Iron ore price drop is a disaster for Australian economy, wage growth

In a world of gamed markets and financialisation, iron ore stands out as one commodity still traded largely on fundamentals.

There are three clear reasons for the current price falls.

The first is that demand for steel in China is weak, notwithstanding its reopening growth surge. The growth is coming largely from consumption and services. Commodity-intensive segments like construction, which devours two-thirds of Chinese steel, are weak and getting weaker.

The largest Chinese consumer of iron ore these days is infrastructure. Funding for new projects is falling from last year’s boom and project approvals have fallen sharply, as shown

in this chart on China major infrastructure approvals:

The second major component is apartment construction which is also very weak. There is a property price rebound underway so it will improve. But nothing like in past cycles because China has cut its developers off from dollar-bond financing. So, these days, developers can only build based on underlying demand, not leverage into ghost cities to sell later.

Real demand is much lower than in past cycles and it, too, is falling as China runs out of people to force from the countryside to the cities:

The second major input into falling iron ore prices is strong supply. All major miners reported strong production through Q1 and we are now coming out of cyclone season so strong shipments will follow. As well, Fortescue Metals Group is ramping up its new Iron Bridge mine and launching a range of new products so its volumes will climb sharply.

Third, iron ore is always weak in the April/May period after Chinese steel mills complete their Q1 inventory builds:

Cyclic or structural?

So, there is a mix of cyclic and structural forces at play in recent weak price action. And we can probably expect iron ore to recover somewhat mid-year (barring a sudden global shock). But the weak demand for steel described above is structural. China has deliberately killed off the leverage in its property development sector. And it is doing the same in local government financing for infrastructure. Both of these are measures designed to lift the efficiency of capital and productivity more broadly.

That makes today’s iron ore price weakness different to previous bouts of the same. This time, it is the canary in the coal mine for the Chinese economy going ‘ex-growth’. Chinese authorities are now aiming for quality growth over quantity and wasteful construction is their number one target to be left behind.

Worse, owing to the base effects of zero-Covid in 2022, the services boom can easily meet the growth target of 5 per cent without the need for any panicked stimulus. So, authorities can stay the course.

This wind down in growth prospects will affect a wider array of commodities than just iron ore. It is already hammering thermal and coking coal lower, as well as LNG, and some base metals.

This is one major reason why the Australian government’s commodity forecaster, the Office of the Chief Economist, was intensely bearish in its outlook this year, forecasting huge falls in Australian commodity income ahead:

Effects on Australia

We know what this will do because we have seen it before. The Australian economy suffered a similar scale commodity bust in 2012-15. It gutted nominal growth and forced a huge pay cut on the nation as the terms of trade fell.

This hits the budget hard, forces taxes higher, lowers economic activity, and sucks the life out of wages.

Last time around, Canberra responded by ramping up mass immigration, which supported property markets but deflated everything else. All signs point to a rerun despite economic outcomes last time that were questionable at best.

We had better hope that the RBA gets inflation under control. Or real incomes and living standards are going to gallop backward faster even than during the last commodity crash.

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geopolitics and economics portal. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.