Iron ore prices, which have fallen by 24% in the past month, have been front and center in our views on the China debacle recently. Following the RBA's decision not to cut rates last night we thought Macquarie's recent insight into just how bad an impact a sustained weakness in demand could have on the Australian economy was worthwhile, as hope seems to remain that the destocking among Chinese steel mills will end at some point and demand will re-emerge phoenix-like (though we strongly suspect not).
Sharp falls in commodity prices undermine mining company cash flow, which could prompt firms to divest assets and cut capex budgets - borne out by estimates of a 50% cut in capex for Rio and BHP if pressures remain.
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With mining investment the mainstay of the Australian economy, this would have profound implications, as business investment would drop (consensus 2013 investment forecasts would fall by 20%) - implying a 4ppts slash in final demand growth or more specifically up to a 3ppt cut in GDP...
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and a 4ppts rise in the unemployment rate...
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The critical aspect is the economic deterioration (and lower commodity prices) would for sure prompt action from the RBA - which would in turn remove support for the AUD (a key carry driver for risk around the world). Furthermore, the combination of reduced mining company profits and weaker economic growth would place severe strains on government revenue and lead to a large budget deficit. That may also undermine foreign investor appetite for Australian government bonds which has also supported the AUD.
It seems AUD remains too resilient relative to its dominant factors... consider the impact on global risk assets if AUD drops 20%...
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Macquarie, Australia Without Mining: Conclusion
- Our base case is that commodity prices do improve from current levels as the Chinese destocking cycle eventually comes to an end. But even if the present period does not signal an early end to the mining investment boom, it might be a foretaste of things to come at a later stage. This note has presented a scenario taking as our starting point the potential impact on mining investment that would occur as mining companies cut spending in response to reduced cash flows.
- In our view, three points quickly emerge.
- First, that the impact of a rapid decline in mining investment would be severe on the economy.
- Second, that one should not take too much consolation from the fact that there are still many investment plans on the books: if cash flows evaporate, investment will be cut back.
- Third, that the current level of iron ore prices is not consistent with the current level of the A$. In the past we have argued that the A$ is not solely driven by commodity prices, but that interest-rate differentials and Australia’s AAA credit rating have become increasingly important factors. But as we have argued in this note, if iron ore prices were to remain at current levels, that would have a material impact on those other factors that are currently supporting the A$.
- In our view, the relative resilience of the A$ suggests that most investors believe that iron ore prices will recover over the next few months. But if they don’t then this could be the “Wile E. Coyote moment” for the A$. What we are referring to here is the well-known cartoon character who, when he's chasing the Road Runner, frequently runs off the edge of a cliff. But, initially at least, he doesn’t fall. His legs are still running as if he is on land and he remains suspended in mid air. But then he looks down, and realises that there is nothing supporting him, and it is only then that he succumbs to the forces of gravity and plunges towards the valley floor.
Source: Macquarie