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Tougher future for iron ore miners as China economy restructures

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John Robertson

Tougher future for iron ore miners as China economy restructures

The more successful China is at reforming its economy to put it on a stable growth path, the tougher it will be for Australian miners to find a home for their product.

Extrapolating past economic trends offers a reassuring backdrop for the Australian mining industry and also for those in government, elected and unelected, who have counted on growing Chinese raw material demand to fill the fiscal coffers.

Chinese steel production increased from 127 million tonnes in 2000 to 683 million tonnes in 2011. A repeat of that rate of growth would result in a fivefold rise in Chinese steel production by 2020 and production in a single year equivalent to all the steel produced in China over the 25 years to 2005.

This sort of extrapolated growth prompted former U.S. presidential economic adviser Herbert Stein to enunciate what has become known as Stein's law: if something cannot go on forever, it will stop.

The ongoing volume of China's steel needs will largely be a function of the level of investment in plant and equipment, technical progress and the amount households will spend on consumer durables.

These influences are pulling in different directions. The new Chinese leadership seems committed to a reduction in the investment intensity of the Chinese economy. At the same time, it wants to beef up household living standards which will mean more emphasis on the purchase of consumer durables. Technical progress will cause lesser amounts of steel to be used in any given application.

In 2011, gross fixed capital formation contributed approximately 46% of Chinese GDP. In the USA, nonresidential private fixed investment accounts for just 10% of GDP. US private consumption spending, including 9% for consumer durables, makes up 71% of GDP. This is twice the 35% contribution of private consumption in the Chinese economy.

The investment intensity of the Chinese economy had been as low as 25% in the mid 1980s and around 35% at the turn of the century. While some of the more recently elevated levels of investment were planned, a significant contribution has also come from efforts to stimulate economic activity after the threat of a global financial crisis in 2008.

The steel intensity of Chinese investment spending increased by 60% in the decade after 2000. The amount of steel required for a unit of investment in the years ahead is likely to be lower than in 2006-07 and closer to the 2002-03 rates of steel usage. Chinese officials are much more sensitive to allegations of wastage. Higher iron ore prices have also constrained the application of steel. Weakening demand for Chinese consumer and capital goods from offshore advanced economies will also have taken its toll.

As well as a lesser emphasis on investment spending, overall growth rates are also likely to have declined permanently. Short term consumption growth supported by a policy of accelerated wage increases will likely moderate as potential inflation pressures loom larger and Chinese industry suffers a clearer loss of competitive advantage. Growth rates of 7-8% moving toward 5-6% closer to 2020 might be consistent with the policies being presented by the new leadership.

On that set of assumptions, steel production in 2016 could be about 5% higher than in 2012 but would start to decline thereafter leaving it at around 2012 levels in 2020. In this circumstance, miners should be assuming that Chinese demand is, for all practical purposes, near its peak. This scenario suggests little scope for iron ore mine expansions.

There could be upside if Chinese policymakers decide to maintain the share of investment spending in GDP where it has been in the past two years. That would be an unambiguous shot in the arm for the mining industry. Within the analytical framework described here, steel production could be about 50% higher in 2020 than in 2012 providing ample scope for continuing expansions of iron ore mining capacity.

This latter scenario is unlikely but worthwhile considering simply to illustrate the extent to which the industry will be hanging on the short term policy settings of the Chinese government for the remainder of the current decade.

With the unshackling of market forces in the 1990s and further market reforms in the past decade, Chinese economic outcomes have been, to a large extent, taken out of the hands of bureaucrats. The planners in Beijing might have been able to moderate the effects at the margin but the underlying growth momentum came from the release of pent up economic and social forces over which they had little control once unleashed.

Fine tuning the Chinese economy will likely become a more prominent feature of the economic discourse and a far more crucial determinant of the demand for raw materials.

This change will mean greater uncertainty for the mining industry whose planning horizons will become increasingly aligned to the next decision by Xi Jinping and his leadership group about the economic outlook for the coming few quarters.

In this sense, China is likely to become more like a western economy. There will also be implications for the investment attractiveness of the major iron ore producers whose earnings are likely to become increasingly volatile and far less predictable than they once might have been.

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