Over the past several months we’ve built on several narratives out of China certainly not the least of which is the idea that economic growth in the country is decelerating quickly at a time when accelerating capital outflows make devaluation an unpalatable (if inevitable) proposition. Signs of a dramatic slowdown were on full display earlier this month when GDP growth slipped to 7%, the slowest pace in six years, while key indicators such as rail freight volume have fallen completely off a cliff:
With the country’s tough transition to a service-based economy being made all the more difficult by the hit industrial production will likely take as Beijing ramps up efforts to fight a pollution problem that was thrust back into the spotlight early last month thanks to a viral documentary, it’s reasonable to suspect we’ll be seeing a lot more of the idle cranes, empty construction sites, and half-finished abandoned buildings that greeted Bloomberg metals analyst Kenneth Hoffman who returned from a tour of the country earlier this month. Ultimately, Hoffman’s assessment was that metals demand in China is collapsing and isn’t likely to pick back up for the foreseeable future.
This is bad news for the Chinese economic machine and it’s also bad news for any iron ore miner out there whose marginal costs aren’t low enough to stay profitable in the face of a protracted downturn in prices because if you can’t convince the big guys that your price collusion idea will pass regulatory muster, well, they’ll likely take the opportunity to keep right on producing despite the slump and run you out of business. With the stage thus set, we bring you the following from BNP who explains why iron ore prices aren’t likely to rebound any time soon, and why the economic outlook for China is indeed “as bad as the data looks, if not worse” (to quote Mr. Hoffman).
Global commodity prices have fallen sharply since last summer, dragged down by a cocktail of fading Chinese industrial demand, surging supply and a strong USD. Oil has inevitably garnered the majority of headlines but iron ore prices have fallen even further. Iron ore prices have collapsed by close to 50% since last July and over 65% since the beginning of 2014. Falls have accelerated in recent weeks, almost becoming a rout, with prices down over 30% year-to-date.
The analogue of China’s unprecedented construction bonanza has been extraordinary levels of both cement and steel production and consumption. We have documented the epic nature of the former with China incredibly producing more than twice as much cement in the last five years than the United States managed in the previous century (China: Cementing The Bear Case).
The increases in China’s steel production and consumption post-GFC have been almost as, but inevitably not quite, so spectacular. Since the end of 2007, China’s steel production has leapt by over 300 million tonnes while production in the rest of the world has slightly slipped. As will be discussed below, China’s steel production has started to flatten out over the last 12-15 months but, at around 810 million tons over the last year, China’s steel production has now accounted for 50% of total global production..
The surge in Chinese steel production has inevitably required a counterpart in much higher rates of global iron ore production. China’s own, typically low grade iron ore production, has not been able to keep pace with demand growth, meaning huge increases in demand for iron ore from the rest of the world. This demand has been fed largely by huge increases in Australian supply and, to a lesser extent, Brazil…
The collapse in iron ore prices over the last 15 months or so reflects the interplay of a levelling off in Chinese demand in 2014 for the first time since the GFC and, given the inevitably long lags between investment decision and output, continued strong gains in global supply. Our calculations suggest that China’s apparent steel use grew by less than 3% in 2014; slower than even 2008’s 4% growth (Chart 5). The latest industrial production data suggest that downward pressure has intensified in the final months of 2014 and early 2015 with crude steel production down -1.5% y/y on average in January and February.
On the supply side, optimistic assumptions over the potential for Chinese steel demand growth to continue strongly for the rest of the decade has led to steady increases in productive capacity which are forecast to come on line in the next few years. Australian iron ore production alone is expected to increase by a further 196 million tonnes between 2014 and 2018….
Even as the risks for global iron ore supply are strongly tilted to the upside for the time being, the outlook for Chinese demand, in contrast to optimistic forecasts of producers, is skewed heavily to the downside. The key downside risk is of course the prospect of a multi-year and deep correction in real estate investment. Given the epic nature of the ‘stock’ and ‘flow’ adjustment that China’s real estate market faces, the best case scenario is probably that real estate investment (c.151?2% of GDP), bolstered by considerable policy support, could achieve a soft landing with zero growth over the next 2-3 years…
The worst case is that increasingly entrenched deflationary dynamics and the unprecedented weight of excess supply (the value of unfinished real estate projects at market prices reached a mind-boggling 75% of GDP in 2014) mean the real estate sector is relatively impervious to stimulus and real estate investment likely to fall sharply for several years.
Another critical dimension is China’s increasingly unsustainable levels of air pollution which is generating mounting political pressure for sharp reductions in steel, cement and, of course, coal output. As with the real estate sector, the best that can be said is that China’s pollution problem has perhaps stopped getting worse over the last year. The tough decisions and the real economic pain continue to lie ahead, however, with some estimates finding that China’s industrial production might need to fall by as much as 40% to meet global pollution standards.
As a reminder, here’s the graphic on the relationship between industrial production and efforts to remedy the country’s pollution problem:
China’s domestic steel prices have fallen to near record discount of c.25% vs. global prices. Meanwhile, China’s steel exports have soared by over 40 million tonnes over the last year; easily the biggest annual gain on record with growth of nearly 60%…
Chinese producers have been able to slash steel export prices (which appear to follow domestic prices with a lag of about five months) as the collapse in iron ore prices is (temporarily) boosting margins…
As already emphasized, there appears to be little to interrupt these strongly deflationary dynamics any time soon. With the large iron ore producers likely to keep increasing supply until prices fall to close to their estimated marginal cost of $35 per tonne, further falls in iron prices look inevitable. China’s continuing real estate correction and anti-pollution drive will continue to weigh on domestic demand although sharp reductions in domestic output ultimately required are likely to continue to be resisted in the short term by the authorities given their high cost in terms of output and employment. Domestic steel prices should fall sharply while China’s steel exports look set to continue soaring, procuring further strong downward pressure on global prices…
And that, ladies and gentlemen, is the decisively precarious situation that Beijing finds itself in as China attempts to project its economic and military prowess to the rest of the world. Call it the growing pains of a rising superpower, but don’t call it an enviable position and don’t be surprised to discover that contrary to what the Ministry of Finance steadfastly proclaims, there may indeed be such a thing as Chinese QE.