Why Iron Ore Is A Proxy for China’s Economic Health

Iron ore prices have tumbled by 58 percent over the past 12 months, far outpacing declines in other industrial metals.  Copper prices, for instance, are down by only about 10 percent the past year while aluminum and lead prices are down by just single digits in percentage terms.

 

Iron ore has a low correlation to other metals, including copper and hot rolled steel making it a potentially interesting portfolio diversifier for those who have exposure to other metals.

 

Iron ore Copper correlation

 

Although China is the world’s largest producer of iron ore (47 percent in 2014), it used over 70 percent of the world’s total iron ore supply.  By comparison, , Chinese consumption [1]of copper in 2013 amounted to 43 percent of the world’s total –still a very large share but much less than its appetite for iron.

China consumes so much iron ore largely because it uses very little scrap in its steel production (which totaled 49 percent of the world’s total in 2014).  This contrasts sharply with the United States, where 60 percent of the steel is fabricated from scrap.  In developed countries like the United States, there is a large and steady supply of scrap steel from used cars, demolished buildings, etc. that can be used to create new products.  Such large quantities of scrap are less readily available in rapidly developing countries like China, whose steel producers have to rely on iron ore and the other raw components of steel, such as carbon, nickel and chromium.

 

When China Sneezes, Iron Ore Catches Cold

The recent decline in metals prices appears to be largely related to the slowing pace of growth in China, the world’s largest consumer of metals.  There are several reasons for China’s deceleration, including:

  • China’s currency, the Renminbi (RMB), remains closely tied to the U.S. Dollar and has followed the greenback higher against nearly every other currency in the world, making Chinese exports less competitive.
  • China’s private sector remains fairly heavily indebted, with a higher debt burden than other emerging market countries This may be contributing to a slowdown in Chinese construction activity.
  • China’s leader, Xi Jinping, is cracking down on corruption, which might slow the pace of approvals for construction projects.

The three factors stated above may also be contributing to a slowdown in Chinese demand for iron ore, which may be facing additional pressures from a buildup of inventories in China.

To be clear, we don’t anticipate anything like a recession in China.  The People’s Bank of China (PBOC) has been easing policy by reducing its reserve requirement ratio for banks and cutting interest rates.  These moves should offset some of the impact from a strong currency, high private sector debt and the bureaucratic paralysis that results from the crackdown on corruption. To the extent that PBOC is able to stimulate investment and demand through easier monetary policy, it could prove to be supportive of iron ore as well as the currencies of the world’s key exporters of iron ore. Therefore, we would expect iron ore prices to respond positively to additional PBOC monetary easing.

 

Australia and Brazil

The collapse of iron ore prices is reverberating around the world.  Australia, the world’s largest iron ore exporter, could see as much as 2.2 percent shaved off its GDP growth as a first order consequence.  Brazil, the second largest exporter, is likely to see a 0.7 percent reduction in GDP as a first order consequence. The actual impact on GDP, however, could differ significantly (and could probably be less) than the first order consequence might suggest.  The recent depreciation of the Australian and Brazilian currencies will boost exports and protect their domestic industries from imports.  In the case of Australia, easier monetary policy will also mitigate the negative impact of lower iron ore prices. Brazil won’t be as fortunate: Its central bank has been tightening policy, and the government has been raising taxes and cutting spending, which in the short term will exacerbate the negative impacts of lower prices for commodities, including iron ore, on the economy.

As such, the undertow from the price collapse may have contributed to the weakening of the Australian dollar (AUD) and Brazilian real (BRL).

Those seeking to evaluate exposures in AUD and BRL currencies might also look to the price of iron ore as a potential driver of returns.

Iron ore AUD

 

Iron Ore BRL

 

China’s slowing economy has had a disproportionate impact on the price of iron ore owing to its heavy consumption of the metal.  In the near term, the price of iron ore will likely remain an important indicator of the health of China’s construction and export-driven economy.  Moreover, it might continue to exert some influence on the AUD and BRL as well as monetary policies in Australia and Brazil.

Erik Norland is a Senior Economist at CME Group.

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