China stimulus and headwinds
China has announced a range of stimulus measures recently. This pivot has been needed partly because of longstanding fragilities. It is hard to see a lasting upside for Australian iron ore exports from the moves.
In recent weeks, Chinese authorities have announced a range of stimulus measures, along with some vaguer statements of intent to stimulate. Westpac Economics’ Head of International Economics Elliot Clarke had the details in our October Market Outlook (PDF 2MB). Since then, the authorities have announced further housing-related measures that have mostly disappointed market observers.
The Chinese authorities have come to this point because domestic demand, especially consumer spending, has been soft and deflation has emerged. This illustrates a general principle about post-pandemic recoveries. The strength of recovery typically depended on the balance between the length and severity of the social distancing restrictions, and the extent of the policy support relative to the ‘income hole’ the restrictions created.
For example, restrictions in the United States were shorter-lived than in some peer economies, while the income support was extensive. Some workers were better off on the extended unemployment benefits than they were when they were working. Together with the stimulus from post-pandemic fiscal packages, it is no wonder that US domestic demand growth has outpaced that in other major advanced economies. In China, by contrast, restrictions (and the risk of snap lockdowns) persisted for much longer than elsewhere, but the income support to households and businesses was more limited. After an initial post-opening burst, consumer spending in China has been soft. In Australia and most European nations, these forces were more balanced; Australia inadvertently overfilled the ‘income hole’ but had restrictions in place for longer, while the Europeans tended to underfill the hole.
Another reason for the turn to deflation in China is that much of the stimulus and other policy measures have been about boosting supply capacity in priority areas, especially in high-tech manufacturing, rather than lifting demand.
More broadly, though, the pivot to stimulus has become necessary because of longer-standing fragilities in the institutional landscape there.
One of these fragilities is a vertical fiscal imbalance. Local and provincial governments are responsible for much of the public spending, especially for infrastructure. However, taxation powers are concentrated at the national level. The central government does redistribute some revenue back to the provinces, but not enough to cover the gap. Local governments therefore rely heavily on non-tax revenue sources such as land sales.
This reliance has made local governments sensitive to housing market cycles, which in turn collides with another fragility: construction activity has been contracting in China for several years. The beginnings of the decline were at least partly intentional. The government was concerned about the risks arising from high leverage and wanted to ensure that housing was for living in, not just speculation. They imposed a range of restrictions on the number of properties people could buy, and how much debt they could borrow to do so. Some of the stimulus measures announced in recent weeks are simple relaxations of those earlier restrictions.
Beyond these policy objectives, though, part of the issue is that housing construction needs to be a structurally smaller part of the Chinese economy than it was in recent decades. The population is shrinking, so there is no need to build homes to house additional people. The urbanisation phase is maturing, so there is less need to build homes in cities to house people who previously lived in rural areas.
Perhaps less well understood is that there is also less need to build new homes to replace older ones. When real incomes are growing at 10% per year, the home built ten years ago – when your real income was less than 40% of its current level – is no longer fitting to your aspirations. So there is a strong impetus to replace older buildings with newer, nicer ones. As living standards converge to those of richer peers and growth rates slow to 5%, or 4% or less, that economic rate of depreciation declines. There is less of an impetus to replace the old homes with new.
We have, of course, seen similar dynamics elsewhere. Economies in South-East Asia grew very quickly in the early-to-mid-1990s as they opened up and industrialised. Ireland and Spain also saw fast growth, and high levels of housing construction, after joining the euro area and converging to euro area living standards. Neither of these episodes ended well, though. Perhaps China can stick the landing on the transition to a smaller housing construction sector, because the authorities are trying to pre-empt the process. But the odds are against it.
That the Chinese authorities are indeed trying to induce shrinkage in the housing sector illustrates another key principle: China’s system is different, and the authorities can and are willing to use a broader range of interventions to achieve policy objectives. For example, while central banks in some major advanced economies resorted to purchasing assets during severe downturns in recent decades, a facility to lend to financial firms so they can buy equities would be deemed a bridge too far. This means that policy support in China can counter even clear fragilities and contradictions in the policy environment for longer than would be likely in the West. The Chinese government can and will ‘kick the can down the road’ for longer than markets can bet against their capacity to do so.
The ‘Iron Law’ for Iron Ore
The question for Australia is whether stimulus in China will be enough to kick the can down the road for the Chinese steel market, and so demand for iron ore, our largest export to China and in total. The question arises because this industry, too, is facing structural limits like those facing the construction industry, and for partly related reasons.
There is an empirical regularity – an ‘iron law’, almost – that, once countries hit a certain level of economic development, domestic demand for steel per capita tops out, unless you are Japan or South Korea and have a big export industry in shipbuilding. Beyond that GDP level, economies become more service-oriented and there is no additional per capita demand for steel. Past analysis by the RBA puts that level at about $US10,000 at 1990 prices; at current prices that would be around $US24,000. China has already reached that level, and with a shrinking population, Peak Steel per Capita also means Peak Steel in Total.
As Westpac Economics colleague Senior Economist Justin Smirk noted in our October Market Outlook, (PDF 2MB) Chinese steel production peaked already in 2020. There is no material upside to the size of this market in the long term. Since Australia remains a low-cost and reliable producer, we will continue to have a significant export market even if China switches to greater use of scrap steel in production in future. And in the short term, the consolidation of China’s steel industry favours the imported ore that Australia produces. But like the stimulus measures announced in recent weeks, these forces delay a near-inevitable slide in industries that have structural reasons to shrink. They do not create major avenues for additional growth for Australia.
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