The End of the China Steel Trade
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Australia has been insulated from the woes that have plagued other developed economies, because the commodity boom in China masked any unsustainable domestic fiscal policies. Australian base commodity producers have been in the right place at the right time to feed the voracious appetite of a Chinese economy growing fat on the excesses of U.S. fiscal and monetary policy. However, these days are coming to an abrupt end, as Chinese demand for Australian iron ore and coal has fallen of the proverbial fiscal cliff.
Australia has provided a relatively cheap and reliable source of raw materials for Chinese heavy industry, including iron ore and coking coal. In recent years, it supplied nearly half of Chinese import demand. Australian exports to China formed the dominant bilateral relationship in world iron ore trade by 2010.
Between the collapse in 62% iron ore prices, and a 22% drop in the price of coking coal since the beginning of July, we are witnessing the end of the big Chinese steel trade. Add in a drop in the Baltic Dry Index back to December 2011 levels -- when it dropped 70% in two weeks -- and we have a number of leading indicators warning of an imminent collapse in global trade. On Tuesday, FedEx (NYSE: FDX) guided lower revenue and earnings for the upcoming year as well.
There are a number of factors that are playing into this, but none of them bode well for miners like BHP Billiton (NYSE: BHP), who announced at their recent earnings statement that they would be mothballing three major iron mining projects on abysmally weak demand. Brazil’s Vale Mining (NYSE: VALE) announced similarly bad earnings and demand numbers across the board for industrial metals.
The limit of mercantilism
The debt situation in Europe and the U.S. is beginning to reach its zenith, and has finally caught up with China’s unbalanced growth strategy. China played the mercantilist growth card for all it was worth, I believe, for far longer than they originally intended and have built far more infrastructure than they ever intended, but the U.S. and Europe kept buying on credit. So the Chinese smartly kept selling to them, even though China knew that eventually, the U.S. and EU had to stop paying.
But now we’ve reached the end of that game. China has all the skyscrapers and phantom towns it needs, along with a massive iron and copper strategic reserve. Demand for Chinese goods is finally beginning to languish in the West so the leaders there have begun shifting China’s economy away from industrial production, cutting production targets for iron and steel, which has driven marginal demand for iron ore through the floor as miners finally ramped up production to meet last year’s demand.
It’s a classic boom/bust cycle, engendered by zero-interest rate policies shifting the structure of production out in time Western central banks desperate to save an insolvent banking system from collapse after Lehman Bros. Now we’re staring at the same situation with the banks in Europe, and U.S. banks such as JPMorgan Chase’s and Goldman Sachs (NYSE: GS) having significant exposure to the debt there.
The weaker demand for steel in China has its roots in monetary policy as well, as the PBoC has been attempting to engineer a soft landing in their real estate markets through the manipulation of every aspect of their interest rate system. Unfortunately, they are caught now between rapidly rising food prices and slowing international demand for everything. Those looking for China to save the world economy better keep looking because for the time being that’s not going to happen.
Moreover, former levels of Chinese demand for steel are never coming back. The industry is going to suffer under an over-capacity problem for a long time. This bodes well for other emerging markets which are just beginning to hit the exponential portion of their growth curve and had been priced out of the market due to the ridiculous Chinese demand. This is not to say that China will not be demanding steel in the future; they just will not be demanding it at $180-per-tonne constant currency basis.
The Aussie set for losses
The Australian dollar has been in a huge bull market since the collapse of Lehman Bros., trading off the back of China reflating the world economy one last time. But the Aussie has reached its limit as a safe-haven trade during this summer’s Eurozone crisis, and has fallen sharply in recent weeks as huge drops in its strongest exports cannot be ignored forever. Moreover, cheaper supplies are entering the market from places like Mongolia (coal) and Brazil (iron ore). Brazilian ore has become more attractive than even China’s domestic supply, despite the 8,000-mile supply line.
Mongolia boasts the world’s largest coal reserve, estimated to be enough to meet China’s needs for the next 50 years. Mongolian coking coal, used in steelmaking, is some $25 cheaper per tonne than coal sourced from overseas. Mongolia now supplies 44% of China’s imported coking, versus Australia’s 22%. The Australian Dollar cannot weaken enough to overcome this price advantage.
The CurrencyShares Australian Dollar ETF (NYSEMKT: FXA) has backed away from its all-time high in sympathy with the crash in iron ore prices. If the RBA resists the siren’s call of cheap exports and holds interest rates it will mean a recession in Australia, so expect them to lower interest rates, which means the yield and the price of FXA are at heavy risk to investors.
The question is not whether this is a short-lived bump in the road for Australia’s currency and economy. The big question is, will the fall in iron ore prices shift demand significantly and quickly enough to keep the coal and iron flowing around the region, and prevent the Australian economy from imploding?
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