Saving Australia from the commodity export rout

It's a long time since Australia experienced anything like what is happening to our exports. It's a rout of enormous proportions -- demand is falling or stationary, while supply is exploding. Morgan Stanley says it will send the dollar to US75c next year and could bring on a recession. (Morgan Stanley warns on recession, November 6).

Already the derivatives market is under pressure and there will be some big losses among bank-backed commodity traders who made the wrong bets.

At this stage, the Australian public sees these developments in terms of low wages growth, but the abolition of the carbon tax and the coming lower petrol prices look like they might stimulate consumer demand at Christmas. There are already good signs, (From carbon tax to spending spree, October 28) and (Retailers tip solid Christmas sales, November 6).

But then comes the crunch. Unless there is a commodity market turn around, these good signs will fizzle out in 2015. I should alert you that our weekend economist, Westpac's Bill Evans, expects such a commodity turn around (Weekend Economist: Rates wait, November 1).

Let's look at what is happening to cause the commodity rout and where there could be some good news.

We need to start with what is happening on the ground in our biggest market, China. That's why Business Spectator's Peter Cai, who is one of Australia's top China analysts, went outside the major cities on his latest China visit. Peter tells the story of province after province in deep financial trouble and a banking system that is cracking (China's high-speed debt train picks up pace, November 4). 

China will work hard to avoid a catastrophe and keep growth as high as it can and, indeed, demand for dwellings in China is rising as the government moves to keep consumers spending. But, if anything like what Cai described happened to banking systems in western countries it would lead to a deep recession. Indeed, the Global Financial Crisis was caused by a similar banking problem in the US.

The chilling message I got from Cai was that, while consumers might hold China together, there was no way China could repeat the enormous infrastructure-driven commodity demand growth we have seen in recent years because it was funded on borrowed money and the financial system can't maintain the pace.

The China problem is at the heart of the commodity rout in iron ore, coal and oil because we are flooding the market with supply at a time of restrained demand. In LNG, most of the contracts have prices that are tied to the oil price, so, while demand is secured, the LNG price is set to be a short-term disaster unless there is a turnaround.

The China problem is compounded by deteriorating economic conditions in Europe and the fact that, while the US is doing well, so far it has not been strong enough to drive the rest of the world. If this rout is to be turned, the drive must come from the US.

On the supply side, the story in iron ore, coal and oil is the same. The low-cost producers are lifting production to drive out the high cost producers. In the case of iron ore – it is Australia and Brazil that are trying to drive out high-cost producers in China. Iron ore stocks are rising, fast pushing prices lower and lower, but China -- on nationalistic and long-term security grounds -- is reluctant to shut down production.

In the case of oil, the Middle East (which needs money for war) is trying to drive out the high-cost producer, which happens to be the US. But the US is basing its revival on local energy. Like China, it will not shut down in a hurry.

Unless there is a change in these conditions is there anything that can save Australia? The answer is that we may see a further boost in Chinese investment on the east coast and a further rise in tourism. That's what is happening now and long may it continue -- at least while the commodity export rout is taking place.

We need the money, although it prices our young people out of the housing market, which will have long-term side effects. However, if China's local problems stopped the flow of tourism and dwelling money, house prices would fall, which would in turn cause a huge spike in loan defaults at Australian banks.