On the Use of International Commodity Futures Spread for Forecasting China's Net Imports of Commodities

• Author: Tao Chen,Isabel Kit‐Ming Yan,Liang Wu
• Date: 01 July 2013
• Published date: 01 July 2013
• DOI: http://doi.org/10.1111/twec.12073

On the Use of International Commodity

Futures Spread for Forecasting China’s

Net Imports of Commodities

Tao Chen

1

, Liang Wu

2

and Isabel Kit-Ming Yan

2

1

Lee Shau Kee School of Business & Administration, Open University of Hong Kong, Hong Kong and

2

Department of Economics and Finance, City University of Hong Kong, Hong Kong

1. INTRODUCTION

THERE is a long strand of academic literature on the identification of business cycle

indicators, which can be broadly classified into the leading, lagging and coincident

indicators. Generally speaking, they are associated with the future, past and concurrent

economic activities, respectively.

1

Nevertheless, even though the leading indicators are

supposed to be predictive of the future economic activities, these economic indicators are

often released with a substantial time lag and thus become less useful in forecasting future

economic conditions. This is evident from the fact that the NBER’s Business Cycle Dating

Committee can only identify business cycle turning points at least 5 months after the facts.

Such delays and subsequent revisions are problematic for policymakers and investors who

need to formulate timely and appropriate strategies. For China, this concern is more

pronounced as the accuracy of some published data (e.g. GDP, inflation, housing prices) is

often a subject of hot debate.

2

In this paper, we analyse the metal commodity (copper and aluminium) futures spread

between the London Metal Exchange (LME) and the Shanghai Futures Exchange (SHFE)

during 2001–12 and develop a forecasting model based on these spreads. Such a research

question comes from the observation that, in China, many state-owned trading firms that have

abundant commodities in stock, free cash flow and privileges from state-owned banks

3

continuously conduct commodity arbitrage when they spot futures price differential between

these two markets. We find that the copper and aluminium futures spread between LME and

SHFE have strong predictive power of the corresponding commodities’ net import in China

2 months later. Our proposed model beats the popular autoregressive integrated moving aver-

age (ARIMA), which just relies on the past dynamics of net imports. Given that copper and

aluminium are crucial for the manufacturing and construction sectors that are important

sectors for China’s economic growth, an accurate prediction of the net imports of these metals

serves as a useful indicator of China’s future economic activities.

1

A comprehensive review of the leading, lagging and coincident indicators can be found in Stock and

Watson (1993).

2

See, for example, Rawski and Xiao (2001) and Young (2003).

3

Since local copper and aluminium makers are almost all government-related entities in China, they

have close ties with local state-owned banks. As a result, they are able to obtain bank credits easily. The

recent bailouts of Jiangxi LDK International Trade Co. Ltd. and Shandong Helon Co. Ltd. provide fur-

ther evidence on how the local governments tend to give financial support to these companies when they

have financial difficulties.

©2013 John Wiley & Sons Ltd 861

The World Economy (2013)

doi: 10.1111/twec.12073

The World Economy

Existing studies on commodity futures can be divided into two strands. The first one exam -

ines the linkage between futures price and spot price. The other investigates the information

transmission mechanism across different markets, which is more closely related to the

objective of our paper. For instance, Tse et al. (1996) analyse the information transmission

mechanism across Eurodollar futures markets. Booth et al. (1998) study the relationship

between US and Canadian wheat futures. Similarly, Ge et al. (2010) examine the association

between the cotton futures in China and those in United States, whilst Fung et al. (2010) con-

centrate on the copper and aluminium futures markets and test the information transmission

between China and United States.

Our paper has a slightly different focus. It aims at investigating whether futures spre ad

contains useful information to predict China’s commodity net import, which in turn is closely

linked with the economic condition in the subsequent quarters. Compared with the previous

literature, our empirical evidence that commodity futures spread Granger causes the corre-

sponding commodity net import in China confirms that futures spread indeed contains valu-

able information. Moreover, our finding that supports the presence of commodity arbitrage

amongst Chinese trading firms is also suggestive of inefficiency in the commodity futures

market.

The rest of this paper is organised as follows. Section 2 reviews the role of commodities

and commodity futures in China’s economy. Section 3 develops our empirical model for pre-

dicting the net imports of copper and aluminium using their respective futures spread. Section

4 discusses the out-of-sample performance of our forecasting strategy. Section 5 provides a

robustness check and Section 6 concludes.

2. METAL COMMODITIES, COMMODITY FUTURES AND THE CHINESE ECONOMY

In the last two decades, the Chinese economy was featured with sustainable returns on cap-

ital investment and extensive reallocation within the manufacturing sector. According to 2009

annual industry report published by the China Economic Information Network,

4

the business

condition of the non-ferrous metal sector has become a leading indicator of the Chinese econ-

omy. A close look at this sector is thus vital to understanding the current and future states of

the economy (China Information Network, 2009, p. 15). It also mentions that the fixed asset

investment has a high correlation (0.78) with the consumption of non-ferrous metal during

2001–08. In particular, the construction industry, the electric power industry, the transporta-

tion industry and the consumer goods industry have consumed 24, 21, 20 and 10 per cent of

the total consumption of non-ferrous metal in 2008, respectively. Being the two most impor-

tant base metals, copper and aluminium are essential for the manufacturing and construction

sectors, which dually drive the GDP growth in China.

5

4

See http://www.cei.gov.cn, which is a website maintained by the State Information Centre of China.

Its annual industry reports are written by recognised economists in China to assist policymakers as well

as various business entities in decision-making.

5

A number of recent financial press reports confirm this premise. For instance, see ‘Copper Rises 50

per cent in ‘Red Gold’ Rush on China Doubling Usage’ (http://www.bloomberg.com/news/2010-11-03/

copper-rises-50-in-red-gold-rush-on-belief-china-to-double-consumption.html) ‘China’s Drive for Rural

Growth Fuels Hunger for Copper’ (http://www.bloomberg.com/video/64199010/), and ‘China Can Use

More Copper Than World Has Now With Yang’s Stove’ (http://www.bloomberg.com/news/2010-11-02/

china-seen-using-more-copper-than-world-produces-now-with-yang-s-new-stove.html).

©2013 John Wiley & Sons Ltd

862 T. CHEN, L. WU AND I. K.-M. YAN