What the Iron Ore Surplus Means for the Australian Economy

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How about a nice piece of symbolism to start the week? The Financial Review reports today that a couple of dodgy kids conspired to use inside information to make millions trading the Australian dollar. After a substantial surveillance operation, the Feds busted them and froze their ill-begotten assets.

One of those assets was a $2.4 million apartment in Albert Park…designed by one of the pseudo celebrities from The Block!

What? We have to explain it? Well, put simply, the fact that a kid who stole millions ended up the owner of one of the most over-hyped properties in Australia speaks volumes for how our society is travelling right now.

But we’ll move on…

This week is Budget week. It’s pretty much all you’ll hear about for the next few days, before it disappears from the headlines all together and we move on with our lives. We’ve written previously how we think the government is blowing the opportunity to enact genuine tax reform, as outlined in the Henry Tax Review a couple of years ago. So we won’t go on about it again.

Not directly, anyway.  But it is a hugely important consideration for all Australians and worth banging on about. We’ll do so from a slightly different angle today.

There is a big elephant (is there any other type?) wandering around the budget room right now…the iron ore price. It’s fallen around 20% in the past month, just as the world’s major producers ramp up production and push the market into oversupply, a situation that will only get worse in 2015.

Why is the iron ore price so important? We’ll, it’s Australia’s largest export by far, meaning it brings in a huge amount of dollars (and tax revenue) into the country. The following chart from MacroBusiness shows this clearly:

Monthly Iron Ore, Gold and Natural Gas exports
click to enlarge

The red line on the chart shows the value of our iron ore exports. Since 2012, the value of monthly exports has jumped from less than $4 billion to around $7.5 billion. (A nearly 90% increase!) It’s a function of a rising price (the iron ore price fell below US$90/tonne back in 2012, before soaring to over US$150/tonne on the back of the final, frenetic stages of China’s property boom) and a big increase in export volumes.

In fact, the increase in export volumes has been more than enough to offset the most recent decline in the iron ore price (it’s now back down to around US$100/tonne) so it’s not affecting Australia’s revenue base just yet.

But this benign situation is unlikely to persist. According to Goldman Sachs, iron ore stocks are piling up at Chinese ports. Inventories are at a record 109 million tonnes. The investment bank says there will be a seaborne surplus of 145 million tonnes in 2015.

There’s only one way you can move such a surplus…increase demand or lower the price. With the Chinese property construction market accounting for nearly half of China’s steel demand, it would seem an unlikely candidate to absorb the iron ore surplus. Especially considering that China’s epic construction boom is now ending:

(Reuters) – China’s efforts to cool its property sector look to have been more effective than intended, as a sharp drop in construction activity and falling prices threaten what had been one of few firing engines of the world’s second-largest economy.

Developers know the market is struggling their inventory is rising and prices are falling but expect that authorities will relax their tight grip on the sector in coming months.

The government has long made it clear that economic growth would moderate as it tries to reform the economy. But by keeping the pressure on property too long, analysts fear the fallout will be more severe than anyone had expected.

Analysts at Nomura estimate that new housing starts fell by 25% in the first quarter of the year, compared with the same period in 2013. That’s a decent fall, and possibly explains why port inventories are at record highs.

Why then is China’s economy continuing to suck in iron ore, despite the drop off in construction and steel demand? Because the government will make sure nothing bad happens. That is the overriding consensus view about China…the government has it all under control and will unleash a new round of stimulus when things slow down too much.

Really?

(Reuters) – China will not use any large-scale stimulus to boost its economy, Central Bank Chief Zhou Xiaochuan was reported as saying on Saturday, in response to speculation that authorities might lower reserve requirements for banks to spur growth.

Zhou, who was speaking at a closed-door session at the Tsinghua University, was also reported by Phoenix New Media Ltd as saying the central bank would only "fine-tune" its policy to counter economic cycles.

The deputy chief of the People’s Bank of China is also wary of repeating past stimulus mistakes, which simply led to financial speculation and created economic distortions. As Bloomberg reports, Liu Shiyu now belatedly realises that the rise of shadow banking in China is not good for the country’s economic development. He told a forum in Beijing on Friday that:

If everyone in society is trying to get into the financing business, we may have entered a phase where a fever has started to affect our ability to think. We must make up our minds to rectify interbank operations and all kinds of wealth management products.

That doesn’t sound like a government about to throw another log on the fire.

Even President Xi Jinping is getting in on the act. Touring the central province of Henan last week, he said China must adapt to its ‘new normal’ condition and stay ‘cool-minded’ amidst China’s biggest economic slowdown in decades.

The bureaucrats are trying to condition the people for slower growth and an end to the property boom. Whether they can control the slowdown without resorting to old and dangerous stimulus programs remains to be seen.

But what is almost certain is that Australia’s old growth model, the one where we relied on China to boost our national income, which we then levered up to speculate on property, is nearly over.

Which brings us back to tomorrow’s budget. The projections you will see are almost certainly wrong. The iron ore price will be lower than what Treasury forecasts over the next few years, which means government revenue will be much worse than expected.

The golden goose has stopped laying eggs, but the government is still feeling around, expecting it to deliver. As Professor Quentin Grafton from the Australian National University is quoted as saying in today’s Financial Review, ‘The only growth in town will be from productivity reforms.

Exactly. But what does the government come up with instead? A deficit levy which tries to tell us that this is just a temporary problem. It’s not, it’s structural. And it’s going to get a lot worse.

Regards,

Greg Canavan+
for The Daily Reckoning Australia

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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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Reuters sez the China construction boom is ending, but do the sino-banksters care? nah. they just talk talk talk like any other banksters in the fiat-printing cabal. as slewienomics as been trying to tell folks: 21st-century economic ‘growth’ is simply the resultant of accounting gimmicks and people’s expectations of [and receptivity to] a happy ending for each night’s bed-time story. boil it down to productivity reforms, a duck is still a duck. Greg sees this well, imo, as ‘structural’. the real growth is in designing and engineering financial fraud as well as the ‘sociological’ and ‘scientific’ bases of the fraudulent… Read more »
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