The Future of China’s Economy and the Iron Ore Price

There’s something tragically comical about last week’s head in the sand, vote buying budget, Atlas Iron’s miraculous recovery from bankruptcy, the government’s inquiry into the iron ore industry, and this news from China, as reported by the Financial Times:

China has ordered its banks to prop up insolvent provincial government projects, in the latest effort to support rapidly cooling growth and put off dealing with the mountain of debt that has built up in the past six years.

Authorities told financial institutions to keep lending to local government projects even if the borrowers are unable to make principal or interest payments on existing loans.

That’s right — China. Let’s not forget it is still dealing with the fallout of an immense credit bubble. It can’t let market forces take over right now. To do so would be to invite trouble.

Instead, China has to get all Communist about it by ordering its banks to keep lending to zombie companies. While such a policy gives the impression that all is well, the economy will pay a price for it.

That’s because capital must be allowed to generate a return above its ‘cost’. This simple little equation is the basis for all real economic value creation. When an investment generates a return above the cost of the capital required to finance it, profits, jobs and economic growth result.

When the investment can’t cover its cost, the opposite occurs. The best thing to happen in this situation is to let market forces play out. That means liquidate the investment and redirect the capital towards a more profitable endeavour.

Capitalism works best (and is ruthless) when capital is allowed to move around unfettered. In such an environment it will constantly move towards the highest returns. More capital then follows until those returns diminish to a point where the weakest die off. Then the process starts again.

Needless to say, this is not happening in China. China’s leaders can’t afford to let capitalism do its job. They fear a spike in unemployment and social unrest, the greatest fear of all China’s leaders.

As a result, vast amounts of value destroying capital lays trapped in China’s distorted economy. Worse, the banks are under orders to keep feeding this value destroying apparatus.

The only thing that can result from this is slower economic growth. Yes, maintaining the ponzi will avoid a nasty bust…for now at least…but it comes at a cost. And the cost is a grinding slowdown in economic growth.

Last week, I spoke to a mate who works in the steel trading business. He told me car production in China is flat year-on-year. As in, no growth. Yet we’re told China’s economic growth is around 7%.

Bollocks it is.

But that’s all right. Treasurer Joe Hockey tells us he’s ‘more bullish about China than a number of other people.

He needs to be. China’s pretend 7% growth rate underpins Hockey’s budget for years to come.

Central to the budget forecasts is the assumption of aUS$48/tonne iron ore price. The general consensus is that this is a conservative number.

But it’s not. The government didn’t do any modelling based on stringent supply/demand dynamics to arrive at that assumption. They simply took the average of the past month and then assumed that’s how it will be for the next few years.

The iron ore price will be much lower than US$48 over the next few years, rendering the budget forecasts meaningless.

One reason why prices will fall is the delayed supply response to already weaker prices. A falling price of anything tells you that supply exceeds demand. As a result, supply should fall too.

But it doesn’t happen straight away. You’re seeing this in the Aussie iron ore market now. Despite a massive fall in the iron ore price, hardly any Aussie supply has left the market.

Atlas Iron [ASX:AGO] went into administration a few weeks ago when the price went into the low $40/tonne region. But following the recent bear market rally, which took the iron ore price to US$60/tonne, AGO is back producing, with a little cost cutting help from its contracting partners.

No one wants the iron ore party to end. Everyone’s cutting costs…which only ensures the inevitability of a lower price. A lower price is the only thing that will knock out high cost supply and improve the long term structure of the iron ore market.

So a lower price is exactly what you’ll get. It doesn’t matter how much Twiggy Forrest complains about the expansion policies of the majors. And it doesn’t matter that the government is going to waste a few million on an idiotic review of the iron ore market.

Falling Chinese steel production and higher iron ore production equals a falling price. That Australia is in denial about it makes no difference whatsoever.

But it’s not just our politicians and miners who are in denial. The whole electorate is deluded. Following last week’s vote buying budget, the government’s position in the polls has improved, which is exactly what they wanted.

Yet if we had any brains, we’d be depressed about the direction the government is taking us. Troy Bramston tells us why in yesterday’s Australian

The fiscal challenge facing the nation is the gravest it has been in decades, and is likely to get much worse. The political class seems incapable of recognising this problem or showing any courage to address it. Blaming the Senate has become a convenient excuse for a failure of compelling advocacy and mixing smart policy with clever politics.

The second Hockey budget earns a place in history as one of the most fiscally reckless in the postwar era. Spending next financial year will reach a whopping 25.9 per cent of GDP. It is forecast to fall only slightly to 25.3 per cent over the next four years. Taxation will hit 24 per cent of GDP next year and continue to rise, up to 25.2 per cent by 2018-19.

There is no other conclusion: this is a big spending and big taxing government. It makes a mockery of the promise of smaller, leaner and more fiscally responsible government. Spending exceeds all of the Rudd-Gillard years bar one, during the GFC. It even outstrips the fiscally profligate years of the Whitlam government.’

In other words, it’s all bread and Circuses in the land of Oz. Meanwhile, there is plenty of dead wood and combustible fuel accumulating. Rome will burn…all it needs is a spark.


Greg Canavan,
Editor, Sound Money. Sound Investments.

PS: If your financial adviser is ignorant of the direction Australia is headed, you should look to take control of your own affairs. For some tips on how to get started, click here.

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Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

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