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Just how worried should the commodity sector be about China?

On the surface the answer would appear to be very worried indeed, given the multitude of issues confronting the world’s second-largest economy, coupled with rising concerns about the rest of the world.

The 16 percent drop in the Shanghai Composite Index since the start of 2016 up to Wednesday’s close is the headline act in a wall of worry over the Chinese economy.

To equity weakness, add in concern about yuan devaluation, reform of state-owned enterprises, a slowing and less globally competitive industrial sector, the limitations of monetary policy easing and bad debts at regional and local government level.

The threat of the yuan dropping more than 10 percent to above 7 to the dollar and concern that there will be little progress in restructuring zombie state-owned companies in the mining, steel, aluminium and industrial sectors were the top two concerns among investors at the UBS Greater China Conference this week in Shanghai.

Put simply, the Chinese authorities are trying to deal with a range of simultaneous challenges, something that would probably be beyond the capability of most governments.

How successful Beijing is at taking on these challenges will probably determine whether China’s bad start to the new year is reversed by the end of 2016, or whether matters become more difficult as the year progresses.

None of this seems positive for commodity demand, even if China’s economy does expand by the 6.2 percent forecast by UBS at the conference.

A weaker yuan would make it more expensive for Chinese companies to import raw materials, although even the most pessimistic forecasts for yuan depreciation would not be enough to wipe out the positive impact of weaker commodity prices.

SOE Reform A Major Challange

It’s the reform of the state-owned enterprises (SOE) sector that holds the greatest risk for commodity imports.

While there may be changes to the giant state-controlled companies such as PetroChina, the real action is likely to be in smaller SOEs in such sectors as mining, steel and heavy industry.

It’s here where the inefficient excess capacity is concentrated, but shutting down or restructuring these companies has proved a bridge too far in the past, given the preference for local and regional authorities to keep loss-making enterprises operating in order to preserve jobs.

For excess capacity to be reduced, Beijing will have to support both the workers that will lose their jobs and the local and regional authorities that will be saddled with mounting bad debts.

If the central authorities are successful in carrying out SOE reform, the chances are that demand for commodity imports such as iron ore and coking coal will be reduced, given lower output of steel, cement, aluminium and other industrial products.

Iron ore imports rose a modest 2.2 percent in 2015 over the previous year, but that figure was boosted by a record 96.27 million tonnes in December.

The chances are that steel output in China will be lower this year, and even if domestic iron ore production does decline, it probably won’t be by so much that more imported iron ore will be needed.

Is there any chance of significant fiscal stimulus boosting demand for industrial metals and steel, especially given signals that Beijing is prepared to increase the budget deficit beyond 3 percent of gross domestic product?

It doesn’t appear to be the current thinking in Beijing that the economy needs a 2009-style spending boost, rather that enough will be done to prevent GDP growth from slipping much lower, with 6 percent the new line in the sand.

Fiscal policy will play more of a part, given the limited scope for monetary easing, Huang Yiping, a professor at Peking University’s National School of Development and a member of the monetary policy committee of the People’s Bank of China, told the UBS conference on Monday.

But he also said that “downward pressure on growth will continue for some time,” and that new industries will take time to emerge and take up the slack from heavy industries, which remain in massive oversupply.

This view would suggest that imports of iron ore, coal, copper and other industrial metals will struggle to post gains in 2016.

But, if you were trying to look for a silver lining, there is little to suggest that imports are likely to drop sharply, rather they are likely to post modest declines or remain largely steady.

Crude Imports To Remain Positive

So, are there any bright spots for commodity demand in China?

Crude oil imports have so far been largely immune to slower growth, although the nature of fuel consumption is likely to shift more toward gasoline and away from diesel, which is mainly used in industry.

There is also a question mark over how much more crude China will buy for commercial and strategic stockpiles, and the timing of such purchases, which will be reliant on when storage tanks

are completed. Certainly, the likelihood of oil prices remaining lower for longer has sapped any urgency to build inventories.

Crude oil imports reached a record 7.82 million barrels per day (bpd) in December, and were up 8.8 percent in 2015 to an average 6.71 million bpd, also a record high.

Strong gasoline demand and more storage flows may be constructive for rising crude imports in 2016, but the risk is that the growth rate this year may be lower than last year’s 8.8 percent.

Imports of both natural and synthetic rubber rose 15.3 percent in 2015, and assuming vehicle sales remain robust, rubber purchases may enjoy another strong year in 2016.

While it’s difficult to construct a compelling bullish case for China’s commodity demand for 2016, there is also a risk that market participants get unjustifiably bearish, expecting large declines that are unlikely to materialize.

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