The Kouk has produced another little piece of analysis that helps us understand the difficulties confronting the economy in the period ahead:
With iron ore prices falling sharply to be down about 15 per cent so far in 2014 in US dollar terms, it is good news for the Australian economy that export volumes are so very strong.
A glance at this chart from the RBA Chart Pack show how the volume of iron ore exports has risen over the past decade.
Export receipts from iron ore are booming even with the lower price, simply because of the volume growth.
Of course it would be wonderful for the Australian economy to maintain sky high prices for iron ore while export volumes were booming. But it is unlikely that that that would ever be the case for any extended period of time. Good old economics is working with higher supply (and exports) being a factor contributing to the fall, regardless of demand from China.
Which of course is where a lot of the current focus is. Just how strong is the Chinese economy and with it, on-going demand for commodities?
Well, the Chinese authorities are aiming for 7.5 per cent GDP growth this year, a pace that seems strong enough to maintain demand.
There is nothing to fear from the falling iron ore price, at this stage, for the future of the economy while ever the growth in the volume of exports exceed the price fall. My guess is a fall below US$90 a tonne without any AUD depreciation would be a worry or if we were to see export volumes drop, it would be all bets off.
For now, watch the iron ore export volumes surge and look at the iron ore price with secondary interest.
The implication of this is that so long as volumes can rise at a sufficient pace then they can offset price declines. There are a number of issues with this line of reasoning, not least being that if price weakness is the result of unexpectedly weak demand then volumes are also going to ease (falling is quite unlikely).
More importantly, a stylised example illustrates how even if volumes rise the same amount that prices fall the end result is still much worse:
- assumed an average cost of productionof $60 per tonne
- 2013 average iron ore price price: $130 per tonne
- 2013 volume (example only) 500 million tonnes
- Total profits: $35 billion
Assume in 2014:
- export volumes grow 20% to 600 million tonnes
- average iron ore price falls 20% to $104 per tonne
- Average cost of production still $60 per tonne
- Total profits = $26.4 billion
So despite volume growth fully offsetting price falls, profits from iron ore exports actually fall by $8.6 billion (24.5%).
Perversely, real GDP, which only measures volumes, would record big gains, whereas national disposable income – the more important metric – would record a fall.
Of course, this is a stylised example with its own distortions (such as the price fall happening all on day one) but you get the drift. Higher volumes are no substitute for high prices. This little formula can be extrapolated to the effect on the entire Australian economy as its terms of trade fall and is one of the reasons why MB sees the period ahead as much more difficult than headline numbers will tell you.
