Iron Ore: Post-Rally Slump a China Warning?

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From its low on December 15 last year to its high on April 22, 2016, iron ore had a spectacular rally, rising 71% in value. The rebound coincided with optimism that China’s economic slowdown had stopped and was going to stabilize at a growth rate of around 6.5%-7.0%, in line with government forecasts for 2016. China may be stabilizing, but iron ore prices have since dropped by over 20% from their April peak. What is pressuring iron ore and why has it been so much more volatile than copper? (Figure 1)

Figure 1: Iron Ore has Been Much More Volatile Than Copper During the Past Two Years.

There appears to be two factors driving iron ore’s recent decline: supply and China. Iron ore supplies have grown much more quickly than almost any other metal. Iron ore mining supply has tripled since 2002, while copper mining supply has risen by only 37.5% over the same period. While iron ore mining supply did fall by 2.9% in 2015, it is coming off very high levels, and production in 2015 is still the second highest on record (Figure 2). The market for iron ore is still vastly oversupplied.

Figure 2: Growth in Mining Supply of Iron Ore has Vastly Outpaced Copper.

Iron ore producers ramped up production mainly to meet demand from China. Unlike the United States, Japan and Western Europe, which meet most of their steel needs using recycled scrap, China relies largely on newly-made steel to meet its infrastructure needs. China’s economy is 17x larger today than it was in 1980, and it had little in the way of old steel from used automobiles and demolished buildings to recycle. China consumes 40%-50% of most industrial metals, but in the past several years it has been using close to two-thirds of the world’s supply of iron ore. While China is the world’s largest producer of iron ore, it still imports 25% of world production, mainly from Australia and Brazil. This makes iron ore exceptionally sensitive to economic developments in China.

As such, when the Chinese government announced economic stimulus measures in late February, it may have contributed to iron ore’s rebound from its recent doldrums. The People’s Bank of China (PBOC) added fuel to the fire with cuts to both the reserve requirement ratio and interest rates. More generally, commodity prices and emerging market currencies rebounded, relieving some of the downward pressure on the Renminbi. In recent weeks, however, both iron ore and the Renminbi have been weakening again. One reason might have to do with China’s high level of private sector debt (Figure 3).

Figure 3: In Q4 2015 China’s Total Debt As a % of GDP Surpassed the Eurozone & U.S.

China’s debt levels are soaring. Relative to GDP, China’s total level of debt (public + private) rose by 20.2% over  the course of 2015 to 254.7% of GDP, according to the Bank for International Settlements (BIS) (Figures 4 and 5). The biggest increase occurred in China’s already highly indebted non-financial corporate sector, whose debt level rose 14% faster than GDP from 157% to 171%. Household and government debt each rose by about 3% of GDP.

For debt to grow by 20% more than GDP in a single year is worrisome for several reasons:

1)        China’s debt levels have now attained levels similar  to those at which Japan (1990), the Eurozone and the

United States (2007 and 2008) began their respective debt crises.

2)        When debt levels are low, accumulating additional credit adds quickly to GDP. When one person or entity borrows, their spending or investment becomes income for another person or entity, adding to economic output. However, when debt levels become high, additional borrowing adds little to GDP as the new loans serve mainly to refinance existing debt.

3)        As debt accumulated, China’s economy has begun to slow considerably (Figure 6). Accelerating the pace of debt accumulation could stabilize the growth rate in the short term but only at the long-term cost of a potentially deeper downturn or longer period of slow growth.

4)        American, European and Japanese officials have  found that fiscal and monetary stimuli are less effective with high levels of debt.

Figure 4: China’s Total Debt to GDP is 254.7%, Near Where Crises Began in U.S., Europe & Japan.

Figure 5: China Responded to the 2008 Global Economic Crisis by Increasing Leverage.

Figure 6: As Debt has Accumulated Chinese Economic Growth has Slowed.

It’s also clear that the Chinese government is becoming concerned about the level of debt. On May 10, 2016, an “authoritative person,” likely somebody close to the top of China’s power structure, wrote anonymously in the People’s Daily, warning against excessive, “blind” credit expansion to inefficient enterprises in China’s non-financial corporate sector. This was an implicit acknowledgment that too much credit was being extended. The article also warned that without supply- side structural reforms, China might have more of an L-shaped, rather than a U or V-shaped economic recovery. In any case, an L-shaped (non)-recovery would be close to what occurred in Japan and Europe following their crises. Even in the U.S. and U.K., which cut rates to zero and initiated quantitative easing much more quickly after their economic crises began, recoveries have been slow and uneven.

So what does the decline in iron ore prices tell us about China? It’s a difficult question to answer with certainty, since iron ore prices are governed by many factors, including oversupply on global markets. That said, the metal’s recent decline might be pointing to a renewed slowdown in China. It might also be signaling that China’s recent monetary and fiscal loosening is not delivering the planned boost to China’s rate of economic growth.

If iron ore prices resume their decline and if China’s economy does not rebound as hoped, this could be bad news for many commodity exporting nations, not least of all Australia and Brazil, which are the two largest exporters of iron ore. Both the Aussie dollar and the Brazilian real correlate positively with iron ore futures (Figures 7 and 8).

Figure 7: Iron Ore Could be a Driver of the Australian Dollar / U.S. Dollar Cross-Rate.

Figure 8: Iron Ore Correlates Positively With the Brazilian Real.

Hot Rolled Steel and Iron Ore Diverge

Steel prices have been soaring recently, completely decoupling from iron ore prices (Figure 9). On the face of it, higher prices for hot rolled steel might be interpreted as a positive sign for iron ore. Unfortunately for the suppliers of base metals, steel prices have risen mainly on hopes that China will be cutting back steel production, perhaps by starving some of its less efficient producers of the credit that they need to stay alive. This is good for steel in the sense that it reduces supply but bad for iron ore given that it means less demand. Eventually iron ore and hot rolled steel will begin to correlate positively once again but that may not be in the cards immediately.

Figure 9: Hot Rolled Steel and Iron Ore Diverge on China Cutting Back Steel Production.

Bottom line:

  • Iron ore is exceptionally sensitive to developments in China.
  • China’s recent monetary and fiscal stimulus might not be working as planned, owing to high private sector debt level.
  • China is cutting back on steel production, which has been positive for steel prices but bad for iron ore.
  • Iron ore remains heavily supplied.
  • A renewed decline in iron ore prices could put downward pressure on the Australian and Brazilian currencies.

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