The dragon breathes a little less fire
China's building frenzy is approaching its end, write John Garnaut in Beijing and Sanghee Liu in Tianjin.
China's building frenzy is approaching its end, write John Garnaut in Beijing and Sanghee Liu in Tianjin. It's 2 o'clock on a weekday afternoon and the traders at Beijing's "steel village" are lowering their bets on China's construction-driven economy. "We don't like playing cards all day here but what else can we do?" said Liu Hongchang, a trader at Lucky China Forever Prosperous Company, as he slaps down a very poor poker hand. "We used to play with 100 yuan stakes but now it's only 10 yuan," he said. "Stay here for the day, or even a week, and see if the phone rings."Nor are there any phones ringing, faxes turning or emails arriving at any of the other 80 steel trading companies in the building or the scores of competitors that lined both sides of the street in Beijing's Baiziwan district. Every person in the complex is either playing cards or war games on their computers, or watching internet videos, or sleeping at their desks.A nearby construction site is silent, where two high-rise towers stand unfinished, and the steel coil and rods that are piled high at the local steel depot are damaged by rust and overgrown with weeds.Compared with the frenzied activity of recent years, the world's second-largest economy, which produces almost 45 per cent of the world's steel, seems to have stalled.Many Chinese business people, international fund managers and on-the-ground analysts are convinced that Chinese growth has dipped close to zero in recent months, regardless of what next week's quarterly GDP figures may say.The contract price of iron ore - by far Australia's most important export - has fallen 20 per cent this year, to $US135.And yet that's still enough to deliver the likes of Rio Tinto and BHP Billiton a profit of about 140 per cent for each tonne of iron ore dug out of the Pilbara, after subtracting freight costs. "They're still raking it in," said Ian Roper, a former analyst at Rio Tinto, now at CLSA.With that kind of money flooding through the economy, the Reserve Bank governor, Glenn Stevens, can afford to keep things steady, despite softness in the US and the eurozone teetering on the edge of crisis."Australia's terms of trade have peaked, though they remain historically high," Mr Stevens said on Tuesday, after leaving the cash rate unchanged at 3.5 er cent.This, it seems, is the stronger-for-longer commodities price boom, where the unprecedented scale of Chinese industrial production means the commodities market will be tight for some time, assuming demand does not fall off a cliff.SupplyChina has been building so many cities, roads, railways, ships and cars in the past five years that the global supply of commodities still needs time to catch up, even as growth slows.Chinese steel production eased in May but it still equalled what the US produced in the previous eight months. In June, China's steel mills were producing at an annual rate of about 720 million tonnes, which was stable from May and only a touch down from April's peak of 737 million tonnes, according to estimates by Macquarie Group.Each of those tonnes of steel require 1.6 tonnes of iron ore - enough to keep the Australian economy humming for a while yet.Steel and iron ore stocks at Chinese ports and mills look high in absolute terms but remain proportionate to the increase in consumption of recent years.Huge mine expansions in the Pilbara are finally paying off at a time when competitors in Brazil have been tangled in protracted logistics problems and India has been hit by a perfect storm of regulatory, infrastructure and weather problems.Smaller Chinese private miners at the high end of the production cost curve have also been quick to stop production as prices have fallen, providing the falling market with a cushion.That's why Australia had no trouble exporting 109 million tonnes of iron ore in the March quarter, which was 15.5 per cent higher than one year earlier, says the Bureau of Resource and Energy Economics.The bureau predicts Australia will export 510 million tonnes of iron ore this financial year, up 46 million tonnes from last year on top of a 46 million tonne rise the year before. Two-thirds of the growth in global seaborne iron ore exports this year will come from Australia, Macquarie says.Beyond iron ore, the price of Australian commodities fell 1.7 per cent in June and 9.9 per cent over the year in Australian dollar terms, according to the Reserve Bank's index.The Reserve Bank cut interest rates by 1.25 percentage points over that time, to counteract the loss of national income from falling commodities prices. Those interest rate cuts have saved $180 a month for households with a typical 25-year, $300,000 loan."We are moving from commodity price-driven growth to credit-driven growth, and that's what monetary policy is all about," says Paul Bloxham, an economist at HSBC. And yet the commodity price index remains more than three times the average levels of the 1990s, before the China boom began.In short, China is still underwriting the greatest surge of prosperity Australia has seen since the gold rush of the 1880s.China's economyThe question dominating the minds of global investors is whether China's construction industry can come back to life.Fixed asset investment - driven by China's vast infrastructure building program - has stopped growing after years of breakneck growth. The private real estate market has also crashed, following strict policy efforts to control the market.Many remain pessimistic about the near-term outlook despite Beijing fast-tracking a slew of major projects and loosening credit quotas. Steel prices have fallen, squeezing industry-wide profit margins to nearly zero, which will lead mills to begin the costly process of shutting down their huge blast furnaces if conditions don't improve."I don't see any rebound in demand in the coming year," said an iron ore analyst, Hu Kai, at Umetal.com."Last year I drove almost every day and earned 5000 or 6000 yuan per month," says a truck driver, Liu, at a steel market further east at Tongzhou. "But now Beijing's construction market is very bad, so we've come now to take our steel bars back to Tangshan."But much of the grief being experienced by traders and middlemen reflects the changes in the way the market works rather than underlying demand and supply.The BHP-led efforts to shift contracts from an annual to a quarterly and now monthly basis has all but eliminated the arbitrage between contract and spot-market purchases. And some traders who are being squeezed out of business are perhaps exaggerating the downturn in demand.Yin Jimei, a Tangshan analyst, pointed to a now-famous story about port authorities at Qingdao knocking down a building last month to make room for unwanted mountains of iron ore. "It was actually knocked down a few years ago."Private real estate transactions are beginning to recover and economists expect the new round of infrastructure projects to make an impact over the second half of this year."I think the economy probably bottomed in April," said Huang Yiping, a professor of economics at Peking University."We believe the foundation for a recovery is being laid," said Stephen Green, an economist at Standard Chartered, while cautioning that the construction recovery could take at least a year.And the price of iron ore, the thing that matters most for Australia, looks like it has found its equilibrium, for now."The market looks pretty well balanced at this kind of pricing," said Graeme Train, Macquarie's commodities analyst in Shanghai.Long termEventually, however, global miners will catch up with Chinese builders and prices must come back to earth.Ian Roper, at CLSA in Shanghai, has identified $US150 billion in iron ore mining projects under way, with the potential for a further $US100 billion if the market holds up.He forecasts the global supply of seaborne iron ore exports will rise from less than 1.19 billion tonnes this year to as much as 1.87 billion tonnes by 2016, with most of that expansion coming from Australia.He believes supply will finally catch up to the China boom just as Chinese demand is flattening, as the country's 1.3 billion people run out of things to build.Since 2000 China has built 7.2 billion square metres of residential space, which is enough for 230 million homes, or 35 per cent of the current urban population. Already the rate of urbanisation is slowing.And even China's leaders - almost all engineers - are reaching the outer limits of their imagination for steel-intensive infrastructure.They are on track to lay 120,000 kilometres of high-speed rail before 2015, limiting the potential for future growth. The road network is planned to add another 500,000 kilometres in the five years to 2015, which is less than the 640,000 kilometres in the previous five years.The working-age population will peak in the next two years and the total population will peak in about 2025, at 1.4 billion.In short, China is nearing the peak of its per capita and absolute steel consumption levels, after the double-digit growth rates of the past decade. The commodities-intensive parts of the Chinese economy are likely to shift down a gear to grow more slowly than headline GDP, after outpacing it for decades.This is when the price of iron ore will fall as low as $US70 per tonne, says CLSA, even assuming the country steers through growing economic structural, societal and political challenges. As one of the traders at Beijing's steel village put it, China has already used up much of its future infrastructure investments."Whenever there is crisis, the government put money into infrastructure building," said Zhang Yongqiang, of Beijing Matengfei Trading Co, while staring at his hand of poker cards. "China has overdrawn its investment in infrastructure for the next 20 or 30 years."