Australia’s iron ore miners are still hoping the slowdown in China’s steel demand is cyclical rather than structural. As Andrew “Twiggy” Forrest, the founder of Australia’s third biggest iron ore miner Fortescue Metals, reminded an audience in Melbourne last June, “a bet against China is the only guarantee of loss I’ve seen for a long time.”
When Forrest made that comment, iron ore prices were hovering around $100 per metric ton. By the end of last week, however, the spot price had tumbled to $55. All but the largest two miners – BHP and Rio Tinto – are almost certainly operating in the red, and heavily in debt after taking advantage of favorable credit markets in recent years. But the miners are continuing to insist the plunge in the price of iron ore is merely cyclical, and Chinese urbanization will eventually boost prices back beyond $100 within a year or two. Keep the faith in China, and all will be right is the message.
American author Upton Sinclair once said it is difficult to get a man to understand something, when his salary depends on his not understanding it. That quote seems apt for the blind consensus amongst Australian miners and their shareholders, and for some time, a government dependent on tax revenues from the commodity boom, is that Chinese urbanization would drive an inter-generational steel production boom. But the reality is shaping up to be something different. For even if China hits its official growth targets over the next couple of years, it won’t be driven by fixed investment, which means the good fortune for Australian iron ore miners, and its China-dependent economy more broadly, is over.
Australian miners are looking to similarities in the history of China’s neighbors to make their case. As the argument goes, China’s per capita income level is still only 21% of what the U.S. had back in 2008, which roughly reflects Japan’s position in 1951, Singapore’s in 1967, Taiwan’s in 1975 and South Korea’s in 1977. The implication is that China’s rapid fixed-investment growth years are far from over, and will continue to support the country’s high steel demand amid a rapidly urbanizing society.
There are several problems with this argument. First, China has done things in reverse order to these successful East Asian neighbors. For those countries, fixed investment took off only after they had reached around a quarter of GDP per capita levels of advanced economies, like the U.S.
China’s development followed a different path. Even when it was still a poor country, with GDP per capita levels at just one-tenth that of the U.S., it embarked on a huge fixed investment splurge. In the 1980s, fixed investment as a proportion of GDP was already around 30% of GDP, rising to just under 40% by the late 1990s, and about 45% during the middle of the last decade.
Moreover, China’s fixed investment not only began earlier but it also grew to higher levels than those seen in Japan, Taiwan, South Korea and Singapore. During each of their periods of rapid industrialization in the 1950s, ’60s and ’70s, fixed investment as a proportion of GDP was around 30%, and only for brief periods of several months did it reach 35%. China’s fixed investment as a proportion of GDP has now reached around 50% – unprecedented for any significant length of time for any economy in history. In fact, if we take the last decade during which China’s official GDP increased by around 162%, 135% can be attributed entirely to additional capital inputs, according to World Bank figures.
But miners will still insist that rapid Chinese urbanization continues and the pure numbers of people moving from the countryside to cities over the next couple of decades equates to an upswing in the future demand for steel.
This argument might be more credible, though, if we were to find that Chinese steel demand in the recent past was primarily driven by urbanization, but the record suggests that something else has been at work here.
From 1980 to 1995, genuine urbanization increased more rapidly than it did from 1995 to 2012. In that first period, crude steel production in China increased by about 5% each year. Yet, from 1998 to 2012, crude steel production growth rates soared to about 18% per annum, and steel production doubled from 2008 to 2012.
The point is that Chinese steel demand bears little historical correlation with urbanization, so the latter cannot be the impetus for a large increase in demand for iron ore from this century onwards. When exports dramatically declined around the time of the financial crisis in 2008, Beijing responded with the largest fixed investment stimulus in economic history by demanding that the state-controlled banking sector pump the economy with credit. Whereas fixed investment contributed 20% to 25% of GDP growth in the 1990s, it was behind 55% of growth in 2007 and 90% in 2009. With dollar signs in their eyes, this 2008-09 period became the ‘new normal’ as far as Australian miners were concerned.
Economics tells us time and again that economic growth based on expansion of (capital) inputs, rather than on growth per unit of input, is inevitably subject to diminishing returns. It could be that China has a way to defy the laws of economics, although the reality is that economic gravity is already having an effect. After all, the amount of capital input needed to produce one additional dollar of output (the capital-output ratio) increased from 2:1 in the 1980s to about 4:1 in the 1990s, and was well over 5:1 in 2011, according to OECD figures. At the end of 2014, the ratio was almost 6:1.
The bottom line for Australian miners, and the wider economy that fed off the resources boom, could well be an ugly one. For the best part of this century, and with its terms of trade (the prices it gets for its exports divided by the prices for imports) more than twice as high as its hundred year historical average, Australians believed their sure-fire path to prosperity was to continue hitching a ride on China’s coattails by exploiting the country’s abundance of natural resources. And while that certainly helped “the lucky country” to avoid the worst of the global financial crisis, it’s now at risk of coming down with a case of so-called Dutch disease. That is, when the commodity boom runs out, other industries struggle to sustain the economy, having been weakened by years of an appreciating currency. In the first half of the last century, Australia rose on “the sheep’s back” as rising wool prices helped the country become one of the richest in the world. Unfortunately, it is unlikely that iron ore can carry that burden for Australia in the early part of this century.