China Boom Mark II

Broken ice or glass with a flag pattern, China
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Wow!

Iron ore staged its biggest rally ever yesterday evening. The priced surged nearly 20% to around US$64 per tonne.

That is incredible!

What caused the rally?

Well, you can put it down to China doing what every other nation is doing. That is, opting for the same old growth policies that got it into trouble in the first place, at the expense of difficult but necessary reforms.

China’s leaders chose the National People’s Congress, which got underway on Saturday, as the forum to announce the ‘going for growth’ plans.

From the Financial Review:

China will put development above structural reform over the next five years, as it outlined an ambitious economic growth target higher than economists and international agencies are forecasting.

While announcing only modest tax cuts and a smaller than expected increase in fiscal spending, the government indicated it stands ready to roll out other stimulus measures to meet targeted growth of 6.5 per cent between 2016 and 2020.

In other words, China will go for growth at any cost. It will continue to accumulate debt to do so, and continue to create financial system risks in the process.

Is the iron ore market right to be so fired up about this announcement? While there is certainly some justification for a price spike, a near 20% surge seems a tad optimistic.

Since the bottom in December 2015, iron ore prices have now surged around 66%. What do you think this does to the profitability of Chinese steel mills? Their main input cost has just got a lot more expensive in the space of three months.

To justify an increase in steel production, steel prices need to rise significantly too. Over the past few days, they have. The expectation of more stimulus is the reason behind this.

But the steel industry suffers from chronic overcapacity. It was only a few days ago, at the start of the Congress, that Premier Li Keqiang said that China would resolve to end industrial overcapacity in areas like iron ore and coal.

Rising prices and endless stimulus rhetoric won’t do that. They will encourage loss making mills to keep on pumping out steel, in the hope that they might finally turn a profit.

China, meet square one…

Now it’s all well and good to say X% growth is what you want to achieve. It’s another thing to actually achieve it. Especially when you already have a gargantuan amount of debt in the economy, as China does.

China’s Finance Minister Lou Jiwei is already concerned. From the South China Morning Post:

There is limited room for China to further expand its budget deficit, Finance Minister Lou Jiwei said on Monday, despite Beijing’s hopes that fiscal policy can take the lead in bolstering the economy.

“There is still room for China to increase its budget deficit, but not too much,” Lou told a press conference. “The outlook for fiscal revenue is grim.”

Government debt is only small part of the problem for China. The bigger issue is corporate debt. According to Standard & Poor’s, China’s corporate debt to GDP ratio is 160%. That compares with 70% in the US.

Part of the reason for higher government deficits in China is to provide a tax break for the corporate sector. And a big part of why China wants to maintain growth as strong as possible is to prop up the highly indebted corporate sector.

But, whichever way you cut it, at some point high debt levels will catch up with you.

It’s one of the central themes of Vern Gowdie’s book, The End of Australia. This ‘end’ might be delayed somewhat if China can pull off its growth aspirations. But it’s only a delay.

China seems to think it can grow out of its debt problems. That assumption will be put to the test in the next few years. In my view, it’s already in too deep.

As for Australia, the rise in the iron ore price (assuming it’s sustained, which it won’t be) is a double edged sword. The rising price takes pressure off the budget and the persistent decline in national income.

This will then encourage the government to do nothing about structural reforms. Instead, it will pretend that all is well and that this was all part of the plan.

One of the interesting side effects in the whole negative gearing debate (which is a structural reform) are the reports coming from various interest groups saying how many jobs will be lost if this or that happens.

That is the whole point!

When you have a generous tax concession, people will take advantage of it. That means capital flows into these concession areas. That creates jobs and activity.

And guess what? If you take the concession away, capital will flow elsewhere. Jobs will redirect to a different part of the economy in a hopefully more efficient manner.

But the vested interests don’t tell you that. They just focus on where the losses will occur. This is why structural reform is hard. You need leaders to enact it. We have no such thing in Australia. Not in the current government, anyway.

The other risk to Australia from a surging iron ore price is a stronger dollar. This is a form of monetary tightening. It’s not what the RBA wants to see.

As I said, I don’t think the price spike is sustainable, but it could hang around for a bit…long enough to lull everyone into thinking it’s all systems go on the iron ore price boom mark II.

This is how financial markets work in a world of unfettered government and central bank intervention.

As I’ve written previously, in such an era, you need to be on your toes. The market will never do what you want it to, or what you expect it to. Only the flexible will survive.

Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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