From its low on December 15 last year to its high on April 22, 2016, iron ore had a spectacular rally, rising 71% in value. The rebound coincided with optimism that China’s economic slowdown had stopped and was going to stabilize at a growth rate of around 6.5%-7.0%, in line with government forecasts for 2016. China may be stabilizing, but iron ore prices have since dropped by over 20% from their April peak. What is pressuring iron ore and why has it been so much more volatile than copper? (Figure 1)
There appears to be two factors driving iron ore’s recent decline: supply and China. Iron ore supplies have grown much more quickly than almost any other metal. Iron ore mining supply has tripled since 2002, while copper mining supply has risen by only 37.5% over the same period. While iron ore mining supply did fall by 2.9% in 2015, it is coming off very high levels, and production in 2015 is still the second highest on record (Figure 2). The market for iron ore is still vastly oversupplied.
Iron ore producers ramped up production mainly to meet demand from China. Unlike the United States, Japan and Western Europe, which meet most of their steel needs using recycled scrap, China relies largely on newly-made steel to meet its infrastructure needs. China’s economy is 17x larger today than it was in 1980, and it had little in the way of old steel from used automobiles and demolished buildings to recycle. China consumes 40%-50% of most industrial metals, but in the past several years it has been using close to two-thirds of the world’s supply of iron ore. While China is the world’s largest producer of iron ore, it still imports 25% of world production, mainly from Australia and Brazil. This makes iron ore exceptionally sensitive to economic developments in China.
As such, when the Chinese government announced economic stimulus measures in late February, it may have contributed to iron ore’s rebound from its recent doldrums. The People’s Bank of China (PBOC) added fuel to the fire with cuts to both the reserve requirement ratio and interest rates. More generally, commodity prices and emerging market currencies rebounded, relieving some of the downward pressure on the Renminbi. In recent weeks, however, both iron ore and the Renminbi have been weakening again. One reason might have to do with China’s high level of private sector debt (Figure 3).
China’s debt levels are soaring. Relative to GDP, China’s total level of debt (public + private) rose by 20.2% over the course of 2015 to 254.7% of GDP, according to the Bank for International Settlements (BIS) (Figures 4 and 5). The biggest increase occurred in China’s already highly indebted non-financial corporate sector, whose debt level rose 14% faster than GDP from 157% to 171%. Household and government debt each rose by about 3% of GDP.
For debt to grow by 20% more than GDP in a single year is worrisome for several reasons:
It’s also clear that the Chinese government is becoming concerned about the level of debt. On May 10, 2016, an “authoritative person,” likely somebody close to the top of China’s power structure, wrote anonymously in the People’s Daily, warning against excessive, “blind” credit expansion to inefficient enterprises in China’s non-financial corporate sector. This was an implicit acknowledgment that too much credit was being extended. The article also warned that without supply-side structural reforms, China might have more of an L-shaped, rather than a U or V-shaped economic recovery. In any case, an L-shaped (non)-recovery would be close to what occurred in Japan and Europe following their crises. Even in the U.S. and U.K., which cut rates to zero and initiated quantitative easing much more quickly after their economic crises began, recoveries have been slow and uneven.
So what does the decline in iron ore prices tell us about China? It’s a difficult question to answer with certainty, since iron ore prices are governed by many factors, including oversupply on global markets. That said, the metal’s recent decline might be pointing to a renewed slowdown in China. It might also be signaling that China’s recent monetary and fiscal loosening is not delivering the planned boost to China’s rate of economic growth.
If iron ore prices resume their decline and if China’s economy does not rebound as hoped, this could be bad news for many commodity exporting nations, not least of all Australia and Brazil, which are the two largest exporters of iron ore. Both the Aussie dollar and the Brazilian real correlate positively with iron ore futures (Figures 7 and 8).
Steel prices have been soaring recently, completely decoupling from iron ore prices (Figure 9). On the face of it, higher prices for hot rolled steel might be interpreted as a positive sign for iron ore. Unfortunately for the suppliers of base metals, steel prices have risen mainly on hopes that China will be cutting back steel production, perhaps by starving some of its less efficient producers of the credit that they need to stay alive. This is good for steel in the sense that it reduces supply but bad for iron ore given that it means less demand. Eventually iron ore and hot rolled steel will begin to correlate positively once again but that may not be in the cards immediately.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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