The Sun Sets in the West

The Lord giveth, and the Lord taketh away, so sayeth the Lord.  Just over a year ago Quadrant Online carried an article predicting that Chinese steel production would fall from 800 million tonnes per annum to half that level.  While that has yet to come to pass, the Chinese themselves are now predicting a similar result, with the deputy chairman of the China Iron & Steel Association saying that a fall in production to 500 million tonnes per annum would be “still healthy”.

If the fall is 300 million tonnes per annum, that equates to a reduction in iron ore consumption of 450 million tonnes.  The Chinese themselves are the world’s highest cost iron ore producers, but their iron ore mines employ close to one million people.  Let’s assume that Australian producers absorb half the fall, with this equating to 225 million tonnes per annum.  Let’s further assume that each person employed in the iron ore industry produces 14,000 tonnes per annum.  Those two assumptions mean that 16,000 iron ore miners would lose their jobs.  If the employment multiplier effect is three to one, then a further 48,000 jobs would be lost in the West Australian economy for a total loss of 64,000 jobs.  Added to the current 93,400 unemployed in Western Australia, unemployment would rise to 157,000 people, equating to 10.7% of the workforce.

Soon after Quadrant Online published the article forecasting a halving of Chinese steel production, FinanceAsia magazine gave the Roy Hill Project it’s “Best Project Finance Deal Award”.  The award was certainly deserved because Roy Hill was able to borrow $7.2 billion of a $10 billion project when the iron ore price was already cratering.  The four major Australian banks are included in the lending syndicate.  A good summary of current iron ore mining economics is provided by Fortescue Mining.  In short, BHP and Rio Tinto are the lowest cost producers, at about US$30 per tonne, and the coming reduction in Australian tonnage would be accommodated by Fortescue and the smaller Australian miners closing.  The way it works is that the iron ore price will fall to BHP’s production cost, at best, until the excess tonnage closes.  Fortescue built its railway line with the same guage as BHP, so BHP will find incorporation of Fortescue’s assets painless.

There will be flow-on effects to the rest of the West Australian economy and history is also repeating itself.  Take the example of Westralia Square.  This was a empty block of land in the centre of the Perth CBD for many years.  In 1988 the site was sold to Kerry Packer for $270 million.  Mr Packer sold it in 2003 for $19 million.  The site is now called Brookfield Place and is the headquarters of BHP’s operations in Western Australia.

The role of Westralia Square as a CBD eyesore is now being assumed by a vanity project from the Premier of Western Australia.  This eyesore is called Elizabeth Quay and to create it the WA Government spent $440 million to destroy a four lane road for east-west traffic — this about a decade after having spent a similar sum to build a four lane, east-west road tunnel.  The building sites created aren’t attracting any building and, like Westralia Square before it, are likely to remain vacant for decades.  A future state government is likely to fill in the pond created and reconnect the road.  The increase in state debt will remain.

Perth real estate prices are now falling and the flow of people has reversed to the eastern states.  So far we have had the fall in iron ore revenue but the mine closures are yet to come.  The Fortescue presentation provides the metric that federal tax revenue falls by $300 million for each US$1 fall in the iron ore price.  So the shortfall in tax revenue from the 2015 budget forecast, based on US$49 per tonne, is easy to calculate.  If you use the current Chinese futures price of US$34.75 per tonne, the shortfall is $4.27 billion per annum.  It is going to be greater than that for the necessary mine closures to occur.

Ever since the boom started, successive federal governments have increased social welfare spending in anticipation of the boom continuing indefinitely.  Any increase in taxation to compensate for the departure from reality will simply further suppress economic activity.  The one wild card politically is the effect of unemployment in excess of 10%, at least in Western Australia.  Those unemployed might feel that none of the current polity speaks for them.  Their concern about global warming, for example, is likely to be very slight indeed. They are likely to be concerned about continued high immigration while they can’t find a job.

Australia as a whole, not just Western Australia, squandered the most recent commodity boom.  The ancient Athenians knew better.  In 483 BC, a major new vein was discovered in the state silver mines at Laurium.  The windfall could have been distributed to the citizens of Athens. Instead, Themistocles persuaded his countrymen to expand their trireme fleet from 40 to 200 vessels.  This expanded fleet enabled Athens to prevail against a much larger Persian fleet in the Battle of Artemisium in 483 BC and Athens was saved.

The modern parallel is this: all the money we made from trading with China should have been saved to pay to fight the war that China wants to start.  Instead, to pay for that war, the cuts to social welfare payments will be painful for the genuine widows and orphans.

David Archibald’s latest book is Australia’s Defence (Connor Court 2015).