asian giant will hit the index hard.
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