The only good thing about economic ‘tough times’ (we ain’t seen nothing yet) is that a pragmatic nation starts talking about fixing things that, if left alone, will get out of hand…like the budget deficit. In this light it’s certainly a good thing that Australia is now having a semi-adult debate about the unsustainability of the current structure of its tax system.
That is, it has many more long term spending commitments than it does revenue generating abilities. Instead of being brain dead and looking for ways to simply tax more, which ends up killing the Australian economy and making the situation worse, the government is at least talking about long term reform.
Of course, doing something sensible is another matter. Yesterday, the Federal Government’s audit commission released a report which contained 86 proposals designed to slash spending by $60 billion to $70 billion by 2023/24.
Realistically, the government will only adopt a handful of those proposals. The electoral cycle is too short, and people are too resistant to change, for wholesale transformations. But at least there’s a conversation starting, and it’s not all head in the sand stuff.
Probably the biggest areas of immediate change will come from pension and health reform. If the upcoming budget can add a bit of decent tax reform there could just be a bit of hope for Australia’s long term fiscal position! (BTW, so far, this is the most hopeful Markets and Money you’ve probably read in a while…having faith in elected politicians to make effective long term decisions is foolish and naïve).
So let’s get back to reality. The elephant (or panda) in the room in all this is out of our control. It’s China’s economy. The Middle Kingdom still has the biggest influence on Australia’s tax revenue base through its impact on the terms of trade (ToT). The terms of trade effectively measures the purchasing power of our exports relative to our imports. When the ToT is high, our export purchasing power is strong, meaning we can buy a greater amount of imported goods for a given amount of exports. And vice versa.
As you can see in the chart below, the ToT started rising in the early 2000s and has been hovering around historic highs for the past five or six years. In other words, the purchasing power of our exports (relative to the cost of our imports) has never been higher.
The ToT has a direct effect on national income growth, which is crucial for the government’s forecasted tax take. When it’s rising, so do incomes, which of course the government takes a piece of. This is why the ToT matters for the budget. Get the forecast wrong and your revenues disappear.
Of course, the decade plus long ToT boom has been all thanks to China. In order to maintain control over its economy and people, China’s central planners mandated a growth path like no other nation in history. Growth came at the expense of profits. And that growth needed vast amounts of resources, specifically iron ore.
Part of China’s growth model was to build build build. It engineered a property boom and seemingly everyone got in on it. But as China’s nominal GDP growth begins to slow sharply (and it is), it’s starting to expose China’s Ponzi economy.
Yesterday, the Sinocism website revealed private comments made by the Vice Chairman and CEO of China’s largest property developer, Vanke. His comments, among many other things, reveal that there is genuine demand (consumption driven, as opposed to investment driven) for property at prices well below the current ‘market’ level, while demand dries up at higher prices:
‘90% demand in BJ’s [Beijing] transactions now is consumption driven. Per request by government, Vanke has launched some property projects in BJ at lower prices ~22K rmb/sqm regardless of the potential financial losses. All units were sold out in 4 hours since the prices were set lower than market price to accommodate consumption driven home buyers.
‘If prices were set at 28K-29K rmb/sqm, buyers would immediately drop, and if priced at 30K rmb/sqm, buyers will drop more.
‘In 27 key cities, ASP [asking prices] dropped 13%, 21%, 30% yoy in March y-y respectively.
‘We expect the trend to continue in April. Credit tightening from the banks and customer’s sentiment towards the economy are the drivers.
‘Most cities have witnessed an increase in inventory-sale ratios for residential buildings. Among the 27 key cities we surveyed, more than 21 cities have day sale of inventory (DSI) exceeding 12 months, among which 9 have DSI greater than 24 months.
‘Supply of residential buildings is rapidly increasing m-o-m but transaction volume remains low.’
In other words, the capitalised value of the land is too high to generate sustainable demand. This has implications for banks and property developers’ balance sheets. That is, their assets are far too high. But you’re not going to see wholesale writedowns in China or honest recognition of overvalued assets. It would destroy most of the banks’ equity and pose too great a risk for a fragile financial system.
It will more than likely happen at a much slower pace. This would avoid a financial panic (hopefully) but it would also lock China’s economy into a much lower growth future, potentially in the same way that Japan went after its late 1980s property bubble.
Japan also failed to recognise and writedown its bad debts, and so they festered in the banking system for years. This blocked the process of capital reallocation, which is crucial to genuine and robust economic recovery.
Anyway, there were a few comments from Vanke’s chief that should be very worrying for Australian iron ore miners and our government. That’s because property development accounts for the lion’s share of steel demand in China.
‘Overall I believe that China has reached its capacity limit for new constructions of residential projects. Only those coastal T3/T4 cities have potential for capacity expansion. We consider it highly unlikely to see housing price surge, especially in the cities with large housing inventory. BJ and SH have already been listed in the most expensive cities for property prices.’
If property prices and construction have peaked in China, then it’s going to be hard for steel demand to increase from current levels, no matter how many more railways or airports local governments promise to build. That means demand for iron ore will be weak too.
In the meantime, the major iron ore miners around the world (BHP, Rio, Fortescue and Vale) are all ramping up production. The market will be in oversupply in 2015, meaning you should expect to see prices continuing to trend down over the next few years. We’ve been calling for US$80 iron ore prices for a while now and we expect they will probably hit that level by early next year.
BHP and Rio can easily handle that price, although their profitability (and share prices) will be much lower than they are now. Fortescue will get by too, but it won’t do so with a $16 billion market capitalisation (around current market value).
That’s why we recommended our subscribers ‘short’ the stock some time ago. Like the iron ore price, we think Fortescue’s share price is headed much lower. That won’t be good for shareholders, but the broader implications won’t be good for Australia’s efforts to bring its structural budget problems into line.
There’s always hope though…
for The Markets and Money Australia