Will Aussie property crash when China cuts off iron ore?

Whether China cuts off Australian iron ore is not in question. Only the timing of it is. As well as what it will do to the Australian economy when it does.

The causes of the cut-off are well understood. There are three main drivers.

First, the US/China cold war is bifurcating the global economy into liberal and illiberal economic blocs. Australia has cast its lot in with the former. This makes Chinese reliance upon Australian iron ore strategically unviable.

Second, the Chinese economic development model is running out of rope. Its urbanisation is all but complete in construction volume terms. It can continue to overbuild but this is now hurting its long-term growth prospects as misallocated capital and debt kill off productivity. It must shift away from building as its primary growth driver.

Third, these two factors combine most forcibly in Chinese politics. CCP legitimacy will fail as the economy slows. It is already being replaced with deliberately stoked nationalism. This makes external conflict inevitable, most particularly in Taiwan. Yet Australia has a virtual veto over Chinese military aggression so long as China relies upon it for iron ore.

So, the CCP must break the Chinese economy’s reliance. It will do so via a combination of structural decline in steel output, a shift towards a greater share of scrap output and by seeding new iron ore developments worldwide.

The timetable for the cut-off will be this decade, probably the second half of it. China will decide precisely when by whatever combination of slowed urbanisation and magnitude of investment it determines is optimal.

What will happen to Australia then?

The first point to note is that global iron ore prices will collapse as unimaginable quantities of Aussie iron ore flood ex-China markets. China absorbs more than a billion tonnes of seaborne iron ore. Australia ships around 700mt there every year. Some large slice of this will be progressively dumped on other markets.

That means a return to $20 iron ore for a time. This will shut-in every tonne of ex-RIO and BHP iron ore, roughly 300mt of it. The remaining 600mt of Aussie iron ore still exceeds the total amount of ex-China global iron ore imports so you can see the problem.

It will not happen all at once. Rather, it will be the inverse of the 2010-2020 period during which Australian growth enjoyed a commodity volumes tailwind. GDP will be hit ceaselessly year after year as iron ore volumes fall. This will cost perhaps 200k direct and indirect jobs in WA.

But the bigger hit by far will be to national income. This year Australia will reap some $150bn in export revenue from iron ore. Nearly all of this will be wiped out by the combination of volume and price pressure.

This hit to Australia’s total exports is big but it is manageable. The following chart is a stylised version of the outcome, it would obviously be more volatile:

As you can see, it is a return to 2015 external conditions not the end of the world. That also gives us a very good guide to what will happen:

  • Nominal growth will be crunched.
  • Inflation and wages will be hit for years.
  • The budget will be a sea of red.
  • Mining stocks will fall.
  • Bonds yields will plunge.
  • AUD will crash.

The last point is the most important. There is no way of parsing all circumstances in this scenario but it is certain that the AUD will tumble a very long way as interest rates remain at zero (or go negative) for the entire period.

Could this result in an external crisis for the country? A balance of payments or financial crisis? Yes, but probably not.

Although I can see the AUD falling deep into the 0.40s, pushing some tradaeble inflation into Australia, the offset in weak domestic demand would prevent any kind of inflation breakout. This would enable the RBA to simply let the currency keep falling until it adjusts the external accounts to lower imports and higher non-iron ore exports.

Any potential run on the Aussie bank’s offshore debt would be mitigated by public guarantees and RBA QE.

There is a risk of sovereign downgrades but we’ve seen that markets these days are tamed by unconventional monetary policy even in that event.

No doubt you are all waiting for me to declare that Aussie house prices would tumble. And they would. They would radically devalue versus the world via the collapsing currency.

Undoubtedly, nominal prices in WA will also fall a long way given their strong correlation with iron ore. Other markets are more interest-rate sensitive. With the RBA reviving its TFF and using negative interest rates for cheap bank funding, mortgage rates could be squashed below 1%. So we might actually see another price rise in eastern capitals.

How long that would last is the more interesting question. Presuming that AUD can keep on falling without creating inflation then there is no obvious immediate limit to it.

That said, the very long term would get much more difficult for house prices with income growth yoked exclusively to non-existent productivity advances post-iron ore.

I wouldn’t recommend owning the ASX. Miners will be wiped out. Banks, too, as their margins are squashed by the RBA. That said, crashed yields would quickly restore a bid for the wider bourse.

In short, the end of iron ore to China is not the end of Australia. It would be a repeat of 2015, only permanent, but just as survivable as the cratered currency rebalanced the economy.

Houses and Holes
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Comments

  1. Nope.

    Iron Ore down = AUD down = Oz property even more attractive to expats and immigrants!

    This magic pudding will never run out.

    • The Model is Houses to 10 million in 10 years.MEMBER

      Rephrase to ” AUSTRALIAN economic development model is running out of rope. It must get more immigration or the model will collapse….. It can continue to overspeculate in Housing but this is now hurting its long-term growth prospects as misallocated capital and debt kill off productivity. It must shift away from building as its primary growth driver.HA….

      …But as property is the only drug, instead it will sell all its industries to support the 2% a month price growth. …..Now its 3 to 4 million for a suburban McMansion in inner sydney. These were 2 million 3 years ago. 18 rooms for 2 people, 1 kid and a dog is the minimum standard if you want to be Mr Average… Houses to 10 million is the plan.

  2. After 10 years of observing Australian property economics, I believe that Australia will crash the economy, and sacrifice their children, to prop up the housing market.

    The interest rate will be pushed to negative territory, which causes dollars to go down. This will cause building materials cost to go up, which justify the high property price. While all these things are happening, some how our inflation will always be on target.

    I’m just bitter.

    • C'est de la folieMEMBER

      I’m initially inclined to agree.  I do think mainstream Australia would currently devour their children through a need to keep house prices inflated.

      But

      I also think that mainstream Australia – in those quiet little moments thinking about things (which isn’t too much) – does have a touch of the guilts, and I do think that mainstream Australia would like a political party to map out how they are going to steer the Australian economy in such a way as to make sure that those (large number of) Australians who are in debt to their absolute (debt stressed) eyeballs can retain their houses (in which large numbers are raising families) and can have that debt relieved, while at the same time giving the speculators a bit of a slapping (or at least less of a reward) and for the taxpayer to cease funding those speculative gains, and at the same time enabling Australian housing to become more rationally priced so as to enable younger Australians to even begin to aspire to owning their own homes.

      I reckon the first party which maps out a plan on how to do that will gain attention for that alone, and would get significant voter support (though not enough ‘win’ parliament alone).

      The only way I could imagine that being enabled would be to

      Remove negative gearing and CGT – and replace with a genuine new housing investment support mechanism.

      Make mortgage payments up to a particular value (eg $400 thousand) tax deductable for PAYE income earners earning less than a particular amount per HOUSEHOLD (often, but not always, 2 incomes – eg maybe $100 thousand) where that household has no significant other (trusts, companies, SMSFs etc) financial vehicles.

      Make a very significant sum available for local councils (or maybe States) to make affordable housing doable on a competitive basis.

      But trying to sustain a national economy through the prism of ever higher house prices is simply madness

      • kierans777MEMBER

        IIRC Steve Keen has done a lot of thinking on this. His “debt jubilee” comes to mind.

      • Agree with the first half of what you say. But the “plan” doesn’t need housing targeted tax reforms. We just need more proactive fiscal policy and in particular public investment. If we had taken up all the aggregate demand slack with spending on infrastructure, education, natural environment etc, then (a) interest rates wouldn’t have fallen (as much) (b) house prices would not have risen (as much) and ( c) our cities would be more liveable. We’d have more public debt but less private debt, and the secret’s out now that the stock of public debt just doesn’t matter in a modern economy, whereas private debt is destabilising at the macro level and socially corrosive at the micro level.

        To the extent that any of the house price boom is due to supply/demand imbalance in the eastern capitals, infrastructure spending would also help to relieve that. But ultimately this has been an interest rate driven boom (rents are still weak…), and extremely low interest rates are the direct result of underutilised fiscal policy.

        Austerity is the underlying problem we need to fix here.

          • Capital city rental yields were 4.5% in 2013; they are 3.2% now. In other words, house prices have risen 40% more than rents in that period. I’m not saying that renting is cheap, I’m saying that house prices are primarily being driven by asset pricing effects (interest rates) rather than an underlying shortage of housing.

            Don’t get me wrong, I’d also love to see higher real wages – but that too is more likely to come from expansionary fiscal policy than it is to come from the current combination of austerity and extreme monetary policy.

        • C'est de la folieMEMBER

          Ok i certainly buy the idea that austerity itself is a major part of the problem (along with the population ponzi) and completely agree with the idea that any sort of wage growth would go a long way.

          But i do think the primacy of housing speculation (over PAYE taxpayers) embedded in the taxation system is equally a major part of ‘how we got to here’ – see SMSFs, a whole generations worth of tax breaks and concessions – and the interest rate dynamics of an economy handed a ‘get out of jail free’ card by a mining boom (which was hosed into the economy by bank lening for housing speculation). I think without doing something about the taxation policy supports we are simply rewarding the status quo and inviting its recrudescence.

    • Houses up up upMEMBER

      Yep, those rational people who didn’t buy 5 houses are now in shock. Houses to 10 million in 10 years is the new normal.

  3. OfficeboyMEMBER

    buy on any pull back await the ressurection of international flights and bank on doubling House prices. I think its crazed too .. but thats what will happen. We own a franchise on better living , better rule of law , limited housing and relative great citys. Still 50 to 70 years left in this .

  4. How many people (families) do you want in Australia?
    How many decent houses do you want in Australia?
    How many families do you want to miss-out on decent housing in Australia?

    Choose any two.

    • Ronin8317MEMBER

      The timing is great. The big question is : is it a tech stock? a real estate stock? or infrastructure? It does have a virtual monopoly on real estate transaction in Australia right now.

  5. Saw the interview this week on the Business with BHP’s iron ore man, basically saying it’s not so bad as they own part of Simandou. I doubt they will own anything by the time production starts, the CCP are going to Simandou to ensure strategic supply of iron ore, there is no way they will allow an Aussie or western company to own those rights. So there will be bribery which will ensure the rights to mining Simandou are withdrawn & wholly owned by Chinese companies. This is one reason I’m against anti bribery rules that affect most western nations, they should be allowed to do whatever it takes in local markets, it’s up tell those countries to sort their own sh*t else they are likely to actually end up with worse deals & less legal protection than with western companies, and of course western companies lose out long term as it’s an uneven competition.

    My hope is that India get it together and pump money into their economy to stimulate development, surely they have chronic under development so that money will be productive investment mostly.

    Also Africa will be exploding demographically, democratic countries must ensure we play a big part in developing Africa and not just using it as a source of commodities
    Adam is right to be concerned about stagnating productivity
    https://twitter.com/adam_tooze/status/1398987564174909443?s=19

    • My hope is that India get it together and pump money into their economy to stimulate development …that money will be productive investment

      Do you think they can do it with money?
      I would have thought that some resources would need to be redirected to better uses.

      Perhaps it is all about printing extra money and pumping it. What would I know?

    • If you’re looking at bribery Frederic Pierucci ‘s book – The American Trap – is an interesting and credible read.

  6. Ailart SuaMEMBER

    We need a new leadership selection process. Under this primitive, donor-hijacked circus we suffer under, governments are never going to produce any detailed, long-term planning – a vision for where Australia needs to be in 50 to 100 years time. The system is not just broken, it’s smashed into tiny little pieces. It simply cannot produce quality, accountable leadership – surely people can see that?

  7. MathiasMEMBER

    Great article.

    Lately, I’ve been thinking, we will either survive to around 2028 ( boomers start dying like flys ) or until we see a significant crash ( real estate destroys the business sector which leaves us helpless ).

    • FUDINTHENUDMEMBER

      Personally I’m just a massive fan of schadenfreude and love a bit of carnage.

  8. Bank guarantee only comes in after the drank deposits are confiscated by the banks from we the people.
    Unless the wording has been changed we are unprotected.

  9. > Miners will be wiped out.

    We do mine other stuff, you know. Not just iron ore. Electrification metals (Cu, Li, Mn, Ni, Ag) and monetary metals (Au, Ag). All of those will do well no matter what happens to China urbanization, as the West needs to reshore supply chains and decarbonize. Individuals also need to protect themselves against crazy central bankers with monetary metals. ASX miners of all of those will do very well if our dollar goes down with Fe prices.

    • Very good point. My bet is that China will launch a gold-backed cryptocurrency to power its “external circulation”strategy. Just so many political and influence opportunities with it. In such a case gold price in USD will spike, and in AUD even more given its devaluation.