The dangerous combination that could end Australia's lucky run

Fasten your safety belts -- Australia is set for a ride we have not experienced for decades. In blunt terms, we will either see a sharp fall in the dollar or we will run into a recession.

If Stephen Bartholomeusz is right about the extent of looming iron ore capacity excesses and former chairman of the Federal Reserve Alan Greenspan is right about what's going to happen in China, then we are in for a rough ride.

Australia was always going to face a tough time given the end of the mining investment boom, the government’s closure of automotive manufacturing and the retrenchments coming from corporate labour shedding. But we had some pluses, including infrastructure spending.

But now comes a dramatic slump in iron ore revenues. Australia rides on the back of iron ore, coal and gas. Gas prices are linked to oil, which is falling. But the position in iron ore is more serious. 

The iron ore price has already fallen 40 per cent, but Stephen Bartholomeusz’s commentary reveals staggering overcapacity looming for the industry, which could see the price fall much further before stabilising at low levels (The worst is yet to come for our miners, September 10). Last night the metal fell again (Iron ore price in fresh slump, September 10).

Bartholomeusz totals the truly enormous expansions coming in the iron ore pipeline: Brazil’s Vale will lift production by 130 million tonnes a year by 2018; Rio Tinto and BHP Billiton combined plan to add a similar tonnage to their already greatly-increased outputs; Gina Rinehart’s Roy Hill will lob 55 million tonnes on the market starting next year. Including other projects, we are looking at an extra 350 million tonnes.

It looks like the market is already oversupplied by 100 million tonnes and that China will not exit iron ore production, so cutbacks in Chinese production will be minor.

If the Chinese economy continues to boom as anticipated, then we would be looking at a temporary problem.

But former US Federal Reserve chairman Alan Greenspan is warning all who will listen that China’s debt bubble is going to burst.

Greenspan explains that China's debt has become over-leveraged, with the overall level of debt rising from 140 per cent of its GDP to 230 per cent of GDP. The country requires ever-larger amounts of public debt to fuel its growth rate.

China’s remarkable gains in productivity and standards of living were all achieved with borrowed capital and technology. Greenspan points out that no Chinese companies feature on the annual lists of the world’s most innovative companies -- nearly half of those lists are made up of American companies. This is leading to a narrowing productivity gap between China and the US, which is putting serious pressure on the Chinese economy.

Greenspan says the reality is that China is hitting the ceiling and its growth rate must slow. The Chinese hierarchy is acutely aware of this and, according to Greenspan, plans to allow a number of companies go into bankruptcy.

Most of the institutional lending in China has been backed by the government but there is a substantial amount of shadow banking that does not have the same backing. The Chinese government is about to let some companies know 'the hard way' that it will not act as their guarantor. Greenspan alerts us to look out for Chinese company defaults in the future, perhaps in its "seriously overextended" steel industry or elsewhere in its manufacturing sectors.

Greenspan believes that a correction in China (if handled correctly) could be good for China in the longer term, but naturally Greenspan does not link this belief with the implications of excess iron ore production.

I do not think Australian markets (and our currency) are ready for the combination of excess iron ore production and a China downturn.