Overview

China’s remarkable economic achievement during the past three decades has stirred up fascination all around the world. Australia, with a population of around 24 million people and a US$1,500 billion GDP, has increased bilateral trade with China by 10 times from 2000 to 2013. In 2013, China remained Australia’s top trading partner, with two-way trade valued at A$151 billion, accounting for 23.3% of Australia’s total trade. Japan (A$71 billion) and the United States (A$55 billion) followed China, accounting for 11% and 8.5% of Australia’s total trade respectively. The relationship is so close that Australia and China are even working on a Free Trade Agreement (FTA), although negotiations have been dragging on since 2005.

China: Australia’s key partner

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Not surprisingly, Sino-Australian bilateral trade has continuously increased since China’s opening up policy in 1978. However, it has significantly picked up starting from the end of 2008, driven by the massive 4 trillion Yuan stimulus package that China launched to counter the 2008 Great Financial Crisis. This measure mainly focused on public infrastructure and real estate, both commodity hungry industries, and as a result Australia saw its exports of iron ore, coal and copper boom. As the chart above shows (monthly data), Australia has experienced a trade deficit with China for every single month between 2000 and 2009, when Australian exports to China increased by 120% and recorded a growing trade surplus.

Most of this trade increase has been driven by hard commodities related to infrastructure or real estate building, including iron ore. China is the largest producer of iron ore, accounting for about 45% of the world production, yet for a mix a reasons including quality issues, convenience and a rapidly growing demand, imports of iron ore boomed, with the bulk share coming from Australia. As of 2013, some 38% of iron ore consumption in China was from imported sources, although consumptions numbers may be distorted because of over-stocking.

iron ore production

chinas gdp iron oreThe chart above indicates a strong correlation between China’s GDP and iron ore price. Indeed, starting from 2004, China’s growth has been mostly driven by fixed assets investment (especially real estate and public infrastructure) which account for around 40-50% of China’s GDP. The real estate sector is thus accounting for a significant share of commodities consumption in China, as shown on the graph above. Commodities prices have thus been increasingly rapidly, and iron ore reached an annual average price of $160 per ton in 2011, up from $40 per ton in 2007. It is important to note that the iron ore price above is computed as the annual average price, and thus doesn’t accurately reflect the current conditions: iron is now trading at around $80/ton.

As a result of rapidly rising prices, many metals and mining producers have expanded production capacity and opened new fields, previously not exploited because they required high production costs compared to the relatively lower commodity price. However, the falling iron prices have significantly decreased profits for producers, some of them having to shut down production or even leave the market.

For a country like Australia, commodities prices are critical. Indeed, iron ore account for 55% of Australian export value to China, and some 67% of all metals exported to China. With China’s economic growth slowing down, its real estate under pressure, and commodities prices down as a result, Australia is facing a ‘perfect storm’: massive oversupply of products dependent on high commodity prices with a rapidly dwindling demand. How Australia manages this downturn remains to be seen.

What to expect for the Australian mining industry?

The ‘perfect storm’ of oversupply and dwindling demand has put heavy pressure on mining companies, who are forced to drastically reduce costs in order to make ends meet. However, the large companies, who are more financially flexible, have been increasing their supply in order to drag the prices further down and forcing the less competitive firms to leave the market. This tactic is obviously risky should some government intervene to support the weakest companies (e.g. China). Inded, the Chinese government may not be willing to let domestic companies fail because of the resulting unemployment and potential social unrest (not to mention a growing dependence on imports).

The consequences of this continuous increase in supply coupled with a weak and irregular demand will be straightforward: iron ore prices could plummet to $50 metric ton or even less (a prediction notably supported by Michael Pettis since 2011). While lower commodity prices will reduce the pressure on the importers around the world, the large iron ore exporters (mainly Australia and Brazil) will be left with massive oversupply and financially distressed companies.

The Chinese rebalancing toward more household consumption as a motor of growth, away from exports and fixed assets investments, may be Australia’s worst nightmare. Indeed, metals represent more than 80% of Australia’s exports value to China. This huge reliance on metals exports does not seem sustainable should China engage in a serious rebalancing process, because no other commodity, goods or services are expected to replace the potential huge decline in metals exports. Food products, which are becoming a rising concern for the Chinese government, are only accounting for 3.4% of Australian exports to China, and are already under pressure internally (due to global warming) and in China, where cheap products are undermining local companies.

Last but not least, if Australia’s metals exportation to China drop significantly, it could lose its trade surplus with China and become a trade deficit, which would eventually put pressure on the Australian government finance.metals share of australia x

Other products, such as energy (especially coal in the case of Australia) are not a solution either. China’s domestic coal industry is under tremendous pressure because of oversupply and lower demand, which may have triggered the recent bill on duty for imported coal. According to Reuters:

The coal resource tax range will be between 2 percent and 10 percent, with the specific tax rates to be set by provincial-level finance departments within the above mentioned range” the Ministry of Finance said in a statement posted to its website.

Coal containing a specified amount of sulphur and ash will be subject to the tax. This implies that the lower quality Chinese coal will be more protected against its foreign counterparts, although the Indonesian coal companies apparently won’t be affected by this new duty. On the long run, the Chinese coal industry will still be under pressure due to the fight against smog in Chinese cities.

But this move, even domestically justified, may endanger the future Free Trade Agreement with China: Australia is one of the largest exporter of coal in the world, and China is Australia’s second largest export destination for coal fuel after Japan, accounting for around 25% in value and volume. Negotiations about the FTA, which have been dragging for close to 9 years, are likely to be further hampered. When national interest comes first, reaching a common ground becomes very challenging.

Conclusion

After having enjoyed a trade surplus with China for half a decade (note that few countries have a trade surplus with China), Australia’s exports to China might have reached an inflection point, with rapidly slowing demand and massive oversupply severely pressuring commodity prices. China’s slowdown is directly affecting Australia’s economy, and there are no potential large customers waiting in line. In fact, the Chinese slow down may hurt other Australian clients, especially South Korea and Japan who have close trade relationships with the Middle Kingdom.

Driven by a fast rising demand from China, the Australian commodity sector has boomed and steadily transformed the country’s internal economics, pushing up the value of the Australian Dollar and crowding out other industries. Given the current world economic outlook, commodities prices are not likely to come back to their highs before long. After years of fast growth, Australia also needs to rebalance its economy and find new growth engines.

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.