Will Chinese economic pick-up save Australia?

May 10th, 2009

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Recently, one of our readers wrote in to ask,

I wonder if you could share your views on the short and long term impact of the current economic circumstances on major mines such as Roxby Downs in SA, which has the world’s largest deposit of uranium oxide, copper, gold and silver.  There still seems to be conjecture as to whether the major expansion of that particular mine will proceed, of which much  reliance on the local economy has been placed.  In recent times, many staff have been laid off due to the cut in production.

Do you feel there will be any circumstances which will see mines like this one pick up again, and what timeframe may this occur?  I have read previous comments that China will begin stockpiling commodities again  now that the prices are low, however I also read yesterday that their economy has been shrinking at a rapid rate of recent times.

I also know several people who own investment properties in mining  towns.  Do you think it could be wise for those people to get out while they can, or is the medium-long term picture rosy for mining town economies?

First, we must again stress that we are not providing investment advice here. Thus, we cannot advice whether this stock or that property in whatever village is a good investment or not. All we provide here are general opinions.

Now, back to our reader’s question. Essentially, this query was about when and whether China will restore itself to the gangbusters economic growth of 2007 to restart the commodities boom again. That in turn will provide hope for Australia’s economy to recover sooner.Let us take a look at base metal prices below:

5 Year GFMS Base Metal Index

As you can see, base metal prices made a double peak in 2007 and the first half of 2008. Then it crashed to a record low in around January 2009 before making a slight recovery since then.

The first question to ask ourselves is this: When prices hit the record highs in 2007/2008, were they primarily driven by real demand from China or by speculative forces? This question reminds us of an article (“Who is to blame for surging food and oil prices?”) we wrote 12 months ago,

So, let?s say a passer-by told you that petrol price had doubled more than 2 ½ times over the past 2 years, would you laugh at the passer-by? ?Yeah right!? you may say. ?Where?s the queue and rationing??

The crash of 2008 makes it clear that it was speculative forces (abetted by monetary inflation) that drove prices to such bubbly high levels. But isn’t China going to grow to a super power and thus, require colossal amount of commodities? As we wrote 14 months ago in “Example of a secular trend- commodities and the upcoming rise of a potential superpower”,

Armed with the understanding from our previous article, Understanding secular vs cyclical, you can see that the rise of China (and India, Russia, etc) that we just described is a secular trend. Thus, the demand for commodities that supports this secular trend must also follow a secular trend too.

But does that automatically mean that commodity prices will go up and up for ever and ever for a very long period of time? From the short-term bubble in metal prices in 2006, it is obvious that there are many speculators who misapplied the commodity super-cycle theory to the extreme.

Sure, commodity prices can even correct 50% in the short to medium term, but do not let the cyclical sub-trends cloud your understanding of the underlying secular trend.

Let’s take a look at Australia. There is no doubt that Australia benefited greatly from the lead up to the bubbly prices of 2007/2008. The bubbly prices brought in huge amount of revenue for Australia’s mining companies. So, property in mining towns sky-rocketed. But that new found prosperity had a dark side- debt. Many mining companies borrowed deeply to fund expansions and developments. In order for such high level of debt to be a winning strategy, the bubbly prices have to be maintained. The crash of 2008 exposed these debt-laden mining companies to be swimming naked (we wouldn’t name names here, but you know at least a couple of big names).

Sure, as we said before in “Example of a secular trend- commodities and the upcoming rise of a potential superpower” and “The Problem that can throw us back into the age of horse-drawn carriages”, the secular growth of giant nations like China and India will mean that the demand for the earth’s resources will have to grow tremendously over the decades.

One of the most important virtues required of an investor is patience. The secular growth of China/India will not occur overnight because it is a trend that will take decades to mature fully. The problem is that many investors/mining companies are so leveraged to the secular growth of China/India that the mighty boom has to occur overnight to make windfall gains. But, as we explained before in “Answer to quiz: error in long-term gearing,” if that does not happen, they can be wiped out in the interim,

The problem is that asset prices do not go up in a straight line. This is especially true if the investor bought the asset at bubble prices (e.g. before the panic of 2008). In the short-run, asset prices can suffer major correction. During bubble prices, when the risk of a major correction is at its highest and investors? optimism at its peak, applying this logical error on one?s investment can result in devastating losses. When the price correction occurs, losses are magnified and the investor?s equity can get wiped out. Then subsequently, when asset prices recover, the investor will not have the equity to take advantage of the upswing. Even if the investor has the equity to take advantage of the upswing, so much capital had already been lost that the overall return in nominal terms can still be negative.

Even if no leverage is involved, buying at bubbly prices will mean that your patience has to be tested significantly. So, the next question is, how long do we have to wait? As we wrote before (in January 2008) in “Can China really ?de-couple? from a US recession?

The needs of the Chinese consumption economy are different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built.

Also, consider the sober warning from a Chinese government economist at “China won’t see quick recovery: govt economist”,

Fan added that China still suffered from excess capacity in some industries, meaning that some obsolete production capacity should start to be phased out starting from this quarter, a process he said could take several years.

The process would be painful, but necessary, he said.

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