Fitch Ratings-Sydney/Hong Kong-18 March 2014: The fundamentals underpinning China’s demand for key commodities from Australia remain unchanged, despite iron ore inventory at China’s major ports reaching a two-year high and lower China GDP forecasts, according to Fitch Ratings.
The high iron ore stockpiles of 105 million tonnes (mt) as of 7 March 2014, and the recent fall in the prices of key commodities, are casting negative sentiment on Australian exporters because China’s factories are the biggest buyers of Australia’s iron ore, copper and coking coal. We believe a combination of seasonal and one-off factors have clouded market conditions, and Chinese demand for Australian commodities is not about to decline drastically.
Steel production fell to 2.0mt during early to mid-February, which caused the consumption/inventory ratio to increase to 29 days at end-February from just above the 27-day long-term average. We expect production to rise back towards the 2.1mt 2013 average – now that seasonal and one-off factors are largely over.
The seasonal slowdown over the Lunar New Year period, together with traders using iron ore as collateral to profit from interest-rate differentials, has contributed to the inventory overhang, and fuelled the negative sentiment. The inventory trade uses interest-rate arbitrage swaps (IRAS) to import iron ore into China based on low-interest letters of credit, and then uses the iron ore as collateral to invest in China’s high-yielding domestic markets.
The seasonal slowdown was extended this year because of severe pollution in many Chinese cities, and a push by steel-makers to upgrade their plants to meet environmental standards in the wake of a government announcement that it will crack down on officials neglecting environmental issues.
Notwithstanding lower forecast GDP growth of around 7% over the next two to three years, the higher base effect of China’s economy after years of rapid expansion means that demand for commodities will keep rising in absolute terms; however, the extent of each year’s incremental demand is likely to decline progressively.
Specifically, China’s fixed-asset investment (FAI) propels growth in the global resources sector, and is still far from saturation. Chinese building starts rose by 13.5% to 2.0 billion cubic metres in 2013, with December 2013 recording the highest year-on-year growth. Such strong construction supports the medium-term outlook for the steel sector, which bodes well for Australian iron ore exporters. Yet Fitch is cautious that China’s incremental demand for commodities (including iron ore) may have peaked – and will not revisit the 2008 to 2013 level that was fuelled by China’s economic stimulus.
China’s reliance on imported iron ore actually increases when iron ore prices are comparatively low, since Chinese production costs are much higher due to the poor grade. For example, when prices were at their lowest in 2013 during the May-July period, Chinese iron ore production managed only anaemic growth of 2% to 3% yoy; whereas iron ore imports grew by 13% yoy. This contrasts with an overall 10% growth in 2013 for both China’s iron ore production and imports. Furthermore, Fitch is wary that weakening profitability at the Chinese mines will limit capex spending and constrain capacity expansion.
TRF Price at posting:
7.6¢ Sentiment: LT Buy Disclosure: Held
