Iron ore and Australian house prices

In my previous post, we started to examine the million dollar question for Australia's economy today. How long will China's rapid growth and the commodity price boom last? We noted that while the arguments for continued growth in commodity demand from China appear fairly plausible, there are significant risks in the near term. And in actual fact, we've greatly understated the risks to Australia's terms of trade so far in this discussion, because we haven't even looked at what is happening on the supply side of commodities.  

Commodity Supply 101
The supply of commodities like iron ore or coal tends to be fairly "inelastic" -- or unresponsive -- to rising demand in the short run. This is because there are massive capital costs involved in expanding mining operations or exploiting new reserves. Unlike agricultural commodities like potatoes, the average punter can't just start digging up iron ore in the back yard and selling it on international markets.

What this means is that when you get a surge of demand in commodities, supply doesn't rise by much in the short term, so prices shoot through the roof and the miners make boatloads of money. But what history shows is that commodity prices repeat long cycles of boom and bust. When prices get high enough, miners eventually find it more economical to add new capacity and expand supply. There's generally a lag until this new supply hits the market, but when it does, prices inevitably cool down again. And that's exactly what we are likely to see over the next few years.

The chart below from Global Mining Investments illustrates the economics of this very well. This is the cost curve for various iron ore producers around the world. I'm focusing on iron ore because, along with coal, it's Australia's biggest export.

You can see that the big three of Rio Tinto, Vale and BHP Billiton can make money as long as prices stay above $30-40 a tonne, around $100 below the current market price. This is because the big three, who control around two thirds of the market, have access to some of the world's highest grade iron ore deposits -- places like the Pilbara in Western Australia and Carajas in Brazil. So it's no wonder they're making a killing. But as the price of iron ore keeps rising, it becomes economical for higher cost producers in places like India and China to start tapping their lower grade iron ore deposits.

Source: GMI

A Coming Iron-Ore Glut?
In fact, one recent report says there could be an enormous 685 million tonnes of new iron ore production capacity coming on stream between 2010 and 2012, which is roughly equal to what Australia and Brazil (the worlds two biggest producers) produced together in 2009. For a list of some of these projects, see here. Furthermore, China has been speeding up the exploitation of domestic deposits and buying up mines all over the world to help ease their dependence on the big three. From a recent article by Stephen Bartholomeusz in Business Spectator:

The notion of a prolonged ‘mother of all booms’ is ... not one that the big miners necessarily subscribe to. They are aware that the mid-sized and smaller iron ore and coal producers, after something of a hiatus during the crisis, are now scrambling to bring their production into the market. There will be big and continuing increases in supply to discipline the prices... Goldman Sachs’ resource analysts suggested earlier this week that the iron ore market could move into balance in 2013 and over-supply as early as 2014. Even if steel production in China continues to grow at current rates the market would still be in an over-supplied position by 2015, they said.

Meanwhile, iron ore spot prices continue to grind higher, and are currently approaching $180 a tonne. But a growing number of analysts are warning that this rise is unsustainable, and that a fall back well below $100 is inevitable in coming years. From another recent report in Barrons:

The fading outlook for iron ore is being driven by miners' investments in new projects and mine expansions around the world. But it is also being driven by China itself, whose flourishing steel industry, currently the world's largest iron-ore consumer, may soon be producing more steel scrap, thus reducing the need to import the ore.

"From 2015, we believe an additional industry dynamic will enter the fray: the increase in Chinese domestic scrap supplies," Credit Suisse analysts say. China's new construction and its growing consumption of metal-intensive products will provide additional fodder for domestic scrap. Worn-out cars, household appliances, construction beams and old railroad tracks—all can be melted down and put it into a furnace to produce new steel products.

"We expect prices to begin falling well below $100 a ton..." Credit Suisse says, referring to the period beyond 2015.

Let's quickly summarize. We can probably expect at least another decade or so of strong growth in commodity demand from China. China isn't going away in a hurry. But the miners all know this, and have been investing accordingly. Which means there is a huge amount of new commodity supply set to come on line in the next few years. Even if everything goes right and the very strong growth in Chinese metals demand continues, this additional supply is likely to send prices lower.

And this new supply will also be hitting the market at a time when some economists (read Michael Pettis, for example) believe China is running into some serious constraints in its growth model. If China was to hit a speedbump some time in the coming few years and fall into recession, there is a chance that commodity prices could collapse, with disastrous consequences for Australia. This is not necessarily a likely scenario, but it is a risk that we need to be mindful of, because Australia's economy is extremely vulnerable to such a potential shock, as we will examine a bit further below.

Australia: Living on Borrowed Time
Let's go full circle back to the terms of trade. Some of you might have read reports of a recent study by the IMF, which surprisingly concluded that Australian house prices were only mildly overvalued. The IMF argued that there were solid fundamental reasons for Australia having the most expensive property prices in the world. And one of the key reasons they cited is the massive rise in Australia's terms of trade.

You can see from the chart below that, indeed, inflation-adjusted house prices have basically increased in line with Australia's terms of trade over the past two decades.

This raises an obvious question. If you agree with the IMF's logic, doesn't this imply that house prices have to fall when the once in a generation boost to the terms of trade reverses?

Now, Australia's terms of trade has gone through long rises and falls over history without huge problems. And a decline in the terms of trade wouldn't necessarily have to be a big problem if Australia had invested the proceeds of the current boom productively. But instead, Australians have turbocharged the boom by taking on record levels of personal debt (see below), mainly to purchase houses. And the Australian banks are financing a good part of this mortgage debt not through deposits, but through a potentially unstable source of funding: the international bond markets.

So we are now left very highly leveraged, and the valuation of the biggest asset that most Australians own (their houses and investment properties) as well as their ability to service this debt (and the banks' willingness to keep extending credit) is dependent on the continuation of the commodity boom. The enormous level of personal debt means that many Australians today are highly vulnerable to potential shocks in the economy, whether from a slowdown in China, or from higher interest rates.

Source: Steve Keen

The chart below, from an excellent post at deflationite.com, shows just how unbalanced the Australian economy has become over the past two decades. You can see that in 1990, the majority of Australian bank lending was being channeled into business investment, or investment in Australia's future productive capacity. But over the past two decades, the portion of bank credit allocated to business investment has steadily shrunk.  In place of this, we have seen massive growth in property-related lending, to the point where one in seven Australians today owns one or more investment properties.

In essence, Australians have been behaving as if the commodity boom and the days of easy credit will last forever. Nobody can predict the timing, but they won't. Now, that doesn't have to mean disaster, but we're kidding ourselves if we think the adjustment is going to be easy.

As Warren Buffet once said, "It's only when the tide goes out that you learn who's been swimming naked."

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.

Australia's unhealthy dependence on China

Debate is raging over whether China's massive boom in construction and real estate -- which is fueling Australia's commodity exports -- is a bubble waiting to burst. This is a critical question, because Australia's economy has become increasingly dependent on China for growth in its mining exports. In the chart below you can see that Japan, our biggest export market for much of the postwar period, is in a slow and steady decline. In contrast, China's share of our exports is growing exponentially.

 

Like it or not, our economic future is now inextricably linked to that of China. China now accounts for an astounding two-thirds of world iron ore demand, around one-third of aluminium ore demand and more than 45% of global demand for coal, according to this recent paper by the RBA.  Thanks to this voracious demand, our terms of trade -- or the ratio of our export prices to import prices -- is the highest it has been since the 1950s.

But is this enormous growth in demand from China sustainable? Many economists think not. My favorite China watcher, Michael Pettis of Peking University, has been arguing for some time that China is running up against the limits of it's investment and export-led growth model, and that the days of double digit growth rates will soon be a thing of the past. In a recent blog post, he says:

By the end of next year, I suspect that the consensus will be that for the rest of the decade we should expect growth rates in the 6-7% range for China.

Pettis describes even this forecast as being "optimistic", and dependent upon China being able to maintain consumption growth of 8-9% a year. 

If GDP growth slows so substantially, it seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range... Non-food commodity exporters will be badly hurt.

What would the implications be of such a drop in China's growth rate? Fitch Ratings recently performed a "stress test" of what would happen if Chinese growth slowed to 5% in 2011. Their conclusions are very interesting, so I am going to quote at length from the report. Firstly, as you can see below, Fitch expects that such a growth slowdown would cause a major crash in Asian stockmarkets, and a 20% fall in commodities prices.

And which countries are most vulnerable to such a slowdown? The chart below confirms that Australia's economy is one of the most commodity-dependent in the world.

Not surprisingly, Fitch identifies iron ore exporters as amongst the biggest potential losers:

Iron ore – used as a key raw material in the steel industry – would be the commodity most affected by a slowdown, with Australian commodity producers in particular being impacted...

But perhaps the most interesting section of the report is Fitch's expectations of what would happen to banking systems and financial markets in the event of a sharp slowdown in Chinese growth. Again, I will quote at length, because some very interesting points are raised.  

It is also worth noting that the domestic banks in those overseas countries that provide financing to corporate exporters to China could face potential deterioration in the credit quality of their loan books in the event that demand for their customers’ products declined. This could affect banks in countries such as Hong Kong SAR, Taiwan, Japan, Korea and Australia.

Investor risk appetite would likely reduce, increasing volatility in financial markets and resulting in capital flight from perceived riskier assets... Certain types of asset with high levels of correlation to the China growth story could be particularly badly hit, given investors’ ongoing initiatives to gain exposure to China through indirect routes such as commodities (especially copper), correlated currencies (the Australian dollar) and equities of multinational companies with global brands and a China presence...

Fitch anticipates that a material slowdown in the Chinese economy would have a negative effect on the willingness of global banking systems to continue providing credit... Those countries with the heaviest reliance on China as a destination for exports (Hong Kong SAR, Taiwan, Japan, Korea, Singapore, Malaysia, Australia, Brazil, Chile, Peru and Russia) could potentially see a retrenchment of their banking systems, with credit availability reducing...

This impact could be exacerbated by negative developments in the real estate markets of those countries with strong trade links to China, particularly those where property prices have risen strongly over the past 12–18 months, such as Singapore, Hong Kong, Taiwan and Australia.

So let's summarize the implications for Australia of a sharp growth slowdown in China. Firstly, our miners will be heavily hit as Chinese demand contracts and commodity prices drop significantly. The Australian dollar will probably fall sharply. International investors will become risk averse, and may be unwilling to refinance the massive external liabilities of Australian banks without demanding a large risk premium. As credit dries up, Australian property prices will inevitably fall. This is an ugly scenario all round.

China's massive boost to our terms of trade has undoubtedly been a huge boon. Along with the government's massive stimulus, it helped us dodge the worst of the global financial crisis in 2008. But this once in a generation boost to our trade is not going to last forever. We could have spent the last decade prudently running large budget surpluses to create a buffer for when the boom ends. We could have invested more in infrastructure and tried to boost the productivity of the non-mining sector through economic reforms. We could have introduced a sensibly designed tax on the mining sector and invested the proceeds in a fund for Australia's future. But instead, in a decade of what economist Ross Garnaut calls "The Great Complacency", we have inflated a massive housing bubble based on an unsustainable rise in household debt, partly financed by foreign investors who will bail at the first sign of trouble.

Now, even Fitch says it doesn't expect it's "stress case" of 5% growth in China to eventuate in 2011. China's economy is still in the relatively early stages of industrialisation and it's obvious that there is still a lot of growth to come. But there are clearly limits to the pace of this growth, and the growth to come is definitely not going to be in a straight line. The question is: are we prepared for when China inevitably hits a speed bump?

Elephants in rooms

So, the story of the week is that the Australian Treasury is becoming concerned about the bubblicious runup in Australian property prices over the past several years:

A SENIOR Treasury official has sounded the alarm over Australia's property market. He has warned that the prospect of a sudden and dramatic drop in prices is "the elephant in the room" and should not be ignored by the federal government.

 
It's nice that somebody in Canberra has finally cottoned on, but I don't expect this to change the head in the sand attitude of the current government and the RBA. We can only hope that the bubble deflates while Australia still has the cushion of strong commodities export growth to China. But on this front, too, there is reason to worry. From Bloomberg today:

China’s reserve-ratio increases for banks and threats of price controls on essential goods are likely to prove insufficient to tame inflation, and the central bank will have to raise interest rates further, economists said. 

All of which is likely to dampen China's growth.  China expert Michael Pettis has been arguing for some time that China's economy is set to slow down sharply in the next few years as the country rebalances it's overly export and investment-led economy. 

Over the next five years or more Chinese economic growth will necessarily be lower than growth in Chinese consumption. The massive but unsustainable investment in infrastructure and new production facilities that characterises the Chinese fiscal stimulus package will not be able to change this fact. From its dizzying heights during the past two decades, the world needs to prepare itself for a decade during which, if all goes well, China grows at a still respectable but much lower rate of 5-7 per cent.

Of course this type of view has been largely ignored by the mainstream press, which continues to assume that like Australian housing prices, China can keep growing at 10% a year until the year infinity. What would the implications be for Australia if China was to slow to 5-7% growth?

Keep in mind that according to this RBA paper, China now accounts for an astounding two-thirds of world iron ore demand, around one-third of aluminium ore demand and more than 45% of global demand for coal. Thanks to this voracious demand, China's importance to the Australian economy has risen exponentially over the past decade. See the chart below from Business Insider, which shows that Australia now exports almost SIX times as much to China as to the United States, although as recently as 2004 both export markets were roughly of equal importance.

Which brings us back to our heroic Treasury official.

"The elephant in the room is house prices or more specifically the risk of a precipitous drop in them, perhaps from an external shock or perhaps from their own internal dynamics when affordability constraints or capacity debt levels see prices and expectations of house prices start to move in the opposite direction," Mr Morling wrote on June 15.

Now, there are several signs that the bubble is simply starting to deflate under it's own weight, but an external shock such as a sharp slowdown in China would severely hamper Australia's ability to deal with the fallout of a real estate crash. It was only dumb luck that we escaped the worst of the GFC, and we have allowed the imbalances in our economy to grow even larger since.

2011/12 could be very messy indeed.