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ASIA Recalibrating China’s high-octane engine for growth


China's growth continues to outpace predictions. The country's economy grew a stunning 11.9 percent in the second quarter, according to official figures, although many analysts think the true growth rate could have been even higher. Investment, currency reserves and now inflation also are outstripping earlier estimates, with huge repercussions for the global economy.

In the steel sector, the picture is slightly more complex. Chinese crude steel output continues to grow at an incredible pace and looks likely to rise by at least 60 million tonnes to more than 480 million tonnes this year. The growth rate is slowing, however; steel production rose 13.6 percent year-on-year in August, down from 14.5-percent growth in July and around 20 percent at the start of the year.

That trend looked set to level out beginning in September as domestic demand entered its peak season, but there are some reassuring signs for Western steelmakers that the Chinese government's attempts to slow growth are bearing some fruit, albeit slowly.

The evidence of the steel industry's continuing expansion—and even the hints that output growth may be coming under control—have caused many analysts to rethink their predictions for the sustainability of the current growth cycle. In particular, demand for steelmaking raw materials—especially iron ore—looks set to surpass many short-term estimates.

As recently as this spring, some analysts, and even some iron ore producers, were speaking of 2008 as a "turning point" in the world market. Under this model, the big increases in investment in new mines that major producers and juniors alike have made in recent years would finally tip the supply-demand balance, sending prices lower or at the very least putting an end to the big double-digit percentage increases seen in recent years.

But that view has been losing a lot of traction in recent months. Top analysts have been lining up to increase their predictions for next year's benchmark iron ore prices, which will take effect April 1 after negotiations between suppliers and consumers.

UBS AG started the ball rolling by revising its prediction of a 10-percent increase upwards to 25 percent in July. JPMorgan Chase & Co. also is tipping a 25-percent increase, again up from 10 percent, while Merrill Lynch & Co. Inc. and Goldman Sachs JBWere Pty Ltd. both predicted a 30-percent increase.

Analysts have been wrong about prices before, particularly ahead of the 71.5-percent year-on-year increase in 2005 that cemented the shift in the balance of power in favor of the three bigger suppliers, Cia. Vale do Rio Doce (CVRD), Rio Tinto Plc and BHP Billiton. However, the fact that most analysts are moving in the same direction—toward a bigger rise in prices—is significant.

There are many reasons why analysts have changed their predictions, but they are all underpinned by the sustained strength of Chinese demand. Even the Chinese themselves appear to be accepting reality Steel company executives are openly conceding that prices will have to rise next year, a sharp reversal from the common practice in recent years that saw the Chinese industry refuse to countenance any chance of a price increase until the benchmark talks were all but exhausted, even as the rest of the world was taking it for granted that prices would have to rise.

The tightening freight market is a big reason behind the predictions of a bigger price increase next year. Freight rates for dry bulk commodities have surged thanks to Chinese demand and congestion problems, in some cases tripling since January. This helped push iron ore spot prices to record highs in August and September. The spot market is dominated by trade between India and China, with the large majority of other seaborne trade tied up in long-term contracts.

Spot prices for iron ore fines reached $155 per tonne c.i.f. China in mid-September, up 50 percent in just three months and double the price at the beginning of the year. Even on an f.o.b. basis, prices are more than $100 per tonne, putting the spot market significantly above last year's benchmark levels and making it virtually impossible for Chinese buyers to argue that prices should fall.

Suppliers are rushing to get new ore to market, but even with the incentive of recent high prices, the market remains tight. Some new projects planned by the largest producers have progressed more slowly than expected, while smaller miners—notably in Western Australia's ore-rich desert—are not yet big enough to make much of a difference to the market balance.

The longer-term picture is not so clear. Huge amounts of new supply is due to hit the market within the next five years as CVRD, Rio Tinto and BHP ramp up output and new producers such as Fortescue Metals Group Ltd. move into the production stage. Fortescue alone is planning to produce 55 million tonnes of high-quality ore per year from its operations in Australia's Pilbara region. Concerns remain about whether it will meet its production deadline of May 2008, although the likelihood that prices will remain strong beyond that date is good news for the company.

But it seems inevitable that iron ore prices will fall in the years to come unless China, India or other emerging economies pour another few hundred million tonnes of crude steel into the world market. Failing that, the iron ore boom will end—but not as soon as many people had expected.

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