The kicker in the federal budget update issued by Treasurer Scott Morrison lies one of the biggest mysteries in global economics: what is really going on in China’s economy?
The government has opted for a reserved position on this, with its price forecasts for Australia’s key exports in coal and iron ore consistent with a view that the commodity price rally this year has been driven more by speculation or a temporary surge in demand than more sustainable, fundamental factors. In doing that, it has abandoned its normal practice of forecasting an average dollar price for metallurgical coal and iron ore.
“After reaching multi year lows over 2015-16, bulk commodity prices have strengthened…,” the Mid-Year Economic and Fiscal Outlook (MYEFO) said today. “In recent years, Budget and MYEFO forecasts have used an assumption that commodity prices would remain around a recent average over the forecast period. In light of the current exceptional circumstances for bulk commodities, this assumption is not considered prudent at this time. An alternative assumption of a phased reduction in prices from recent levels has been adopted for metallurgical coal and iron ore.”
So Treasury is forecasting a fairly significant crash in commodity prices, with iron ore returning to an average of $US55 by the September quarter of next year. But some analysts don’t see the fall being this steep at all, believing sustained Chinese demand will keep the price higher for longer.
The question of what has driven the commodity rally, especially iron ore, and its associated volatility, really vexes markets right now.
How much of it is driven by fundamental forces, mainly the unexpected level of steel and coal demand in China thanks to a stimulus injection this year?
On the other hand, to what extent are a certain group of Chinese investors – sometimes described as “Shanghai cab drivers”, a shorthand for retail investors and money managers essentially gambling on moves in futures and spot prices – responsible for the price action?
The real answer to both questions is that nobody really knows for sure. Treasury – in a moment of uncharacteristic bluntness – admitted as much in the MYEFO:
Liaison with industry indicates that there is very considerable uncertainty around the drivers of the recent price movements, with the only consensus being that current elevated prices are unlikely to be sustained. That said, there is no consensus as to when prices may fall and by how far.
Only the most hardened commodity sector analysts would disagree with this.
So back to the kicker: if iron ore prices do fall but to a level higher than the $US55 eventually anticipated by Treasury, then there would be a potential upgrade in revenues. An average of around $US65 (as forecast by Goldman Sachs, for example), would, if sustained over a couple of years, lead to a flood of extra revenue running into billions of dollars.
A tidy upside, but not one to bank. Taking the high side on commodity price forecasting right now runs a risk that, if those volatile prices overshoot, on the way down there will be further ugly writedowns necessary from Treasury’s political masters.
Given the fragile standing of the messaging on the path to surplus, Treasurer Scott Morrison needs to be careful to avoid being forced to announce more revenue challenges – even if they can be blamed on commodity market volatility – to the ratings agencies.