Monday, January 17, 2011

Is Australia living on borrowed time?

Credit Suisse this week predicted a sharp slowdown in Australia's GDP growth for 2011 and recommended selling shares in resource companies, based on their view that the Chinese economy is headed for a slowdown. It remains to be seen if they're right, but one thing is for sure; Australia's economic fortunes are more closely tied to China and its demand for commodities than ever before.

In this recent post, I argued that Australia is extremely vulnerable to a slowdown in China because of our highly leveraged households and a banking system that is overly dependent on overseas funding. Today, I would like to take things a step further and examine what is driving China's demand for commodities and for how long we can expect the commodity boom to continue. This is a complicated question, so I'm going to break it up into two posts. Today we'll look at the demand for commodities, and in a follow up post, I'll examine the supply side.

You might ask the question of what there is to worry about, since commodity prices continue to shoot through the roof. Indeed, the Queensland floods have only exacerbated this upward pressure on prices, with many coal mines flooded and supply looking like it could be restricted for some time. The chart below shows the CRB commodity price index, which has been on a very steady climb for the past six months now.


This continued rise in commodity prices is likely to push Australia's soaring terms of trade even higher still. As you can see from the chart below, we are currently enjoying the biggest boom in our terms of trade since the early postwar years. But how long can this extraordinary situation last?


Our Terms of Trade
First, some definitions are in order. What does the explosion of the terms of trade mean in English? It means that the price of the stuff we export (commodities like iron ore, coal, etc) has been rising much faster than the price of the stuff we import (finished goods like cars, flat screen TVs, etc). All other things equal, a higher terms of trade means more purchasing power for Australians, and therefore a higher standard of living.

Let's now take a look at what drives the terms of trade and try to get a handle of whether its massive rise in the past decade is sustainable. Like any other good, the price of commodities is determined by supply and demand. The demand side of the equation is what usually gets the most attention, so we'll examine that first.

China and the Demand for Commodities
The first important thing to understand here is that there has been a massive shift in the composition of demand for commodities in the past couple of decades. While industrialized economies used to be the biggest consumers of non-food commodities, that is no longer the case, as the charts below from the Brazilian miner Vale show. You can see that emerging market economies now make up more than 80% of global demand for iron ore, and two thirds of demand for nickel and copper.


To simplify the analysis, let's just look at China, because it's pretty safe to ignore everybody else. Why? Take iron ore for example, which is the raw material used to make steel. World steel production has risen by two thirds in the last decade, but 90% of this growth has come from China, according to this article.

How much longer can we expect this enormous growth to continue? Well, that's a very difficult question, because it depends on factors like the rate of urbanization in China, and the timing of when China shifts its economy from the current investment and export-led model to a more consumer-driven one. In any case, the consensus seems to be that we can expect the high growth period of China's demand for commodities to last at least another decade, since the country still has a lot of infrastructure to build to support its huge population. See more forecasts from Vale below.


One recent study from academics at ANU forecast that China would reach "peak steel intensity" -- or the peak consumption of steel per capita -- by 2024. The chart below from the RBA illustrates the similar point that China is still in an early stage of economic development that tends to be very intensive in the use of raw materials. If we assume a similar path of development to that of Japan, then China still has some way to go along the path of industrialization before its demand for steel peaks.


And this is broadly consistent with what the miners and other analysts say. As the investment bank Barclays put it in one recent report:
The shift from metals-intensive, investment-driven growth to consumer-driven growth is likely to be gradual in China. Chinese steel consumption of about 480kg per capita for 2010 is still significantly below peak levels of 600kg-1000kg per capita seen historically in other developing economies.  In addition, Indian steel consumption is growing at close to 10% per year but is still estimated to be just 60kg per capita for 2010.  We see significant upside in demand for steel, steelmaking raw materials, and other metals in China and India over the next 5-10 years.
So there are good reasons to expect the strong growth in Chinese demand for commodities will continue for some time yet. But there are a couple of important caveats here.

What Are the Risks?
Firstly, long-term economic forecasts for metals demand -- or anything else for that matter -- are little more than educated guesswork. As I noted here, economists don't exactly have a great track record at getting these things right. And this may be even more relevant in the case of China; the world has never seen such a large economy industrialize so rapidly, so we have no prior experience to base the forecasts on. So no matter how plausible these estimates sound, we should treat them with a healthy degree of scepticism, allowing for the possibility that they could turn out to be completely wrong.

Secondly, even if the bullish long-term forecasts for Chinese metals demand are correct, that doesn't mean we won't hit any speed bumps along the way. There are plenty of signs that some of the infrastructure spending going on recently in China is unproductive at best, and at worst, reflective of a speculative bubble waiting to burst.

See the chart below, for example, which shows that China is set to build 44% of the world's skyscrapers in the coming six years. One analyst calls this rush to build higher and higher skyscrapers a classic "sign of economic over-expansion and a misallocation of capital." Eerie footage of entire vacant cities, and reports of up to 64 million unoccupied houses in China (recently highlighted by the Unconventional Economist) also raise questions about the sustainability of China's boom, and have reportedly prompted some hedge funds to start betting on a crash. 


So there are some big question marks on the demand side for commodities, even if we do agree with the bullish long-term picture. And a temporary collapse in demand from China could cause a lot of damage to other economies and financial markets, because very few people are prepared for it. As Albert Edwards, an investment strategist at the French bank Societe Generale puts it:
"In reality, China is a much more potentially volatile economy than people think. The Chinese situation is the one that could come out of nowhere because people are not considering it as a serious possibility."

In Edwards' view, China is a "freak economy"; its investment-to-GDP ratio is off the scale in terms of size and endurance. "In development history, Korea is the only one that got close. It then collapsed. China is basing a growth model on the most unstable part of GDP. The Chinese authorities have recognised this and are trying to steer the economy over to consumption – which is fine, but it will take a long time.

The danger, he suggests, is that China has produced such strong growth for such a long time that investors assume the process will last indefinitely. "There is too much confidence in the lack of volatility. If you get a zero or a small minus for Chinese GDP, in the great scheme of long-term development it's not a great problem. But it's a bit like investing in Nasdaq stocks in 2000 – there would be a big adjustment in price. There is an investment edifice built on the idea that China is the new growth engine of the world."
This sense of complacency that Edwards talks about seems particularly relevant to Australia, which -- with the help of China and some massive government stimulus -- largely avoided the global financial crisis of 2008 and has not experienced a recession for two decades.

In any case, to summarize, we can be cautiously optimistic that China's demand for commodities will continue to grow for another decade or more, but there could be some very painful adjustments along the way. Having said that, we've still only looked at half the story, because it's the interaction of commodity demand with supply that determines prices and ultimately, Australia's terms of trade. What about the supply side?

This is where the story starts to get interesting. And that will be the subject of my next post.

13 comments:

  1. Yes,complacency is the "in" thing in Australia at present although some of the dwellers on the lowlands have got a rude and wet awakening of late.
    I believe Edwards is correct in describing China as a "freak economy".As such it will not survive in its present form.Too bad about all the pixies who think that things can only get better,never worse.

    ReplyDelete
    Replies
    1. HOW I GOT MY LOAN (Lexieloancompany@yahoo.com)!!!

      My Name is Nicole Marie, I live in USA and life is worth living comfortably for me and my family now and i really have never seen goodness shown to me this much in my life, As i am a struggling mum with two kids and i have been going through a serious problem as my husband encountered a terrible accident last two weeks, and the doctors stated that he needs to undergo a delicate surgery for him to be able to walk again and i could not afford the bills for his surgery then i went to the bank for a loan and they turn me down stating that i have no credit card, from there i ran to my father and he was not able to help me, then when i was browsing through yahoo answers i came across a God fearing man (Mr Martinez Lexie) who provides loans at an affordable interest rate and i have been hearing about so many scams on the Internet mostly Africa, but at this my desperate situation, i had no choice than to give it an attempt due to the fact that the company is from United State of America, and surprisingly it was all like a dream, i received a loan of $82,000.00 USD and i payed for my husband surgery and thank GOD today he is ok and can walk, my family is happy and i said to myself that i will shout to the world the wonders this great and God fearing Man Mr Martinez Lexie did for me and my family; so if anyone is in genuine and serious need of a loan do contact this GOD fearing man via Email: ( Lexieloancompany@yahoo.com ) or through the Company website: http://lexieloans.bravesites.com OR text: +18168926958 thanks




      Delete
    2. HOW I GET A LOAN HELP @ 2% INTEREST RATE With victoriafinancier@outlook.com

      I was not sure of getting a legit loan lender online But when i could not face my Debt any more, my son was on hospital bed for surgery that involve huge money and i also needed some money to refinance and get a good home then i have to seeks for Assistance from friends and when there was no hope any more i decide to go online to seek a loan and i find VICTORIA LAWSON Trust Loan Firm (victoriafinancier@outlook.com) with 2% interest Rate and applied immediately with my details as directed. Within seven Days of my application She wired my loan amount with No hidden charges and i could take care of my son medical bills, Renew my rent bill and pay off my debt. I will advice every loan seeker to contact VICTORIA LAWSON LOAN Company with victoriafinancier@outlook.com For easy and safe transaction.

      *Full Name:_________

      *Address:_________

      *Tell:_________

      *loan amount:_________

      *Loan duration:_________

      *Country:_________

      *Purpose of loan:_________

      *Monthly Income:__________

      *Occupation__________

      *Next of kin :_________

      *Email :_________

      Delete
  2. Australian property is a ponzi scheme developed by many governments over the years. Buy now and you could end up being the ‘greater fool’ unless the government and powerful organisations have too much to lose for them to let the scheme crash. They might do everything they can to stop it crashing and then the only thing that will bring it down will be the China factor and if that happens, we are all screwed. China is largely responsible for the majority of recent global demand for commodities (oil, copper, coal, iron or whatever else). When (not if) the Chinese economy begins to decelerate and their bubble (if that's what you want to call it) pops, then global demand for the aforementioned commodities is going to plummet. This will seriously impact Australia and other countries that benefit from Chinese demand. Coal and iron prices will fall along with oil prices and all other commodities. Obviously China is not going to disappear, but the recent dramatic growth can't go on forever. And when it does slow down considerably... POP!

    Andrew B
    Oz Real Estate Bubble/Crash Chat Forum

    ReplyDelete
  3. Ponzi schemes follow their own dynamic from bloom to bust. China does not need to slow down or crash for the homeland property bubble to collapse. The resource boom has helped delay he day of reckoning, but as the pool of greater fools dries up and debt overload saps at those already fully invested, it can self-destruct perfectly well on its own.

    ReplyDelete
  4. This is interesting reading. I am starting to read alot of these big investment houses are saying to stay away from some of these emerging markets. Great article FF.

    http://www.siasat.com/english/news/goldman-sachs-warns-against-investing-india-china

    ReplyDelete
  5. There is something to be said for the view that as the urbanization and industrialization of India accelerates, this will take some of the pressure off China as the main sustainer of commodity demand. India's demand for iron ore, coal etc is coming off a very low base. There may be bumps along the way, but it is hard to see a prolonged slump in commodity demand any time in the next 30-40 years.

    ReplyDelete
  6. Heyworth > Agreed. I may look at India in a future post some time. In any case, I guess my argument is that because of Australia's fragile fundamentals (highly leveraged households, banks' reliance on overseas funding,etc) you don't need a prolonged slump to get us into trouble. Even the bumps along the way might not be easy to deal with.

    ReplyDelete
  7. FF, I'm sure you are right about Australia's vulnerability. It is still possible that we'll muddle through, but the odds favour a recession at some point.

    ReplyDelete
  8. Property for Sale in Australia Search for property and real estate across Australia largest list of properties for sale and rent. Find homes for sale, houses and flats to rent or buy residential and commercial property.

    ReplyDelete
  9. Business firms carry a high risk of non-payment of their customers who have purchased goods on credit.so credit insurance is a best option for every small or large business owner.Thanks for the useful information, really appreciated!!

    National Credit Insurance Brokers

    ReplyDelete
  10. HOW I GOT MY LOAN (Lexieloancompany@yahoo.com)!!!

    My Name is Nicole Marie, I live in USA and life is worth living comfortably for me and my family now and i really have never seen goodness shown to me this much in my life, As i am a struggling mum with two kids and i have been going through a serious problem as my husband encountered a terrible accident last two weeks, and the doctors stated that he needs to undergo a delicate surgery for him to be able to walk again and i could not afford the bills for his surgery then i went to the bank for a loan and they turn me down stating that i have no credit card, from there i ran to my father and he was not able to help me, then when i was browsing through yahoo answers i came across a God fearing man (Mr Martinez Lexie) who provides loans at an affordable interest rate and i have been hearing about so many scams on the Internet mostly Africa, but at this my desperate situation, i had no choice than to give it an attempt due to the fact that the company is from United State of America, and surprisingly it was all like a dream, i received a loan of $82,000.00 USD and i payed for my husband surgery and thank GOD today he is ok and can walk, my family is happy and i said to myself that i will shout to the world the wonders this great and God fearing Man Mr Martinez Lexie did for me and my family; so if anyone is in genuine and serious need of a loan do contact this GOD fearing man via Email: ( Lexieloancompany@yahoo.com ) or through the Company website: http://lexieloans.bravesites.com OR text: +18168926958 thanks




    ReplyDelete
  11. HOW I GET A LOAN HELP @ 2% INTEREST RATE With victoriafinancier@outlook.com

    My son was on hospital bed for surgery that involve huge money and i also needed some money to refinance and get a good home then i have to seeks for Assistance from friends and when there was no hope any more i decide to go online to seek a loan and i find VICTORIA LAWSON Trust Loan Firm (victoriafinancier@outlook.com) with 2% interest Rate and applied immediately with my details as directed. Within seven Days of my application She wired my loan amount with No hidden charges and i could take care of my son medical bills, Renew my rent bill and pay off my debt. I will advice every loan seeker to contact VICTORIA LAWSON LOAN Company with victoriafinancier@outlook.com For easy and safe transaction.

    *Full Name:_________

    *Address:_________

    *Tell:_________

    *loan amount:_________

    *Loan duration:_________

    *Country:_________

    *Purpose of loan:_________

    *Monthly Income:__________

    *Occupation__________

    *Next of kin :_________

    *Email :_________

    ReplyDelete