The Future of China’s Economy and the Iron Ore Price

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There’s something tragically comical about last week’s head in the sand, vote buying budget, Atlas Iron’s miraculous recovery from bankruptcy, the government’s inquiry into the iron ore industry, and this news from China, as reported by the Financial Times:

China has ordered its banks to prop up insolvent provincial government projects, in the latest effort to support rapidly cooling growth and put off dealing with the mountain of debt that has built up in the past six years.

Authorities told financial institutions to keep lending to local government projects even if the borrowers are unable to make principal or interest payments on existing loans.

That’s right — China. Let’s not forget it is still dealing with the fallout of an immense credit bubble. It can’t let market forces take over right now. To do so would be to invite trouble.

Instead, China has to get all Communist about it by ordering its banks to keep lending to zombie companies. While such a policy gives the impression that all is well, the economy will pay a price for it.

That’s because capital must be allowed to generate a return above its ‘cost’. This simple little equation is the basis for all real economic value creation. When an investment generates a return above the cost of the capital required to finance it, profits, jobs and economic growth result.

When the investment can’t cover its cost, the opposite occurs. The best thing to happen in this situation is to let market forces play out. That means liquidate the investment and redirect the capital towards a more profitable endeavour.

Capitalism works best (and is ruthless) when capital is allowed to move around unfettered. In such an environment it will constantly move towards the highest returns. More capital then follows until those returns diminish to a point where the weakest die off. Then the process starts again.

Needless to say, this is not happening in China. China’s leaders can’t afford to let capitalism do its job. They fear a spike in unemployment and social unrest, the greatest fear of all China’s leaders.

As a result, vast amounts of value destroying capital lays trapped in China’s distorted economy. Worse, the banks are under orders to keep feeding this value destroying apparatus.

The only thing that can result from this is slower economic growth. Yes, maintaining the ponzi will avoid a nasty bust…for now at least…but it comes at a cost. And the cost is a grinding slowdown in economic growth.

Last week, I spoke to a mate who works in the steel trading business. He told me car production in China is flat year-on-year. As in, no growth. Yet we’re told China’s economic growth is around 7%.

Bollocks it is.

But that’s all right. Treasurer Joe Hockey tells us he’s ‘more bullish about China than a number of other people.

He needs to be. China’s pretend 7% growth rate underpins Hockey’s budget for years to come.

Central to the budget forecasts is the assumption of aUS$48/tonne iron ore price. The general consensus is that this is a conservative number.

But it’s not. The government didn’t do any modelling based on stringent supply/demand dynamics to arrive at that assumption. They simply took the average of the past month and then assumed that’s how it will be for the next few years.

The iron ore price will be much lower than US$48 over the next few years, rendering the budget forecasts meaningless.

One reason why prices will fall is the delayed supply response to already weaker prices. A falling price of anything tells you that supply exceeds demand. As a result, supply should fall too.

But it doesn’t happen straight away. You’re seeing this in the Aussie iron ore market now. Despite a massive fall in the iron ore price, hardly any Aussie supply has left the market.

Atlas Iron [ASX:AGO] went into administration a few weeks ago when the price went into the low $40/tonne region. But following the recent bear market rally, which took the iron ore price to US$60/tonne, AGO is back producing, with a little cost cutting help from its contracting partners.

No one wants the iron ore party to end. Everyone’s cutting costs…which only ensures the inevitability of a lower price. A lower price is the only thing that will knock out high cost supply and improve the long term structure of the iron ore market.

So a lower price is exactly what you’ll get. It doesn’t matter how much Twiggy Forrest complains about the expansion policies of the majors. And it doesn’t matter that the government is going to waste a few million on an idiotic review of the iron ore market.

Falling Chinese steel production and higher iron ore production equals a falling price. That Australia is in denial about it makes no difference whatsoever.

But it’s not just our politicians and miners who are in denial. The whole electorate is deluded. Following last week’s vote buying budget, the government’s position in the polls has improved, which is exactly what they wanted.

Yet if we had any brains, we’d be depressed about the direction the government is taking us. Troy Bramston tells us why in today’s Australian

The fiscal challenge facing the nation is the gravest it has been in decades, and is likely to get much worse. The political class seems incapable of recognising this problem or showing any courage to address it. Blaming the Senate has become a convenient excuse for a failure of compelling advocacy and mixing smart policy with clever politics.

The second Hockey budget earns a place in history as one of the most fiscally reckless in the postwar era. Spending next financial year will reach a whopping 25.9 per cent of GDP. It is forecast to fall only slightly to 25.3 per cent over the next four years. Taxation will hit 24 per cent of GDP next year and continue to rise, up to 25.2 per cent by 2018-19.

There is no other conclusion: this is a big spending and big taxing government. It makes a mockery of the promise of smaller, leaner and more fiscally responsible government. Spending exceeds all of the Rudd-Gillard years bar one, during the GFC. It even outstrips the fiscally profligate years of the Whitlam government.’

In other words, it’s all bread and Circuses in the land of Oz. Meanwhile, there is plenty of dead wood and combustible fuel accumulating. Rome will burn…all it needs is a spark.

Regards,

Greg Canavan+,
For The Daily Reckoning Australia

PS: If your financial adviser is ignorant of the direction Australia is headed, you should look to take control of your own affairs. For some tips on how to get started, click here.

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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slewie the pi-rat
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slewie’s ‘FLATION Report ~for US Monday ~US Dollars only BLOOMBERG COMMODITY INDEX 105.0; -0.2; [-0.19%] US Dollar INDEX 94.19; +0.94 well, now! the USDX has got up offa the mat and started throwing DEflationary punches at recent INflation! for today? DEflation! with Correlation! however [in US Dollars], ~gold is UP, a tad. ~silver is UP over 1%. ~London [+ 3.1%, maybe NOT in US Dollars?] and US Wheat [+ 2.1%] led soybeans and corn, also, higher, today, with coffee very perky. and how did the cross-currencies fare? http://quote.goldseek.com/dollar.php the Oz Dollar? well it didn’t fall as hard as some of… Read more »
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