Last week brought one of those magical moments in Australian business media when a sweeping delusion was quickly agreed as the rightful consensus on a major story for the economy in the next 10 years. China reaffirmed its 7.5% growth target for the year ahead and so, it was declared, Australia was fine too, on the back of an ongoing boom in resources exports.
The truth was far less reassuring and is already showing up in the hard data emanating from China. Our Great and Powerful economic friend is embarking on an historic shift away from the economic drivers that have benefited Australia above all other countries.
While it is true that China reaffirmed its commitment to an “about 7.5%” growth target, scratch the surface and a different truth emerges, supported by four simple facts:
- Within 24 hours senior officials were fudging the figure to 7.2% — it is not a hard target;
- The planning meeting also affirmed a big fall in fixed-asset investment for the year ahead, from its current rate of 19.6% to 17.5% — that may not seem like much, but it is the lowest growth rate in the measure of GDP that most benefits Australia in 12 years, offset by higher consumption growth;
- The meeting recommitted to a “prudent” M2 growth target of 13%, the same level that is currently forcing the industrial economy to slow; and
- Beijing declared a “war on pollution”.
These four notions represent a concerted attack on one sector of the Chinese economy in particular: steel.
The Chinese steel sector is huge. It accounts for almost half of global steel production at 779 million tonnes of output in 2013. It has been one of the fastest-growing and most employment-intensive sectors in the Chinese economy for over a decade. Capping its growth will inherently hit China’s growth model harder than just about any other sector you could choose.
It is also the one sector that relies more than any other upon leverage for its former high growth rates. It is leverage that drives the building of China’s many uneconomic infrastructure projects, which need so much steel. It is leverage that drives its property boom, which needs so much steel. These two combined make up over half of China’s steel consumption. It is also leverage that has fuelled the expansion of the steel sector itself, and it is Ponzi leverage that allows it to continue to operate despite the collapsing margins owing to the oversupply.
And there is one more unique kind of leverage in the steel market. It takes steel to expand steel production. To build the mills, the mines, the railways, the ships, the trucks and the ports to feed steel manufacturing also takes masses of steel.
In short, Chinese steel is leverage upon leverage upon leverage upon leverage. It is a synthetic CDO cubed.
As you have probably guessed, steel is also one of the major contributors to Chinese pollution. This is especially the case in Hebei, China’s most steel-intensive province, producing roughly one-quarter of the nation’s output. But Hebei also has the misfortune of sitting adjacent to Beijing, so any “war on pollution” can’t overlook it. The government declared it would shut 15 million tonnes of production last week. It’s a drop in the ocean, but the intention is clear: there is no need to be more aggressive because the weakening economy already brought about by tightening credit has begun to rationalise steel production anyway.
So, contrary to reassuring Australian reporting, last week Chinese authorities in effect committed to a “war on steel”, which hardly bodes well for Australian iron ore prices — already falling precipitously — nor for coking coal, which is down 60% over several years and is still falling. This is especially the case since our major miners are still in the throes of a major ramp up of production for both.
But the fate of the Chinese steel sector cannot be entirely separated from that of the broader Chinese economy. An overly swift shakeout in the steel sector would drag Chinese growth below its target, which is rightly seen as at least one leg in the stool of legitimacy upon which the Communist government sits.
How long and how severe can we expect the Chinese steel shakeout to be? Most observers still see the Chinese steel sector growing this year. Australia’s sell-side analysts are almost unanimous that output will grow 3-5%. Most in China agree with the China Steel Industry Association, which sees similar growth and no peak in output until 850 million tonnes per annum is reached. Australia’s miners have planned their investments around the assumption that 1 billion tonnes will be needed by 2020.
“Australian mining equities, corporate profits, budget receipts and national income flows have planted their collective feet in a Chinese steel trap.”
But some significant steel executives have recently mused that China is already at “peak steel”. Zhang Wuzong, chairman of private steelmaker Shandong Shiheng Special Steel, said last week:
“You can basically say that Chinese steel output has reached a peak … If the rate of economic growth can be adjusted properly, it can be sustained, but it won’t be growth in steel mills, or growth in polluting enterprises.”
Deng Qilin, chairman of Wuhan Iron and Steel (Wugang), China’s fourth-biggest steel producer, also said:
“I can tell you that the steel industry, globally and in China, is facing a big, big imbalance of supply and demand — it is facing serious overcapacity, and if we don’t control it the industry at home and overseas will fall further into a deep winter … Expanding further is meaningless — if you are making losses, having more capacity will lead to even more losses.”
Australian markets generally take these kinds of comments in a context of talking down raw material prices, but within the emerging context of reform they can no longer be dismissed as gaming the iron ore production system.
Whether this proves to be true over the medium term, there are real reasons to fear that Chinese steel output will not grow at all this year. Daily rates of production over the first two months of 2014 have been 6% below the equivalent in 2013, and the economy is weakening, not strengthening, for a number of reasons.
The first batch of Chinese February data was out over the weekend and showed exports still fell 1.9%, the most for the period since 2009. The CPI and PPI were out too and also showed ongoing weakness. The CPI registered a softening and thoroughly Western 2% per annum while the PPI is accelerating downwards again at 1.9% year on year.
Adding to fears was the Friday default of the Shanghai Chaori Solar corporate bond, which has immediately spilled over into some tightening in corporate finance (though has had had the opposite in effect in interbank markets).
The Chinese commitment to tightened monetary policy has got a mini-credit crunch going in mining and steel sectors and, with a lot of refinancing activity in the pipeline for the year ahead, much uncertainty and downside risk is in play for steel. In macro-economic terms, China’s authorities are using these oscillations between credit tightening and loosening, fiscal expansion and contraction to nudge forward productivity over credit-driven growth.
We can take some reassurance from the notion that if the headline growth target is seriously challenged then the next swing of the pendulum should be to more stimulus, but the pain needs to be higher yet and when the stimulus comes it will be directed mostly away from steel-intensive activity towards environmental amenity and social infrastructure.
What this means for Australia is simple enough. We already saw it in 2012-13. Iron ore and coking coal represent some 40%-plus of Australia’s terms of trade. Iron ore is down 14% this year and is 20% below last year’s August peak, in a bear market and going lower. Coking coal is down 7% this year and 20% from last year’s August high, also in a bear market and struggling to find a bottom.
The recent rebound in the Australian sharemarket was largely built upon last year’s rebound in iron ore prices. The majority of profits growth was due to iron ore miners, and the re-rating of the market over the past several months hangs on that as well. Corporate profit growth expectations are going to be hit hard in the next few months.
Treasurer Joe Hockey’s much-criticised bearish Mid Year Economic and Fiscal Outlook projected a 5% fall in Australia’s terms of trade for 2014-15, but we are in danger of meeting that before we even get there. That will keep pressure on nominal growth and national income, adding to downwards pressure on revenue coming from falling corporate profits.
Australian mining equities, corporate profits, budget receipts and national income flows have planted their collective feet in a Chinese steel trap.