China still hungry for zinc?

China remained a net importer of refined zinc in August, while imports of zinc concentrates also continued to run at a robust pace. Both phenomena are underpinned by the London-Shanghai arbitrage, which has been import-friendly since just about the start of the year.

However, the continued flow of metal and concentrates into China may be a harbinger of future problems for both the domestic and international zinc markets.

REFINED ZINC Imports of refined zinc (not including zinc alloy) were 25,590 tonnes in August, compared with just 5,900 tonnes in August 2007. Cumulative imports of refined zinc surged by 36.9 percent to 125,499 tonnes in the first eight months of this year. With exports simultaneously plummeting by 78.4 percent to 50,952 tonnes over the same timeframe, China has flipped rom

heavy net exporter to net importer for the first time since mid-2006. Net imports so far this year have totalled 74,547 tonnes, with 46,880 tonnes of that occurring in the two most recent reported months, July and August.

But does China really need this metal to fill a domestic production-consumption shortfall? The answer seems to be no. Visible stocks in the form of inventory held by the Shanghai Futures Exchange (SHFE) are high and largely static at 71,214 tonnes as of last Friday's warehouse report. Off-market stocks are said to be even higher and also largely static. Prices in China have fallen by over 25 percent this year and are currently stuck either side of the 14,000 yuan per tonne

level. Indeed, the domestic market has been so weak that a grouping of small producers announced in July a collective production cutback in an effort to support prices. Such conditions hardly seem supportive of rising net imports, but this is exactly what is happening. The driver appears to be not physical metal shortage in China but the fact that SHFE prices have still not fallen as far as LME prices. This has kept the arbitrage open for imports since the start of this year, creating a dollar-denominated financing

opportunity for merchants seeking to circumvent tight yuan-denominated lending conditions within China.

CONCENTRATES

While imports of refined zinc are rising, so too are imports of zinc concentrate. At 195,838 tonnes August imports of concentrates were down by 6.1 percent year-on-year but the underlying trend remains upwards.

Cumulative imports of the raw material rose by 11.9 percent year-on-year to 1.42 million tonnes in the first eight months of 2008. (Note, by the way, that these figures are for bulk-weight concentrate, not metal contained.) This uptrend is being extended from an already high base. Imports of concentrate rocketed by 159.7 percent in 2007 as Chinese smelters feasted on global market surplus after a period of highly constrained mine production growth. At first sight rising raw material imports also look incongruous at a time of smelter cutbacks and market weakness. China's annualised production of refined zinc peaked at 4.5 million tonnes in June, since when it has fallen back sharply to 3.9 million tonnes in both July and August. The country's mined zinc production has been experiencing accelerating growth this year with cumulative output up by 17.6 percent in the first eight months of 2008.

Why then does China need growing amounts of concentrate? The answer seems to be to feed an imminent refined metal production growth spurt. The country's top zinc producers declined to join their smaller counterparts in cutting back production and several are now bringing on stream major expansion projects. In August alone three producers, Zhuzhou, Yuguang Gold and Dongling Group, activated a combined 280,000 tonnes per year of new capacity. These facilities will ramp up steadily over the end of this year.

BEARISH AND BULLISH

This new capacity is only going to add to the existing oversupply in the country, which is already being exacerbated by rising metal imports. This has bearish implications for domestic prices in the short term. It also has bearish implications for the international market because if domestic market surplus keeps building, there will be increasing pressure for it to burst the dam walls and flood into the international market-place. This has happened before, between November 2006 and March 2007, when 280,000 tonnes of refined zinc were exported. All it takes is a switch in the London-Shanghai arbitrage in favour of zinc exports. Over a longer-term horizon, though, this curious Chinese dynamic may turn out to be bullish. The country's producers are bringing on new smelter capacity just as the international concentrates market is re-tightening. The list of mine closures and cutbacks in response to low prices is lengthening all the time and the consensus is that more will come.

Chinese treatment and refining charges are already starting to slide in response and concentrates availability may become a major constraint on Chinese smelters from next year onwards. Depending on the evolution of the current Chinese zinc dynamics, it is just possible that the country is going to need that refined metal surplus after allif it hasn't already left, of course.