SMM: although alternative indicators, including electricity generation, purchasing managers' index (PMI) survey and consumer sentiment, can better reflect China's economic cycle, commodity prices may be the best real-time indicator of China's economic growth.
Iron ore is China's second-largest import after oil. We have found that iron ore has been a timely and often leading indicator of China's economic growth since 2012. The indicator provides additional insights that other markets cannot provide.
Therefore, in order to track China's economic growth in real time, iron ore prices should be combined with other market indicators such as copper, oil and Baltic dry bulk.
Investors and policy makers are increasingly concerned about China's growth.
Since the global financial crisis in 2008, China's economy has achieved substantial growth. On a purchasing power parity basis, China has overtaken the United States to become the world's largest economy. China's economy is also much larger than the second-largest economies such as India, Japan and Germany. Therefore, in determining the direction of the global market, in addition to the growth of the United States, investors and policymakers are increasingly concerned about the growth of China. The Fed now regularly incorporates China's development into its policy-making process, mentioning China more often than any other country at its FOMC meetings.
Indicators that reflect China's economic growth
This inevitably raises the question of what kind of growth to track and predict: whether to use the officially reported GDP, or look for other raw measures of growth? Many people are trying to find measures that reflect China's economic growth. China also reportedly tends to focus on indicators such as rail freight volume, electricity consumption and bank loans, rather than GDP. In addition, there are other methods, such as the use of nominal GDP, which is more volatile than the actual GDP, the wider use of Chinese growth data, the use of export data from other countries to China, and even alternative data such as satellite data.
In this article, we choose three alternative metrics:
Nominal GDP. Unlike the actual GDP, the nominal GDP can show greater volatility. This means that the adjustment to the price deflator may be the reason for the unusually smooth performance of the actual GDP.
The Fed's China cyclical activity tracking indicator (C-CAT). The recently developed index covers eight indicators (Fernald et al., 2019), each of which is published monthly, including consumer expectations, electricity generation, China's exports, floor space, rail freight, retail sales, industrial production and fixed asset investment.
China's import data derived from export data from other countries. We have high confidence in the data of other countries, so we can calculate the exports of these countries to the mainland of China and Hong Kong. The data will reflect China's imports and will be used to measure China's demand.
Take the price of iron ore as an indicator
Although these three indicators are good, we can go further and capture the development cycle of China's economy in a more timely manner. To do this, we can use commodity and financial market prices instead of monthly or quarterly data. Given that China is one of the world's largest commodity importers, changes in commodity prices are clearly a candidate indicator of Chinese demand.
In terms of the composition of Chinese imports, integrated circuits have the largest share, followed by oil, iron ore and copper. For a long time, the price of oil and copper has been widely concerned and often used to track China's economic growth, but the price of iron ore has not been well studied. This is partly due to the poor quality of the data up to 2008 due to the failure of its benchmark pricing system and iron ore swaps that began in 2009, and partly because old habits are harder to change. The good news is that iron ore futures are more liquid and reflect changes in demand than before.
What is the relationship between iron ore and China's economic growth?
We use GM's 2nd month SIMEX iron ore 62% iron powder contract as our preferred iron ore price index. When we compare the annual changes in iron ore prices with our three indicators of China's economic growth, we find that there is a strong correlation between them. The relationship was particularly close from 2009 to 2018. However, despite the slowdown in China's economic growth last year, iron ore prices rose in the first half of last year. Part of the reason may be that China produces ahead of time or builds inventories and needs iron ore to offset the downturn caused by the imposition of tariffs on US trade with China.
But it may also suggest that iron ore may be able to measure growth that cannot be captured by three main measures. Of course, the Chinese stock market is thought to be improving, with the A50 index rising 40% in the first half of 2019. Other economic time series also rose in the first half of 2019, particularly non-manufacturing and consumer expectations in China.
What is the relationship between other market prices and China's economic growth?
Apart from iron ore, the commodity markets most closely related to China are oil, copper and the Baltic dry bulk index. China is the largest importer of oil and copper, so they are highly related to China's economic growth, while Baltic dry bulk shipping reflects China's dominance in trade and shipping. The other two candidate market prices are the yield on Chinese 10-year government bonds and the Chinese stock market. Similarly, we look at the annual changes of the two separately and use the futures prices of the new exchange where applicable.
Overall, all of these indicators seem to be related to China's economic growth indicators to varying degrees. The comparison between these indicators and the C-Cat index is shown in the following figure. Bond yields, oil and copper seem to capture most of the ups and downs, while the correlation between Chinese equities and Baltic bulk and the C-Cat index is not stable.
In order to clarify the relationship between these market prices and economic growth, we can carry out correlation analysis. We use the C-CAT index, the Fed's measure of China's economic growth, to compare and focus on three time periods that capture different cycles. The results show that the correlation between stock market and economic growth is very low and often negative, so it is unlikely to be a reliable indicator of China's economic growth. All other indicators, including iron ore, show a strong correlation with growth. Except for the stock market, all correlations are statistically significant.
We can also evaluate the antecedent nature of market prices by comparing the data that lag one or two quarters. This approach can show whether they can predict China's economic growth in three or six months' time. We found that if we lag by one quarter, iron ore, copper and oil will continue to be highly correlated from at least 2012. If there is a lag of two quarters, the correlation of iron ore is the highest and the most stable. This suggests that iron ore may have important foresight that other markets cannot capture.
The C-CAT index is calculated on a quarterly basis, but we can also look at monthly data. After looking at the electricity consumption data, we find once again that there is a positive correlation in most market prices. The Chinese stock market is still an exception. Oil shows the strongest correlation, but there is also a strong correlation between iron ore and copper.
In order to understand its leading attribute, we calculate the correlation by lagging behind the market price by six months. We find that there is still a positive correlation in most market prices, but the range is declining. The only exception is iron ore, which has shown greater relevance since 2012. This confirms that iron ore has the characteristics of some leading indicators.
What do these measures tell us now?
Judging from the annual changes in iron ore prices on the SGX, they have been low and sideways in the past few months. However, judging from the changes in the three-month period that can capture the dynamics of short-term growth, we will find a significant rise in prices. This shows that the growth situation has been improving in the context of the global novel coronavirus epidemic blockade measures, at least since April.
We can combine the five best growth indicators of iron ore, government bond yields, copper, oil and Baltic dry bulk to produce a China tracking indicator. Here, we find a similar situation, that is, the rising trend of prices is similar to that of China's economic growth. Part of the reason for this rise is the sharp rise in oil prices. In other words, the level of this short-term tracking indicator has risen, and there may be room for a pullback.
If we compare iron ore prices with this overall growth tracking indicator (3-month change version), we find that iron ore prices rise with this overall tracking indicator. Importantly, at the beginning of the novel coronavirus epidemic, the iron ore market fell by less than the overall indicator, suggesting that it was more optimistic about growth, which turned out to be correct.
Iron ore prices have been rising since July, while China's overall tracking indicators have been sideways. This could mean that iron ore earnings are limited, or that the iron ore market is more optimistic about China's economic growth than the overall tracking indicator. In any case, using iron ore as one of the indicators will broaden our understanding of China's growth direction, and combining iron ore with other China-centric indicators can provide a real-time growth tracking indicator.
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