Iron ore and world economy instability

Chinese Premier Wen Jiabao not only warned the world of a possible return to recession, but was subject to impassioned pleas by steel makers over the enormous price rises looming in iron ore. The Australian economy depends more than any other in the world on the Wen Jiabao forecast and the iron ore strategic discussions.Whether we have a global recession will depend in part on whether the world cost of money rises substantially as the US, European and other governments step up their borrowing. In turn, that will partly depend on how much of the global money demand China can fund.But when it comes to iron ore pricing, it is China that caused the problem and Wen Jiabao has made the first moves that may lead to a big fall. The spot market for iron ore is double the 2009-10 contract prices, so the Chinese are looking at a truly enormous rise in costs, which will flow right through the Chinese economy. That spot iron ore price increase was mainly driven by incredible spending by the Chinese on infrastructure and dwellings as part of their response to the global financial crisis. In turn, that forced the Chinese steel mills to pay big prices on the spot iron ore market to gain material to satisfy the demand.A lot of the Chinese infrastructure spending was very productive, but a vast amount was wasted. The Chinese have built empty blocks of apartments, roads and rail that they will not need for years.This took place because the bulk of the capital expenditure was undertaken by local governments. Imagine what would happen if our local councils or state governments had the ability to borrow virtually unlimited amounts of money. Almost certainly they would spend it to satisfy local vested interests. The Chinese behaved exactly as you would expect equivalent bodies in Australia to do.According to JPMorgan, Chinese local governments were responsible for some 80 per cent of the capital spending and therefore dominated demand for our iron ore and are the main drivers of the price rises. It is also a force fuelling overall inflation in China.Even though it is the wasteful spending that is causing the problem, reversing the policy will be hard. But Wen Jiabao has taken an important first step removing the guarantees that enabled the local councils to borrow. In theory at least, the central government will then have a much bigger say over what takes place, but slowing the economy means many jobs will be lost.The stance of BHP is that annual iron ore price talks are just too disruptive, but a switch to spot prices would see the price sky rocket. Gradually, Rio Tinto and Brazil's Vale are coming to a similar view although they are sensitive to the Chinese demand for certainty.But one way or another, iron ore pricing is going to be much more orientated to the spot price and/or other short term price mechanisms.If Wen Jiabao is successful in curbing the expenditure of the local governments, then we will see a significant fall in the demand for iron ore late in 2010 or 2011, assuming current tasks are completed. Such forecasts have been made in the past and have been wrong as the demand for iron ore just keeps rising. But Wen Jiabao's prediction of a possible global recession is unprecedented.Both BHP and Rio Tinto believe that the Chinese growth story will not be a straight line graph and will have big variations. We will need to watch the curbs on Chinese local government work. And if the Chinese do pull back, Australia will bear a lot of the short term pain.

This article first appeared on Business Spectator.