If you think we’ve been too hysterical on the China debate, have a read of this. It’s the bearded one, Ross Gittins, telling us to chill out…the China/Asia/commodity boom has only just started.
The points that he makes seem fair enough, especially if you only have a mild grasp of economics. But on closer examination it’s a completely irresponsible interpretation of the facts. Critically, it ignores trade and capital flow dynamics.
Gittins rightly points out that the decade long China boom saw our terms of trade peak at a level that was nearly 80% higher than the 20th century average. And according to the perennially wrong government forecasters, the terms of trade should still be around 50% higher than the long term average by 2019.
We’ll come back to that in a moment.
Gittins then explains how mining is on its way to reaching 10-12% of GDP, up from 5% at the start of the boom. In the meantime, manufacturing’s share of output declined from 12% at the start of the boom to 8% today and probably 6% by the end of this decade.
Before you worry about the decline of our manufacturing sector, Gittins explains it’s all because of the ‘faster growth of the services sector as we, like the rest of the rich world, move to a knowledge based economy.’ Soothing words, huh?
As he must, Gittins acknowledges the current China slowdown. But he dismissively says ‘it has prompted some of our smaller mining companies to shelve their plans for new mines.’ Some of the smaller mining companies? Like BHP, Rio and Fortescue?
Writing in The Age today, Gittins’ colleague Elizabeth Knight tells the story of cost blowouts at Gina Rinehart’s $9 billion Roy Hill iron ore project in WA and how it may not even go ahead given the iron ore price falls. And how QR National (the rail operator) is unlikely to go ahead with planned joint ventures with iron ore juniors Atlas Iron and Brockman Resources.
This is more than just smaller companies shelving projects. It’s a (Austrian economics) textbook case of misallocation of resources due to China’s credit boom. It pushed iron ore prices to a record US$180/tonne in 2011. Companies assumed permanently higher prices and made investment plans to exploit these higher prices.
But projects take time to develop. They require billions of dollars in capital expenditure before they earn one dollar of revenue. Such a large upfront capital commitment requires a high (and stable) price to see the project through from start to finish. As soon as the price falters, only the genuinely low cost, high quality projects remain.
Gittins provides soothing words that Australia’s terms of trade will remain 50% above the long term average by 2019. We’ll bet that forecast is almost certainly wrong. That’s because the Treasury economists, like Gittins, are all Keynesians. They don’t understand the nature of credit booms and busts.
Iron ore prices got completely out of hand because China had a massive property boom. According to the Peterson Institute’s China Economic Watch,
‘Growth in residential real estate has been the key driver of economic growth over much of the past decade. This sector has grown unsustainably fast, reaching a point where China is investing 11 percent of GDP in residential real estate. Just for perspective, this is more than either the United States or Spain invested at the height of their housing bubbles. The housing sector must come back down to reality along with all the sectors (steel, cement, etc.) that have grown unsustainably alongside it.
‘NBS [the National Bureau of Statistics – ed] releases a monthly series on resident real estate investment. Investment growth has moderated significantly since last year when it was growing 35 percent year on year. Despite having fallen to the low double digits, investment continues to grow faster than GDP. Thus residential real estate investment is continuing to grow as a share of GDP.’
That’s not exactly what China’s central planners want to see. They want to rebalance away from steel intensive property and infrastructure and promote internal consumption. They’re not going to do that by lowering interest rates and encouraging further property market speculation.
The bottom line is that demand for steel will continue to slow. With a big jump in iron ore supply forecast in 2013/14 from the three global majors (BHP, Rio and Vale) we think prices will struggle to stay above US$100.
But the biggest issue we have with Gittins’ interpretation of China’s and Asia’s rise is the effect on Australia. He seems to think we’re well placed. Next up is an agricultural boom followed by a growing demand for ‘better services, goods and experiences.’
But here’s the unpleasant thing to think about. Despite Gittins’ claims, the boom hasn’t made us wealthier. We’re still running trade deficits (to the tune of $2billion last quarter) and still have a nearly $900 billion credit bill from the rest of the world. It costs us around $40 billion a year just to service the interest on that bill.
The commodity boom hasn’t stopped Australia relying on the kindness of strangers to maintain our standard of living. It hasn’t stopped us from being a nation of ‘net consumers’…we consume more than we produce and have done so since the 1970s.
What happens when Asia ‘rises’ and decides to consume the capital it has for years been lending to Australia? The rise of Asia will indeed be a profound event. But it will come with changing trade and capital flows. Instead of lending to ‘wealthy’ countries like Australia, these newly wealthy countries will probably find better things to do with their savings, like spend it on themselves.
Yes, Australia will still be exporting iron ore from the Pilbara, coal and gas from Queensland and wheat and other grains from southern WA. But whether Asia will keep lending so we can consume more than we produce is another matter entirely, and it’s one that our economic commentators don’t seem to get.
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