As late as November 2012, head of Rio Tinto’s China operations Ian Buert attacked the “impending doom camp” of China analysts in a speech to The Zone conference in Western Australia. In offering an analysis that mirrored hundreds given by big and small mining executives until very recently, Buert argued that continued urbanisation would sustain and even increase recent rates of growth in Chinese demand for decades.
Former mining executives turned China-economy experts, such as former BHP Billiton China head Clinton Dines bought entirely into a paradigm-busting Chinese urbanisation story. Until the past 12 months, those holding a different view were frequently ridiculed or else ignored by much of the Australian business community. There was such a consensus that their analyses were uncritically endorsed by Julia Gillard’s government and a number of senior Treasury, Finance and Reserve Bank officials.
To be sure, the bullish view of a paradigm shifting event that would defy cyclical trends in commodity demand was common, or perhaps more accurately, ‘received’ wisdom. For political reasons, the government desperately wanted to believe what mining executives were telling them. But if one needed to predict the revenue growth potential of casinos in the country, any assessment submitted by Jamie Packer would have to be taken with a grain of salt. Likewise, if one wanted to estimate future demand for iron ore in China, one should have always maintained a healthy scepticism of presentations by mining companies feverishly falling over themselves to expand output. There is nothing that clouds one’s judgment like the expectation of ever increasing returns.
Even if the fear of stagnating Chinese demand is possibly overblown, there is now widespread acceptance that the boom days are over. While Chinese iron ore demand is unlikely to collapse suddenly, the argument that Chinese urbanisation is driving demand for steel was always overstated, and misunderstood by those who spruiked it. In reality, the unprecedented jump in Chinese demand for steel from the middle of last decade onwards had much less to do with urbanisation, and more with domestic Chinese politics. Present commentary looking only at Chinese macroeconomic and firm-level data in order to predict future steel consumption will therefore continue to ignore some major non-economic determinants of commodity consumption in the country.
Let’s begin with the argument about urbanisation in China. We know the conventional argument. The country is rapidly urbanising with around twenty million rural citizens moving to the cities each year. This means 300-400 million rural dwellers becoming city slickers over the next two decades. At around 50 per cent, Chinese urbanisation has a long way to go and cities need steel. The country’s ‘steel intensity’ of urban residents – amount of steel required for each urban citizen – is far below that of advanced countries. Where’s the flaw in any of these arguments?
The first point is that urbanisation in China is not a straightforward process of people moving from the countryside to the city.
Officially, the number of urban residents has increased from about 150 million in 1970 to almost 700 million in 2010. But this ignores the consequences of the Mao Zedong-era ‘hukou’ household registration system which is still largely in place. During Mao’s time, those classified as rural residents (i.e., those generally born in rural areas) were forbidden to enter into, and work in cities; and had to spend the rest of their working life growing food for the rest of the country. In modern times, ‘rural migrants’ are allowed to work and live in cities. But they are not permitted to own property in these areas, have few welfare or healthcare rights afforded to genuine urban residents, and earn a far lower wage than their urban classified counterparts. In other words, migrant workers do not enjoy the increase in lifestyle generally associated with urbanisation. Most live in crammed dormitories or shanty towns, and will never own a city unit of their own.
They are generally known as migrant or seasonal workers since they move from job to job, while having their permanent residence in rural China. If we exclude migrant workers from urbanisation statistics, the number of urban residents falls from 700 million to about 450 million. Indeed, since the late 1990s, the growth of migrant workers entering cities has outpaced the population with genuine urban rights. Indeed, of the roughly 300 million additional citizens moving into cities since 1998, more than half have been migrant workers, meaning that the increase in the population with urban rights has been far slower than is generally understood. This is important because the needs of migration workers to cities are far less steel-intensive than that of genuine urban residents.
Genuine urbanisation in China is actually increasing by only around 0.6 per cent-0.7 per cent each year. But if steel demand is driven primarily by urbanisation, there is something that doesn’t add up. From 1980-1995, genuine urbanisation (ie., increase in number of urban citizens minus migrant workers) increased more rapidly than it did from 1995-2012. From 1980-1995, crude steel production in China was increasing by around 5 per cent each year. Yet, from 1998-2012 when rates of genuine urbanisation was actually increasing at a slower pace than the previous decade, crude steel production in China increased from about 10 million metric tonnes in 1999 to about 60 million MTs currently – an increase of about 18 per cent each year compounded. From 2008-2012, crude steel production almost doubled from about 330 million MTs to 600 million MTs.
The takeaway is that Chinese steel demand seems to bear little historical correlation with urbanisation – whether we include or exclude migrant workers. This is not to deny that increased urbanisation is one driver of demand for steel – just that urbanisation cannot primarily account for the huge increase in Chinese iron ore demand from this decade onwards. But a better answer to the question of Chinese iron ore demand lies in politics rather than economics. In essence, the huge increase in fixed investment has primarily occurred for political rather than economic reasons. Let me explain.
From 1980-1989, the primary driver of Chinese economic growth was actually domestic consumption – a result of land reform that gave rural residents free licence to use their plot of land in any way they wanted and dramatically raised across-the-board household incomes. From 1992 to early this century (after the so-called Tiananmen Interlude from 1989-1992 when the leaders of the country were paralysed from the countrywide protests,) export manufacturing took over the mantle of primary driver of growth.
Australia’s interest in China takes off from early this century until now since it is this time that fixed investment becomes the dominant driver of growth. The key period is really late 2007 to 2008.
When exports dropped off a cliff sending the country into a brief recession, Beijing responded with the largest fixed investment stimulus in the world had ever seen. State-owned banks were instructed to pump the economy with money in order to preserve growth and jobs. In 2009, loans from Chinese banks increased to about $US1.4 trillion from $US730 million the previous year. From 2008-2010, the outstanding loan portfolio of China’s dominant state-owned banks increased by a massive 58 per cent. Whereas fixed investment contributed around 20-25 per cent of GDP growth in the 1990s, fixed investment was responsible for around 55 per cent of GDP growth by 2007. In 2009, fixed investment drove around 90 per cent of GDP growth.
What did China spend its fixed investment monies on? Earlier this century, the majority of fixed investment went into infrastructure broadly supporting the export manufacturing sector. But from 2008 onwards, only about a quarter of the fixed investment benefitted export manufacturing while more than half was in residential construction. Much of the latter was in luxury housing, which were bought and sold by Chinese investors as speculative assets in an era of high liquidity.
The construction of high-end residential property bore little relationship to actual residential demand, meaning the price of them bore next to no relation with yield. The sector was driven by over 10,000 ‘Special Investment Vehicles’ established by local governments to take advantage of the free money offered to them. From 2008 onwards, many local government authorities became reliant on income from property construction and sales to balance their fiscal books – as local government entities cannot directly issue bonds or raise new taxes. Chinese researchers estimate that over 50 million farmers have had their land seized by local officials for inadequate or zero compensation, only to see these lands rezoned in order to build luxury housing on them. Knowing that ‘ghost cities’ are not a sustainable strategy for growth, Beijing has been attempting to rein in the construction zeal of local authorities ever since.
Back to predictions about Chinese iron ore demand. Urbanisation has a long way to go in China. But this tells us very little about how much steel they will need now and into the future. As late as December 2012, Prime Minister Gillard told us to ‘relax’ amidst growing concern about stagnating Chinese demand for iron ore, and that the budget was on track for surplus. Instead, the good old days of the boom – and her government – may be soon ending.
Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.