Will there be a more important driver of Australian growth over the next decade than Chinese investment? The near-term prognosis for investment is reasonably good but iron-ore producers must be getting nervous as prices decline and demand shows tentative signs of slowing and Chinese authorities look to curb excess capacity.
Investment has been a major driver of China’s economic success story. Real gross fixed capital formation has increased by an average annual rate of 11 per cent since 2000, although this has declined a little in the past couple of years.
Investment accounts for almost half of total Chinese GDP; by comparison, investment in Australia accounts for almost a quarter of economic activity. In fact much of our recent investment has been in response to rising demand for iron ore, which has been necessary to facilitate Chinese infrastructure investment.
As a result, the outlook for Chinese investment is of central concern to not only Australian miners but also the broader Australian economy. Resource export growth will be a key determinant in whether our economy returns to trend growth and whether we can successfully transition away from a growth model that relied disproportionately on mining investment.
It should then be no surprise that the Reserve Bank of Australia published a recent piece on the outlook for Chinese investment in their quarterly bulletin. It presents a fairly bullish picture of investment, noting that “there is still some way to go before China achieves convergence with the provision of infrastructure seen in advanced economies”, including some other developing Asian economies.
The rural-city migration in China will continue to push the demand for greater and improved infrastructure. The government’s urbanisation plan targets an urbanisation rate of 60 per cent by 2020, which is an increase of 6 percentage points on its current level.
According to Chinese Vice Foreign Minister Wang Bao’an, a further 100 million people will migrate from agricultural and rural areas toward the cities by 2020, resulting in investment worth around 74 per cent of Chinese GDP divided over the next six years.
Those estimates only include the investment necessary to facilitate further infrastructure -- just one component of total investment. But it helps to highlight one risk to the investment outlook in China: the pace of urbanisation is beginning to slow.
For investment to contribute to growth, activity must increase year-after-year. If the pace of urbanisation slows, then this will weigh on the contribution investment makes to growth, even if by developed standards investment growth remains quite high.
Further weighing on demand is China’s anaemic population growth, which may begin declining over the next 10 to 15 years, as well as excess capacity through over-investment.
As Peter Cai noted last week, the Chinese economy is showing signs that it is determined to rein in excess capacity (Curbing China’s excess capacity, June 10). In May, the Ministry of Industry and Information Technology, which oversees the steel industry, said the country would need to cut an extra 1.7m tonnes of steel and 8.5m tonnes of cement in 2014.
In an ideal world, curbing excess capacity would be offset by greater household spending and higher productivity as a result of earlier investment. Unfortunately, this would be to the near-term detriment of Australian growth, since we produce very little that the household sector consumes.
Another concern for infrastructure investment is project selection and evaluation. According to the RBA, about 85 per cent of infrastructure investment in China is undertaken by the government -- a much higher share than is typical in other countries.
With the lack of price signals available, this gives rise to poor project selection and inadequate evaluation of alternatives. This is currently an issue in Australia and given the sheer level of investment in China, the likely costs must be far greater (The great infrastructure drain must be plugged, March 17).
There is also growing concern regarding the financing of infrastructure in China. This mostly relates to local governments, which sometimes lack the capacity to finance investment through revenue or via debt issuances. Chinese authorities are looking at a range of reforms to address this issue, which are discussed in detail in the RBA’s article.
For the Australian resource sector, the risk relates not just to Chinese demand but also to commodity prices. Obviously the two are related in a sense; high commodity prices and our elevated terms-of-trade were a direct result of high Chinese demand. But with greater supply coming online recently -- mostly from Australia -- iron ore prices have declined by over 30 per cent, presenting an existential risk for some domestic iron ore producers.
This is already weighing on margins across Australia’s resource sector and as The Australian reported yesterday, it has already claimed its first victim: the Cairn Hill iron ore project in South Australia. Fortescue remains at risk, with high levels of debt and a relatively high break-even of $72 per tonne (Fortescue gets another wake-up call, June 17).
Urbanisation will continue to drive demand for infrastructure investment in China but we shouldn't ignore the effects of population growth and the declining rate of urbanisation. Both will weigh on growth in the medium-term.
Of more immediate concern, however, is the excess capacity resulting from past investment. This points to softer demand for iron ore and coking coal and may result in commodity prices falling even further. This presents a near-term risk for the Australian economy, not just in the broadest sense but with regards to individual iron ore producers.