The Commodity Cycle Turns
SCMP June 3 2012
Naturally, the world's attention is focused on Spain, Greece, the euro and their consequences for the global economy. Any day could bring a turning point for better or worse. But perhaps just as important in the longer run is a turning point in something that is gradual and undramatic but ultimately has a profound impact on the balance of wealth and power in the world: commodity prices.
Recent days have seen sharp drops in many commodity prices - including oil, coal, copper and iron ore - over fears that euro chaos and a slowing China will squeeze demand. The currencies of mineral exporters such as Australia, Brazil and Indonesia have fallen by up to 10 per cent against the US dollar in response. But those short-term impacts on prices should not disguise the fact that the longer commodity cycle has turned - and that those that benefited most on the upside are extremely complacent about the medium-term outlook.
Such complacency is evident in two countries I have just visited: Indonesia and Australia. Australia's terms of trade (the prices of its exports compared to imports) have risen by almost 40 per cent in a decade. Even so, it runs a current account deficit, its consumers are heavily reliant on foreign bank financing of the local banks, and its non-mining sectors have been hollowed out by an overstrong currency. Indonesia is better diversified, but its terms-of-trade gain has been about 25 per cent, underpinning the expansion in consumption, which has been the main driver of growth. Recent belated foreign investor enthusiasm for the country looks like a sure sign that the good times have peaked.
Reality threatens not just these countries but most of the so-called BRICS (Brazil, Russia, India, China and South Africa), which are supposed to be leading the whole world to sustained growth. Of these, three owe much of their apparent success in recent years to the rise in commodity prices. So a sustained reversal of those gains will leave them struggling to show per capita growth equal to that in the advanced countries. China, on the other hand, will be a major beneficiary of lower prices, while the overall impact on India may well be neutral. Of the smaller Asian countries, the Philippines will be a beneficiary and give more credence to the view that, over the next decade, it could reverse 40 years of falling behind, and grow faster than neighbours like Thailand and Indonesia.
The main reason for this likely sustained turn in the commodity cycle is not fear that China's growth will fail to reach expectations. For sure, China's future growth is likely to be driven more by consumer demand for light manufactures and services and less by steel, copper and cement for heavy infrastructure development. But commodity cycles turn for reasons that are more to do with supply, which increases at very uneven rates, than demand, which grows more steadily. Prices of items such as iron ore, copper, coal and rubber have risen dramatically since a low point around 2002 because there was so little investment in new capacity after the 1980s boom. Rubber trees take time to grow; major mines, often in remote places, take even longer to come on stream. But once the investment has been made, prices have to fall a long way to close the mine or stop tapping the trees. The recent price up-cycle was extended by the 2008 financial crisis, which brought some projects to a halt. But there is every prospect now that for the next few years, for many key items, supply will grow faster than demand.
China itself has become a direct driver of new production by investing in mines on every continent. Some of these may prove very unwise for the individual companies. But they make sense from China's national point of view: it wants supply to increase and prices to fall. Its terms of trade may well become even more important in the coming years as its exports of manufactures slows amid rising domestic costs and protectionism while domestic demand continues to grow apace. Lower commodity prices will help keep its trade in balance.
The Philippines has other causes for hope. Its two main foreign exchange earners are remittances from overseas Filipinos and contract workers, and its booming business process outsourcing sector, which has overtaken India's. The merit of these income streams is that they are much less dependent on global conditions than those that rely mainly on resource and/or manufactured exports. These factors partly explain why the Asian Development Bank recently suggested that the country could grow at roughly the same rate as China and India between now and 2020. That may well be an overly rosy outlook but it does indicate how fundamental factors are changing.
Of course, commodities do not all move in lock-step, with agricultural ones subject to many factors other than long-term investment. But even with food crops, there is growing evidence that supply is growing faster than demand as the global population increase slows and the demand in China and other middle-income countries for richer foods levels off. Finally, there is the prospect that cheap money cannot continue for much longer to support stockpiling of commodities and the flow of investment into assets with zero yield.
The brutal fact is that in the long term, commodity prices almost invariably decline thanks to sustained improvements in mining and extraction technology, and in plant genetics. As ever, the answer to (temporarily) high commodity prices is high commodity prices. The cycle works. Don't get run over.