Chinese Trouble in Iron Ore

Iron prices are failing to rebound. Blame the popping credit bubble in China...

In The PAST FEW weeks, writes Greg Canavan, editor of Sound Money, Sound Investments, from St Kilda, Melbourne, we've had renewed stimulus attempts from the US Fed, the Europeans and the Japanese – the three big dogs in the central banking world.

What has it achieved? Apart from giving stock prices a temporary boost, all it's done is to act as a counterweight to the extreme deflationary forces weighing on the global economy.

Now the world is looking to the People's Bank of China (PBoC) and hoping that they can do something too. Yesterday's announcement that the PBoC had injected nearly US$60 billion into the market gave them some more...errr...hope. But as we'll explain in a moment, if you're betting on more China stimulus to boost markets around the world, you are going to be disappointed.

You're also going to be disappointed if you were expecting a quick rebound in iron ore prices. Based on Fortescue chief Andrew Forrest's comments at the PGA conference we spoke at the other day, he is one of those whom disappointment awaits. Reuters reports:

"China's steel market, the world's biggest, is feeling the pinch of a slowing economy that has sapped demand for new ships and construction work. Its largest listed steelmaker has halted output at a 3 million tonnes-a-year plant, and over a third of the country's iron ore mines stand idle."

The largest listed steelmaker referred to is Boasteel. The fact that it has bit the bullet and decided to slash production is an ominous sign for the steel industry. Up until now, China's steelmakers have been content to keep churning out steel, sacrificing profits to maintain employment levels.

But the resulting oversupply of steel pushes prices down, and is no doubt affecting companies' cash flows. Now, they have little choice but to start mothballing their highest cost production.

Perhaps more ominously for the steel (and iron ore and coal) industry is comments by Liu Xiaoliang, deputy secretary general of the Metallurgical Mines Association of China. At a recent industry conference in Dalian, he said that China's consumption of crude steel could be around 705 million tonnes by 2015.

According to Friday's Financial Review, steel production this year will be around 710 to 720 million tonnes, but consumption is much lower than this. If Liu Xiaoliang is right, growth in demand for steel making raw materials will be flat at best for years.

Of course the 2015 prognostication is just an opinion. But in China, official opinions tend to have some weight. They are an indication of where and how the Party tries to steer thinking on a topic. If this is the case, the message contained is that the infrastructure boom is over.

The silver lining here for Aussie iron ore producers is that the fall in steel prices and demand, and the subsequent fall in iron ore prices, knocks high cost Chinese iron ore producers out of the market. Iron ore from the Pilbara is amongst the highest quality and lowest cost in the world to produce. It will always be in demand.

The question for Rio, BHP and Fortescue investors is at what price will this iron ore sell? With all companies gearing up for production increases in the next few years (the result of boom time investment decisions), along with Brazilian company Vale, the iron ore market is going to see an increase in supply at the same time as static demand for steel.

The bottom line is that low prices are here to stay for a few years to come. We wouldn't be surprised to see iron ore fall back towards US$80-$90 per tonne as we head into 2013.

The action in the Chinese steel market and the recent actions of the PBoC have a lot in common. In recent weeks, the PBoC has had a preference for injecting liquidity into the market via a mechanism known as 'reverse repos'. This is basically a way for the PBoC to inject cash into the system on a short term basis. That's because the bank 'reverses' the cash injection after a certain amount of time. In short, it's a temporary measure.

It differs from more permanent actions like outright interest rate cuts or reductions in the 'reserve requirement'. This suggests to us that the authorities are very determined not to reinflate the infrastructure boom. While doing so might produce a short term boost, they know it would only lead to longer term problems.

Our theory is that the point of the PBoC liquidity injections is to stop the financial system from seizing up. When you go from boom to bust (and make no mistake, China is in the bust phase now...look at the performance of its stock market in the chart below) you get liquidity problems.

What do we mean by that? Well, when one company starts to struggle it might hold off on paying its creditors. Those same creditors have their own creditors to deal with and so on down the line. Cash flow problems at one company tend to flow through and impact many companies.

This is the genesis of a credit crunch. Credit within the system 'freezes up' and the system grinds to a halt. To offset this risk, the PBoC is now conducting regular 'liquidity injections' to ensure the system remains tepid at least.

But we see it as no reason to get excited. Overnight, commodities and particularly gold performed well, apparently on the back of China's liquidity announcement. Funnily enough, the gold market didn't react at all during the Asian trading session when the PBoC made the announcement.

But when the US markets opened, paper commodities and precious metals benefited. The (more permanent) liquidity provided by the Fed's open ended QE program loves other liquidity type announcements because it can take advantage of them through the derivatives/futures markets.

Which brings us to an absurd point of QE. When central banks print money, investment banks design products to help you offset the inflationary impacts of the money printing. They tell you to buy 'real assets' and then sell you a wheat or copper or Gold Futures contract...or put you into an Exchange Traded Fund (ETF) that gives you exposure to the cash price of real assets but only via the derivative market.

And just like that, you 'escape' the invidious effects of monetary inflation by putting your savings into paper based investments which are the very result of the monetary inflation you're seeking to escape.

So here's something to think about over the weekend. If the price of 'real' assets is largely the product of demand for paper derivatives seeking exposure to real assets, how do you hedge against the risks of increasingly reckless central banking?

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