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.