Why does China care so much about iron ore prices: Implications for global base metal players and inflation

China’s economic recovery has proven to be a boom for base metal producers over the past year. For example, since last summer, the unit value of China’s imported iron ore and copper have been increasing significantly. Such a price response is, at least partly, justified by a strong demand stemming from China’s economic rebound. However, Chinese authorities, including the National Development and Reform Commission, have resorted to new regulatory measures to control commodity prices, stirring up a storm in the market.

Why did such a commodity price movement encounter such strong response from the Chinese government? Chart 1 gives us a sense of what is happening in China. The movement of the iron ore and copper price are shown to be positively associated with the sharp rise in China’s upstream industrial producer prices. But at the same time, Chart 2 also shows that the downstream producer prices and the consumer price index have only experienced a moderate increase so far. The latter is clearly related to the weak recovery in Chinese household’s propensity to consume which is still below pre-pandemic levels (see our activity gauge for Q1 2021). Against such backdrop, China’s manufacturers, especially those relying on base metal goods, start feeling the pain of the surge in input prices while final demand is not yet fully there.

There are two possible outcomes to this. First, if the upstream price is finally passed through to the downstream sectors such as the electronic manufacturers, there will be inflation. This means that the price competitiveness of these producers will be affected, and the purchasing power of households further reduced. Furthermore, the PBoC will also be restricted if it suddenly needs to hike rates to respond to rising inflation.

A second scenario is that upstream prices are not passed through to the downstream sectors. This means that the current downstream-upstream price gap is expected to further narrow, eroding the downstream manufacturer’s profitability and weakening its ability to invest. Such an environment will not only hamper China’s growth recovery but also increase financial risks for the industrial companies, especially if we take into consideration of the debt surge over the last year.

Neither of the two possible outcomes is desirable for China’s policy makers. More importantly, China relies heavily on imports of base metals, which means the sharp increase in commodity price yields little benefit for domestic manufacturing producers.

All in all, China wants to make sure that the cyclical economic recovery for 2021 is well in place and that no inflationary pressure will be added to the problems faced by policy makers. This is the underlying reason for China’s reaction to the commodity price surge. But beyond the short-term consideration, China has already slowed its pace for old-fashioned infrastructure investment with an aim to take on more new-style infrastructure like 5G and AI. The latter is going to further reduce China’s reliance on imports of commodities, especially iron ore and less so copper.