Why iron ore is doomed to a $20 future

Readers will know that the MB view is that the stronger this year’s global recovery, the quicker that China will tighten its most recent credit binge as its export sector booms. That clamping is already underway.

The reason why is well known and understood. In its formative stages, super-charged catch-up growth in a developing economy is a process of high investment into cheap wage exports and infrastructure modernisation. But, as the economy matures, those easy investment oppotunities with high returns fade and wages begin to rise resulting is fading exports snd rising consumption.

If the economy is not allowed to slow on this natural path then capital misallocation slowly bogs it down anyway, lumbering the economy with bad debts that clog its liberalisation process and productivity.

Owing to the need for high growth to sustain CCP legitimacy, China has already pushed this process well beyond its use-by date. So slowing the economy has become a priority every time there is clear air to do so.

BoA has some more detail on how this might play out over the next 15 years:

The key question is which reforms are needed for China to reach the GDP doubling goal in the next 15 years. We identify three important policy tasks for potential growth, which we summarize as “the invisible, the incredible, and the impossible”:

  • “The invisible”: new urbanization, hukou and land reform, new infrastructure
  • “The incredible”: further opening up, especially in services
  • “The impossible”: innovation, supply chain self-sufficiency

Admittedly, even with these reforms, China will face various constraints and challenges on its growth path. Top decision makers’ vows to stabilize leverage ratio and pursue a low-carbon, green growth path also set limits on how economic growth can be achieved. On the external front, geopolitical uncertainty still looms large. However, with the proper policy mix, China could and would show how it can manage sustainable and stable growth in a changing environment.

1. “The invisible”: new urbanization, hukou and land reform, new infrastructure

Urbanization has contributed significantly to China’s high-speed growth in recent decades. Up until the 2008–09 Global Financial Crisis, a massive movement of abundant labor from the countryside to city drove China’s industrialization and boom in laborintensive export sectors.

While the nation’s urbanization ratio has surged from less than 20% in 1980 to 60.3% as of 2019, it is still low compared with developed economies in the world (Chart 12).

According to the latest UN projection, China’s urbanization ratio could reach 73.9% by 2035. If this estimate turns out to be close to the ballpark, the resulting lift in consumption and investment demand will be significant (Chart 14).

But the new wave of urbanization will come in a different form. Unlike previously, it will mainly feature large cities expanding into wide metropolitan areas/city clusters, which naturally urbanizes the surrounding rural areas. The agglomeration of information, knowledge and resources can lead to economies of scale, while massively lifting the asset value of residential and commercial properties and infrastructure investment in those areas. This has already driven some of China’s city clusters, e.g., the GuangzhouShenzhen metropolitan areas, into regional economic powerhouses (Chart 15).

2. “The incredible”: further opening up, especially in services

China has benefited from globalization tremendously over the past few decades. Its opening-up policy and accession to the World Trade Organization (WTO) contributed greatly to the country’s economic success by providing export markets, investment funds, faster adoption of new technology and better utilization of human capital. On the other hand, China has maintained a high barrier to foreign entry in service sectors, especially in finance, telecommunications, healthcare, education, and entertainment. The natural next step, it seems, should be to grant foreign access to these sectors. Some of these sectors were identified to be strategically important and were dominated by SOEs. It was not until recent years that they started to open to private companies, and hence opening to foreign entry would be seen as “incredible.”

3. “The impossible”: innovation, supply-chain self sufficiency

As China gradually loses its low-cost advantage in labor-intensive manufacturing sectors to other EM countries, it faces the inevitable challenge of upgrading its capacity in hightech and high value-added industries and moving up the global value chain. Top policymakers have long recognized that and already started to prioritize technology
innovation in the past decade.

But technology security and independence have become ever more urgent, with the US restricting component supplies to Chinese companies such as Huawei and threatening to choke the nation’s technology supply-chain. As US-China tension is likely to remain high for the foreseeable future, a bigger focus on core technologies and strategic sectors (e.g., 5G and semiconductors) is crucial to achieving technological independence and supply chain self-sufficiency.

But there is also a broader picture we need to look at. China’s overall R&D expenditure accounted for 2.1% of its GDP in 2018. This share has risen steadily over the past few decades, from a mere 0.7% in 1991, but it remains low compared to countries that have a competitive edge on technology, such as the US, Germany, Japan and South Korea (Chart 17). For China to embark on an innovation-driven growth model, more intensive and effective spending on R&D will be required to sustain high productivity (Chart 18).

Meanwhile, though China has scored high in the quantity of innovations produced, detailed data reveal an insufficiency of quality. One such indicator is the share of investment in basic research, in which China still lags behind many developed economies (Chart 19).

A fair assessment. But we need to leaven it with a few facts for Australia’s purposes:

  • China inflates its GDP to the tune of 1-2% because it does not write-down bad investments like other nations. So even this success represents a considerable slowing to western levels of real (volumes) growth.
  • It is the pace of urbanisation that matters to commodities demand not just the level. If China meets these forecasts for urbanisation then the pace of people it will be moving per annum will slow by 40% over the next 15 years:

Even if China pushes harder to 80% urbanisation by 2035, the number of people being shifted per annum will be the same as the decade to 2020 meaning no growth.

And given some large slice of the urbanisation build-out has happened in advance, with 70m empty apartments plus underutilised gleaming airports, roads, railways, ports and CBDs all over the joint, the amount of building needed will slow even more.

Add that the drive up the value-chain will also involve a big push towards greener resource efficiency and recycling and raw material demand falls even more.

A great change is coming to Chinese bulk commodity usage. The only question is the time frame.

David Llewellyn-Smith

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