The rout in global commodities threatens to strip hundreds of millions from the federal budget


Commodities are suffering yet another of their China meltdowns, but this time it could be more threatening warns JPMorgan.

That isn’t good news for Australia’s budget, which was delivered this week and set out in some detail the impact that different price scenarios could have on forecast taxation receipts.

Even if China’s latest campaign to clean up its financial systems by curbing leverage and excessive speculation is not longer than previous attempts, the current meltdown is worrisome for a lot of commodities, John Normand, JPMorgan’s head of foreign exchange, commodities & international rates research said in a note to investors titled “Little trouble in big China again.”

He explains:

“First, China’s economy-wide leverage continues to rise due to successive rounds of mini-stimulus and asset price inflation has simply rotated across sectors –from equities in 2015 to housing currently.”

“Second, targeted tightening appears to be influencing some broader measures of financial conditions like corporate borrowing rates, even as policy rates remain stable.”

“Third, some sectors like metals and commodity currencies had overshot standard China business cycle indicators like housing construction, auto sales and fixed asset investment, reflecting optimism around China’s 2016 stimulus, hopes for US infrastructure spending under President Trump, or local investor flow into commodities due to tighter capital controls.

Normand shares this chart showing how iron-ore prices have overshot China’s credit cycle:

And this chart shows how China linked markets have slumped this year.

If China’s current tightening effort – part of what appears to be a recurring theme every 12 to 18 months – drags on longer than usual and slashes commodities demand then forecast for metal prices and non-oil commodity currencies will need to be lowered, Normand said.

Such an outcome will blow a hole through Australia’s budget.

Of course, another round of stimulus could prove a windfall.

A look at the budget papers shows if iron ore prices were to fall immediately to US$55 per tonne, two quarters earlier than expected, nominal GDP could be around $3.1 billion lower than forecast in 2017-18, resulting in a decrease in tax receipts of around $400 million.

A fall in metallurgical coal prices $US120 a tonne six months earlier than predicted could strip $4.2 billion off GDP forecast and cut tax inflows by $500 million.

If prices were to stay at current levels for two quarters longer, tax receipts could jump up by $900 million, the budget papers show.

The following tables shows the Australian budget’s sensitivity to coal and iron ore prices.

Iron ore, which is Australia’s largest mining export, plunged into a bear market last month. It has slumped closer to $US60 a tonne from $US94.86 in February, the highest since 2014.

Australia’s budget assumes the metal would decline from a recent average of around $US66 per tonne to reach $US55 per tonne in the March quarter of 2018. That is still higher than some analysts forecasts. Macquarie analysts expect the price to fall to $US48 a tonne by the end of the year while Citigroup sees the iron ore price averaging $US45 this year.

Since credit stress began emerging, we haven’t altered forecasts or recommendation significantly,” JPMorgan’s Normand said. “Metals and forex forecasts from late 2016 always assumed an eventual slowdown. If we are wrong – and this credit cycle proves longer, more restrictive and more damaging to demand than previous one, second half targets for base metals and non-oil commodity currencies will need to be lowered.”

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