Is Chinese iron ore demand going to crash (thereby crashing the Australian economy)?

September 12th, 2010

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Last Thursday, an article in the Sydney Morning Herald screamed, Slump likely in iron ore demand,

Chinese demand for iron ore seems set to slump after Beijing’s extraordinary move to turn off the power supply to its industrial heartlands.

There seemed to be fears in the industry that the Chinese government is slamming on the brakes on their economy. As the article continued,

Radical power cuts across the country reflect the promise of the Premier, Wen Jiabao, to use an "iron fist" to achieve tough, five-year energy intensity targets that expire this year.

There seemed to be an air of incredulity floating around. Is the Chinese government really hell-bent in crashing their own economy? As one of Macquarie Bank?s commodities analyst said,

You can’t just turn steel production off and expect the economy to function – it’s insane.

If the Chinese government are really that insane, then it doesn?t take a genius to figure out that iron ore prices will slump significantly going forward. Share prices of companies like BHP will follow as well.

But are they really that insane?

To answer this question, we recalled a comment by one of our readers (Paul in Beijing) in Concerns about China?s slowdown,

Put this in your diary. The restrictions will last until November. By December this year, production of key items such as steel and cement will be returning to full pelt.

As Paul said in Do you think China will crash soon?, we are now at the final months of China?s 11th five-year plans.

The first is that the 11th 5-year plan is now just a few months away from concluding. As in all political situations, it is of paramount importance for the current leadership to return an unblemished report card at the next Plenary meeting of the Communist Party. Hence the attacks on inflation, energy intensity and other issues.

What we think has happened is that on the issue of emission targets, the Chinese government realised that they were not going to reach it at that rate it was going. They had a set of numbers for the targets to reach by the end of this year and they realised that they weren?t going achieve that based on the status quo. Hence, the urgency to slam on the brakes so that at least where the aggregate numbers were concerned, they had done their job.

Why is it so important to reach the targeted numbers? Some say it?s a matter of saving face. That is, not reaching the targeted numbers is humiliating for the government. Others say it is a matter of having a perfect report card for the Hu-Wen team. That is, reaching the targeted numbers is another tick in their report card.

But assuming that by December, the restrictions are relaxed, the Australian economy is still not out of the hook yet. As Paul said,

The second point is that the 12th 5-year plan has not yet been promulgated. Already there are rumblings as to what it might include. The China Nonferrous Industry Association, for instance, has drafted a plan that would limit the capacity of alumina, aluminium and copper over the next 5 years. If such a plan were to be introduced, it would have massive repercussions for the world (buy UC Rusal shares for a start!).

In hand with this is the fact that the current leadership has only 18 months left in their tenure. The next generation of leaders has apparently been tapped and is being groomed. But unlike the present pair, the next generation come from opposite factions within the CPC. their ability to lead harmoniously may well be sorely tested! (Should they fall out, it would leave the Howard-Costello schism, or the Gillard-Rudd antagonism, for dead.

This is what we have to watch out for!

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  • Pete

    Great article CIJ.

    If you read this Paul, thanks for alerting us all to China’s 5 year plan.

    I wonder what will happen to Australia in the short-term?
    The Australian economy seems to be on a knife edge. Huge private debt and reliance on international investment (and sentiment/confidence) puts us at the mercy of good and bad news.

    The Australian dollar has rallied against strong GDP figures and a strong August growth report from China. But what happens next quarter, or the December quarter, when China’s factory shutdown(s) are factored in? Will it look like a complete mess for our resources sector? Will international investors suddenly take flight from Australia, not realising that the following quarter ‘may’ (depending on next 5 year plan) see an increase in ore demand from China?

    And if there is a flight from Australia, could that trigger or exaggerate local issues, such as deflation of the housing bubble? Once that starts, it would take a serious effort (by the Govt. or RBA) to stop.

    My oz crash/slump prediction: Dec/Jan

  • Australia has put all the eggs in the China basket. The problem is, we are not watching the China basket close enough