Treasury needs a better crystal ball on China

When Treasurer Joe Hockey releases his first budget tomorrow, all eyes will be on his spending cuts. But don’t forget to look at Treasury’s forecast on the Chinese economic growth rate and the demand for iron ore -- the single most important commodity for the health of federal budget revenue.

The department has a relatively uninspiring record when it comes to predicting Australia’s terms of trade -- the prices we receive for exports relative to the prices we pay for imports. The review of Treasury Macroeconomic and Revenue Forecasting in 2012 found that the department consistently misjudged the evolution of the Chinese economy and the mining sector.

The decision by the department to rely on consensus economic forecasts, which combine several separate forecasts, led to a consistent underestimation of economic growth in China and hence the underlying strength of demand for iron ore and metallurgical coal.

Chinese economic growth was underestimated on average by 2.5 per cent points per annum over the period 2003 and 2007. On the supply side, Treasury economists were more optimistic about the speed at which global and Australian mining productions would increase to meet the rising demand from China.

They had overlooked the long lead time required to scale up iron ore production, the country’s infrastructure bottlenecks, and the impact of natural disasters. The misjudgement saw Treasury’s forecasts for export volumes consistently overestimated over the 2003-04 and 2008-09 periods.

Since the 2012 review, the Treasury has significantly strengthened its China and resources analytical ability, establishing a dedicated China policy unit to look after Australia’s largest and most important trading partner.

The department is also expected to draw on expertise from the Bureau of Resources and Energy Economics to forecast the outlook for bulk commodities.

Will Treasury get it right this time as we see iron ore prices sliding to $100 per tonne? Last time the price dropped to this level, the previous Labor government was forced into a humiliating concession -- that it could not deliver a budget surplus as promised.

The Bureau of Resources and Economics offers us a glimpse into what Canberra econocrats think of the iron ore price -- the single largest export earner for the economy in its March quarter report. In short, the BREE is still reasonably bullish on Chinese iron ore demand and believes government spending programs are expected to result in a rebound in steel consumption throughout the remainder of 2014.

The bureau expects China’s steel production to increase by 3.5 per cent, relative to 2014, to 802m tonnes with a spot price for 2014 at around $110 per tonne.

“Any sustained period of CFR North China prices below US$100 a tonne should result in higher cost Chinese producers closing down mines if China’s announced market reform’s extends to the iron ore industry,” says the report.

Australia’s leading resources forecaster’s prediction is taking place against Beijing’s avowed effort to reduce excess capacity in industries such as the steel sector, concerns over the country’s real estate sector which is the biggest consumer of steel products and the banks’ decision to crack down on steel mills and traders’ practices of using iron ore as collateral to obtain unsecured low interest rate short-term loans to boost their cash flows.

However, analysis of BREE’s past forecasts has raised concerns over its reliability. For example, the bureau’s short-term forecasts for China’s demand for iron ore imports have been revised upwards significantly since last year.

In its 2013 forecast, China’s iron ore imports was predicted to rise from 805m tonnes to 916m tonnes over the 2014-17 period. In its latest update, BREE forecasts the demand will increase from 871m to 1019m per tonne over the period. BREE has had to revise China’s expected iron ore import growth over 2014-17 upward by as much as 34 per cent.

Luke Hurst, an Australian National University researcher, says the upward revisions are somewhat puzzling given BREE’s previous forecast assumption that “in the second half of 2013, contract prices for iron ore are forecast to increase, based on an assumed stimulus package from the Chinese government generating an increase in steel-related consumption demand”, which never happened.

Though John Kenneth Galbraith, one of the leading economists of the 20th century has said “the only function of economic forecasting is to make astrology look respectable”, it is still important that Australia’s lead forecasting agencies get a better grip on what is happening in China and the commodities market.