LONDON (Dow Jones)--China's strong growth has been the anchor to a significant portion of the recent base metals price rally but the jury's out on how sustainable this is, metals market participants told Dow Jones Newswires Monday.
Data last week revealed China's GDP grew by an unexpectedly high 11.3% year-on-year in the second quarter. But this was swiftly followed by a hike in the required banking reserve requirement and revisions to the investment criteria for several industries including copper, steel and alumina.
Some analysts say the Chinese government's self-proclaimed intention to slow growth could create a hard landing for the economy that will in turn cause a sharp downturn in metals prices.
But other analysts argue that economists have been underestimating China's growth to such an extent that overinvestment remains necessary.
Certainly the exposure of base metals to Chinese growth is vast. According to analyst Robin Bhar of UBS, in 2005 China accounted for between 20% and 25% of global consumption for each of the copper, aluminum, zinc and nickel markets.
Although this exposes these markets to severe downside risk in the event of China performing "an emergency stop," Bhar said it is right that the government "must take prudent action" to prevent growth running away with itself.
"There's of course danger of the Chinese economy overheating and the government does need to take steps to bring growth to a sustainable level that will help retain strong metal demand," said Bhar.
"If the Chinese didn't do anything, I'd be worried they were creating a runaway economy and that they would eventually react too little too late," he added.
Similarities exist between the current Chinese attempts to slow growth and those seen in early 2004, when the rapid pace of industrial production and fixed asset investment growth resulted in a series of government tightening measures, analysts said.
These measures included monetary policy tightening, a reduction in export tax rebates and direct administrative measures to reduce the pace of growth in overheated sectors.
With a rotation in economic activity from the U.S. to Japan and Europe, and a continued robust pace of growth in China, Gutman said he expects economic activity to likely remain supportive of base metals demand.
"As with the 2004 experience, we expect Chinese metals demand to remain relatively robust," said analyst James Gutman at Goldman Sachs. "Domestic demand continues to be driven by rising incomes and infrastructure growth, and our economists do not expect policy measures in China to do more than moderate domestic demand growth," he added.
But growth rates suggest there's still a long way to go and that the Chinese government will have to be more draconian in future, analysts said.
"The concern is not that China is touching the brakes, but that the attempts to apply the brakes have done nothing," said Societe Generale analyst Stephen Briggs.
Briggs noted that factories in China are not only planning to hike capacity, but there's already an unsold surplus. "Industrial growth is so exuberant that it's out of line with underlying demand," Briggs added.
And with the possibility that Chinese demand for base metals is cut, the impact on prices would be significant.
"Without China, world lead demand is lower than it was in 2000. Chinese exports of lead batteries alone account for 5% of world demand," Briggs said. "The market continues to underestimate this factor," he added.
Yet Macquarie Bank analyst Jim Lennon said that as China's massive trade surplus continues to create very strong growth, sustainable metals demand growth is being underestimated.
"There's a perceived risk that overinvestment leads to over capacity but the reality is that economists have under-forecast China for the last five years - so if the country is now over-investing, this is a good thing," he said.
"Underlying demand remains very strong and there are the not the same degree of bottlenecks as were seen in 2004, when demand growth slowed," he added.
But analysts said despite more double digit growth in the Chinese economy, base metals demand will be a lot lower. Industry consultant Simon Hunt estimates that Chinese copper demand will only grow by 3-5% this year.
He cited increasing substitution of copper for other materials as one reason for slowing consumption, as well as increased refined output, lower imports and domestic destocking.
"Exports will slow considerably from China and the government is driving trade tariffs to encourage the production of value-added downstream products. This will contribute to a slowing economy," he said.
Looking ahead, analysts believe there could be some tough times this year as new controlling measures kick in, however.
"The effects of the current tightening together with likely future policy announcements could keep both markets and real fundamentals weak over the next few months," said Jonathan Anderson, UBS's Hong Kong-based chief economist, Asia.
"And with a rising trade surplus, the risk of specific measures aimed at dampening heavy industrial exports is also increasing. So while we do expect a more visible recovery by end-year, there's still some water to come under the bridge before then," he added.
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