My China contacts tell me that the anger China is currently displaying over issues like Australia’s call for a COVID-19 inquiry and journalistic disputes is minuscule compared to the fury in China created by the recent jump in the price of iron ore.
Rightly or wrongly, Chinese President Xi Jinping believes that Australia has ruthlessly exploited the COVID-19 pandemic to force China to pay exorbitant prices for iron ore. Xi is determined to teach us a lesson as early as next year, but certainly in the years to come.
Australia has undertaken a massive domestic expenditure program to reduce the economic impact of the pandemic and has been able to fund at least part of that expenditure by the massive tax revenue that is being generated by the high price of iron ore.
If China succeeds in slashing the price of iron ore next year and in the following years, Australia will feel great pain. But so will the shareholders in BHP, Rio Tinto and Fortescue, who have been basking in higher profits and dividends in the wake of the higher iron ore price.
Of course if China is successful in slashing the iron price it will, almost certainly, reduce the value of the Australian dollar which will cushion some of the impact of the lower mining profits when converted to the Australian currency.
‘Australian extortion’
The Chinese belief that the current iron ore price is simply Australian extortion imposed on China is partly frustration over a series of events that coincided to send the price higher than anyone could have expected.
Earlier this year in the midst the early stages of the pandemic, iron ore fell to around $US80 a tonne. At that level, the local Chinese production incurs losses, so production was curtailed.
China was able to contain the effects of COVID-19 more effectively than any other developed nation and to restart its economy it embarked on a major program of infrastructure and property investment, so increasing the demand for steel and iron ore.
China’s second largest supplier, Brazil, could not respond to the higher demand because its main producer, Vale, became a victim of COVID-19 infection.
In contrast, Australian iron ore mines did not become infected with COVID-19 and lifted output marginally.
The combination of increased demand and restricted output by local Chinese producers, as well as Vale, set the scene for the big price rise to around the $US125-130 mark — the highest since 2014 and the largest rise of the major commodities.
To slash the price China is looking to increase local production, which is profitable at prices above dollars $US90 a tonne. And it expects that next year Vale will be able to produce greater tonnages.
At the same time, this latest Chinese round of capital investment is similar to what happened at the end of the Japanese capital investment boom: new capital expenditure was of marginal value and often totally useless. Accordingly, the Chinese expect to decrease their capital spending next year and look to consumers to fill the gap. At the same time, it is likely that exports to the US will decline further in 2021 – particularly if Donald Trump wins a second term.
Teaching us a lesson
Then, in China’s view, Australia will be taught a lesson about not exploiting a pandemic against your main trading partner. But in Australian, eyes we are simply benefiting from a market price increase just as we suffer from market a falls. There is no extortion.
But China will take its plan to lessen dependence on Australian iron ore to a second stage and is encouraging Brazil to open up new mines and new deep water ports to enable the Chinese supercarriers to take Brazilian ore to China at costs that are comparable or lower than to transport from Australia, where smaller ships are used.
China hopes that this will further lower the iron ore price and decrease Australia’s role in the trade. Further down the track China, with the help of London-based Rio Tinto, hopes to open the massive Simandou iron ore mines in Guinea.
I suspect the full force of the lesson China plans to teach Australia will be felt by BHP. The Big Australian played a large role in converting iron ore contracts from fixed price to market price around a decade ago and the largest shareholder in Rio Tinto – BHP’s major iron ore rival – is a Chinese state owned enterprise, Chinalco. It will be fascinating to see the reaction of Chinalco in the Indigenous caves issue that is putting the job of Rio CEO Jean-Sébastien Jacques under pressure from Australian institutions.
China believes that the Australian currency is vulnerable to a big fall in the iron ore price, given its huge deficits and dependence on borrowing. And so a collapse in the iron ore price will inflict significant punishment on the recalcitrant nation down under.
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Australia must brace itself for the next round of the war of words and actions with China – an attack on the price of iron ore and the nation’s key revenue base.