Copper, Iron Ore Shaky on China Worries

High exposure to the European market may be a negative for China's exports and lead to excess supply in the domestic market and a decline in copper and iron ore prices.
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Even as China continues to drive the momentum, we reckon there are a few sectors that investors should play with caution.

China recorded gross domestic product growth of 11.9% for the quarter ended in March, the highest quarterly growth since March 2007. This represents a 1.2 percentage point increase over December 2009.

On the other hand, industrial value-added output, the main indicator of manufacturing activity, slowed down to 17.8% in April from 18.1% the previous month. The Purchasing Managers Index, an important economic indicator of China's manufacturing sector, increased slightly to 55.7% from 55.1% over this period.

Exports grew from $112.11 billion in March to $119.92 billion in April, whereas imports fell from $119.35 billion to $118.24 billion. As a result, the latest balance of trade indicated a surplus of $1.68 billion as opposed to a deficit of $7.24 billion in March.

Even though the Consumer Price Index fell to 2.4% in March from 2.7% in February, it remains at around 15-month highs. In order to keep a tab on this, coupled with concerns over a real estate bubble, the Chinese central bank raised the reserve minimum for commercial banks to 17% on May 10. The move is expected to sap 300 billion renminbi from the market. Moreover, the central bank has also issued RMB110 billion three-year bonds and RMB14 billion short-term three-month bonds in order to restrain credit.

These moves are bound to impact China's imports, particularly in the case of metals such as copper and iron ore, for which the country has emerged as the world's largest consumer. China's consumption of other metals such as aluminum, lead, zinc, and ickel stands at 0.6%, 0.2%, 1.5%, and 13% of the global total, respectively.

Satistics released by China's General Administration of Customs finds the country's refined copper imports jumped 53% during March to 337,125 tonnes from 220,520 tonnes in February. While China accounts for 16% of global consumption, speculators believe that some of these imports are on their way to warehouses and not really to production units. This is also reflected in copper stockpiles at the Shanghai Futures Exchange as they rose 165% this year alone.

Iron ore imports during March increased 20% month over month to 59 million tonnes from 49.4 million tonnes. China is the largest producer and consumer of iron ore, accounting for approximately 54% and 40% of the global demand and supply, respectively.

The ongoing crisis in Europe and the weakness in the euro are likely to adversely impact China's exports to the European Union. The EU is China's largest trading partner, accounting for 16% of the country's total trade, according to the GAC. Bilateral trade between China and EU increased 35% year over year to $137.77 billion during fiscal 2009.

"The yuan has risen about 14.5% against the euro during the past four months, which will increase cost pressure for Chinese exporters and also have a negative impact on China's exports to European countries," said China's commerce ministry spokesman Yao Jian.

We reckon that the high exposure to the European market may be negative for China's exports and lead to excess supply in the domestic market and, in turn, a decline in copper and iron ore prices.