Here Comes the Next Great Recession? The Dual-Stimuli Dilemma
Editor’s Note: The below is part two of a two part series. Read part one here.
For years now, China’s global infrastructure stimulus (a seemingly permanent phenomenon) drove countless emerging economies. Infrastructure constructed to support infrastructure. And commodity producers had another tailwind to bolster the China boom—Fed policy. For the past decade commodity producers have benefitted from a weak U.S. Dollar as the Fed first held interest rates low for a longer than expected time frame, and then experimented with unconventional tactics. Since most of the commodity trade is settled in the U.S. dollar, a weak dollar commands a lower price for a commodity in non-Dollar terms—if the Euro rises against the dollar and oil stays flat, oil has become cheaper in terms of Euros. This stimulates demand for a commodity, in turn pushing the price higher. For the last decade, then, the U.S. has been stimulating demand for commodities worldwide in an attempt to spur on its own domestic growth.
In other words, China’s infrastructure boom supported volume while Quantitative Easing put a floor under the demand and increased prices by pressuring the U.S. Dollar lower. Commodity producers had the best of both worlds—China and the U.S. working simultaneously to hold the commodity bubble together—but may soon be seeing the worst of all possible worlds.
Australia is a case study in overshooting the China story with at least one commodity—coal. In recent years, Australia built coal mine after coal mine to deliver to China’s steel industry and electric utilities. The bet—at least for a few years—paid off, but then came the oversupply and declining prices. There have already been shutdowns of mines, and any signs of weakness in China would portend more. This is particularly distressing for Australia, with coal being its second largest export behind iron ore. China has become the destination for over 35 percent of Australia’s exports, and, since the turn of the century, constitutes more than half the growth in exports.
Different countries have differing levels of exposures to a slowdown in Chinese infrastructure investment. The type of commodity countries sell to China is also important. For instance, there is a difference between commodities used for consumption and those used for infrastructure—a commodity used for consumption would be less impacted by an investment slowdown than infrastructure. The end use of coal is much different from the end use of iron ore or copper, and demand for all three has been pushed higher and higher by China. Global iron-ore demand is dominated by China with Beijing constituting more than half the demand. But after rising consistently, iron-ore prices are now falling to post-recession lows. This is not only a product of Chinese demand, but also an incredible amount of supply brought on to support the demand creating a surplus. The story of copper is similar—except that copper demand would have been negative without the marginal demand from China over the past decade.
In a paper exploring the effects of a hard landing on commodity exporters, Gauvin and Rebillard assume—quite reasonably—that China GDP falls to 3 percent growth per year and investment in infrastructure flat lines. The results are worrisome. Australia, by their calculation would suffer a cumulative loss of 3.5 percent of GDP over five years in a soft landing—nearly 6 percent in a hard landing. The emerging world is worse—probably due to its nearly singular exposure to Chinese growth. In a hard landing scenario, the authors estimate the RIBS would be some of the most challenged, at least from the first effects of a slowdown. The BRICS would no longer hold their elevated status as the harbingers of a new economy. Instead, a pandemic of Dutch Disease would break out. The story of emerging markets changes from outstanding growth to containing the carnage.
But there is more to the story. Australia and Canada, both of which have strong ties to China’s infrastructure, have had two of the best housing markets in the developed world. Canada appeared to entirely avoid the financial crisis, and Australia’s housing prices continued their steady march higher. Much of their successes should be attributed to their economies relying so heavily on commodities and the Chinese infrastructure stimulus. Not to mention the incremental benefit of creating jobs in constructing the facilities necessary to meet the projected increase in demand. It now seems unlikely all of the anticipated demand will ever materialize. And neither economy reset their financial system during the Great Recession as the U.S. was forced to do. This leaves the commodity countries—not simply Canada and Australia—vulnerable not only to a decline in the volume of commodities exports, but to generally lower prices. Lower prices lead to right sizing of supply, the shuttering of high cost mines, the loss of employment, and lower employment leads to lower consumption and so on.