METALS INSIDER: China's lifeline sinks aluminium sector

LONDON, March 24 (Reuters) - The Chinese government has been buying aluminium for its "strategic reserves" as a way of propping up the country's biggest producing companies during a period of historically low prices. However, this state-sponsored lifeline risks doing more harm than good and poses a major problem not just for national favourites such as Aluminium Corp of China Ltd (Chalco) <2600.HK> <601600.SS>, but for the entire global producer community. PRICE UP, STOCKS UP LME aluminium prices have actually performed rather well over the last couple of weeks. Three-month metal posted an 8.4 percent gain last week, outperforming every other metal, even copper, which has been buoyed by Chinese restocking and the resulting mini-downtrend in LME warehouse inventories. However, the light metal's robust performance has been purely technical in nature, a function of covering against the massive short position accumulated by CTA technical funds during the price collapse of the fourth quarter of last year. That short positioning was the largest of any LME-traded metal, which is why aluminium has out-performed on the cross-metals rally occasioned by the Federal Reserve's move towards quantitative easing and the resulting plunge in the U.S. dollar. Take a look at aluminium's fundamental dynamics, however, and there is nothing to cheer about. Visible surplus in the form of LME stocks is still accumulating and it is still doing so at a scary pace. LME-registered inventory increased by another 90,000 tonnes last week, bringing the year-to-date increase to 1.12 million tonnes. Over the last four weeks LME inventory has risen by almost 300,000 tonnes, equivalent to an annualised 3.6 million tonnes. STOCKS UP, ER..PRODUCTION UP? The supply-side response to the dramatic collapse in aluminium demand has been slow to gather momentum. To be fair to producers, this is at least partly because it is not possible just to hit a switch and turn an aluminium smelter off. Capacity must be gradually ramped down in a controlled fashion to avoid damaging potlines. Thus, a collective Western producer response is only now starting to materialise in the form of sharply slowing production of the light metal. The latest figures from the International Aluminium Institute (IAI) showed daily average Western production falling to 66,200 tonnes in February, its lowest since November 2006. Annualised non-Chinese production fell by around 475,000 tonnes in February, bringing the cumulative annualised decline since October 2008 to 1.57 million tonnes. Production can be expected to continue falling over the coming months as more plants are gradually ramped down. However, it may all be to no avail since after four months of decrease, Chinese production actually increased again in February to the tune of an annualised 790,000 tonnes, according to figures from the China Non-Ferrous Metals Industry Association published on the IAI's website. Since Chinese production re-accelerated faster than non-Chinese production slowed, the result was a net increase in global daily production to 97,300 tonnes from 96,400 tonnes. This leaves the market in the curious position of producing more metal in February than in January despite no sign of returning demand growth and growing visible surplus in the form of rising LME stocks. LAW OF UNINTENDED CONSEQUENCES To understand this anomaly look no further than the Chinese government buying programme and the law of unintended consequences. China's State Reserve Bureau has bought 590,000 tonnes of aluminium at above-market prices. The aim is to prevent forced plant closures, particularly among key pillars of the state aluminium sector, and preserve jobs. Other regional governments are now getting in on the act for the same reason. Guangxi, for example, intends to buy 200,000 tonnes of aluminium, a senior official told Reuters earlier this month. [ID:nPEK256253] But by setting an artificially inflated price to bail out local and national favourites, the government seems to have encouraged other producers either to restart idled capacity or bring on stream new capacity that was previously lying dormant. Even worse from Beijing's point of view, it has also opened an arbitrage window, through which increasing amounts of metal are starting to flow. February's trade figures confirmed the seismic change of trend evident in January. From being historically a net exporter of aluminium to the rest of the world, China has turned to net importer as merchants capitalise on the price differential between Shanghai and London prices. Indeed, net imports of primary aluminium and aluminium alloy picked up pace to 13,000 tonnes in February from 8,000 tonnes in January and that may just be the start, judging by anecdotal reports coming out of the Asian market. [ID:nSP501194] China shows every sign of being able to pull itself out of the manufacturing slowdown caused by collapsing exports to the rest of the world but it is still early days and there is no evidence the country's demand for aluminium is strong enough to cope both with rising domestic production and soaring imports. Quite how the Chinese authorities now react is going to be very interesting. It could determine the shape of the aluminium production sector, both inside and outside the country, for years to come. Maybe they should heed the words of Russian president, Vladimir Putin, who dismissed suggestions Russia too should look to build up stocks of metal to help support its national favourites. "To buy metals from producers for a state reserve -- and there was such an idea -- is impossible," Putin said earlier this month, adding: "Firstly, it's impossible to buy metal for the whole world. Then, we would stop paying wages and pensions. Secondly, we wouldn't know what to do with it." [ID:nLC109465] (Editing by Sue Thomas)