Underpinning the government’s 2015-16 Budget is a fairly dire forecast for iron ore prices. At the time of preparing the budget papers, the Treasury assumed an underlying price of $48 per tonne.
Now iron ore has fallen a long way – more than halving over the last year at its low. On Treasury estimates, price action has a significant effect both on government revenues and nominal GDP growth - the government claiming it has reduced revenues by about $20bn, the single biggest writedown in recent years.
In terms of its effect on GDP, Treasury modelling suggests “a $10 per tonne reduction/increase in the iron ore price results in just over a 3 per cent fall/rise in the terms of trade and a 0.8 per cent reduction/improvement in nominal GDP.”
That’s a big effect, but consider the direction the iron ore price is moving. It’s off a low base, but we’ve seen a substantial rebound – which if it’s sustained, will add close to 1 per cent to GDP as it is. Assuming prices stay where they are. So already the government’s forecasts are on track to be out by a full percentage point – with all the flow-on effects to employment, income and company profits that entails.
Now everyone agrees that there is tremendous uncertainty in forecasting commodity prices and I’m not arguing strongly against the assumption of $48 a tonne. I think the Bank for International Settlements is spot on when they suggest that some of the moves we’ve seen in commodity prices cannot be explained by fundamentals. While they were referring mainly to the crude market, I think this is also quite evident across the spectrum – and especially in relation to iron ore.
Now with that in mind … think about the backdrop. Is it more likely that we’ll see a 10 per cent move on the upside or downside over the next few years?
Well let’s think of what we know – China’s economy has slowed. That’s a fact, but as I’ve highlighted to investors before, and as the Treasury make plain in the budget – this was a policy goal. China’s economy is now twice the size it was a decade ago – roughly $16 trillion. It simply isn’t feasible – nor desirable - for an economy that size to grow at those double digit rates.
Yet even as growth slowed, physical demand for commodities has surged. Press reports suggest that China is now the world’s largest consumer of crude, recently overtaking the US. Elsewhere, the actual demand for iron ore remains strong. Australian exports volumes of iron ore have been growing at very strong rates – even as the Chinese economy “slowed”.
Treasury concerns over reduced Chinese steel consumption have a place certainly but should not be regarded as anything other than a short-term phenomenon… Even on Treasury analysis.
So consider that on the Treasury’s own estimates, China’s middle class is expected to grow "from around 12 per cent of the population in 2009 to around 70 per cent by 2030”. Very clearly the process of urbanisation – and associated construction - isn’t even close to completion. So concerns over excess housing stock would appear wildly over blown, especially as this state of "imbalance" has existed for at least a decade and through several property cycles. Aggregate macro data often hides the underlying state of affairs and I think that is certainly the case in relation to the Chinese property sector.
That’s not to forget recent measure by the Chinese authorities to ease the current tight monetary and fiscal policies in the wake of low inflation outcomes. As Treasury suggests “alongside increased infrastructure investment, these measures will support growth”. Of most importance for the iron ore outlook, they will support Chinese demand for steel.
With all of that in mind, the chances that iron ore could give the budget and the economy at large an unexpected boost are high.