Evergrande, Sinic, Fantasia: a tidal wave of Chinese debt is about to sink Australia's economic recovery

As we know, dirt in Australia is rich in important minerals and there is a lot of it. Early settlers discovered large quantities of iron ore deposits and digging it up to make iron became a meaningful business in the early 1900s. One hundred years or so later, the Australian economy has become more reliant than ever on revenues from iron ore.

Yet Australia's mining is not driven by domestic consumption but rather by overseas buyers, with around two-thirds of its total 2020 export revenues coming from minerals shipped overseas.

Australia's economic growth continued year after year, with no sign of a recession, and money sloshed around all sectors of the economy until the pandemic hit and almost everything slowed to a crawl. I say almost everything because iron kept being dug up at a rapid pace, along with copper ore and coal, to meet strong demand from the Chinese property sector and railway expansion, which also drove a strong upward trend in prices. In 2020, iron ore alone made up 41 per cent of all exports from Australia by value, at about A$149 billion.

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Unfortunately, 2021 has proved to be the year that the merry-go-round stopped and Australia's mining industry, and indeed its economy, reached a turning point. The era in which China could be trusted to buy an abundance of Australian dirt, and pay good money for it too, has come to an end - and probably for good. Three things have happened recently that dashed hopes that mining would drive the economic recovery.

China has become progressively less keen on spending hard currency on imports, as suggested by the way it suddenly backed away from Australian products in 2020 blamed on a trade spat. This included copper, sugar, timber, barley and the tons of lobsters it refused to pay for or allow in. It would appear Beijing is holding onto its hard currency, indicating it may be getting harder to obtain.

China's demand for iron, coal and copper ore and concentrates are now in a very sharp decline as a pending tidal wave of debt threatens to destroy three property developers - Evergrande, Sinic and Fantasia - and signal the end of China's building boom. China's infamous ghost cities are now starting to be demolished, releasing large quantities of scrap iron and copper. The Financial Times estimates there is an abundance of idle property that could house 90 million people, though most likely it never will. This inventory of steel and copper will be recycled, as recycling is cheaper and more energy efficient than smelting from ores. This reduces the need for imported Australian coal.

In the 2020s all roads will lead to Beijing, with the expansion of China's new empire through central Asia to Europe and then south to its new friends in Africa. China has new sources of raw materials and other goods, for which it won't have to spend its hard-earned US dollar reserves, and the relationships are soundly sealed through loans and infrastructure projects.

Simply put, China will no longer need Australian iron, copper and, in time, coal.

Steel production in China has already been slashed. As the funding problems surrounding Evergrande mounted it was easy to see where demand would go when construction stopped. With iron ore prices running at twice their average of the past 15 years - US$200 per metric ton versus an average near US$100 per metric ton - why keep making new steel for the construction industry and just build inventory for the sake of it?

Demand from other industrial sectors and infrastructure buildout will remain - in particular for railways, with internal expansion clearly defined through 2035. And by demolishing unused buildings and freeing up steel, domestic recycling businesses will benefit. In July the National Development and Reform Commission stated that China's increased use of scrap would be boosted to 320 million metric tons of steel by 2025, or 23 per cent. It also set ambitious targets for recycling of non-ferrous metals such as copper, aluminium and lead.

No matter what analysts say at the moment, as they recover from the shocks of recent weeks, we can safely assume that the effects of the building boom "bust" will last a very long time. Just ask the Japanese about theirs, which dragged on for twenty years.

So here is the problem: China is in no great rush to buy iron ore. Or copper, aluminium, or lead. And if it was, it would rather not pay hard currency for it. Restocking of new steel supplies is not likely to happen this year, and I have no faith in analyst predictions that iron ore prices will jump again by the end of the year. By the time the scrap is used up, abundant supplies will be available from Central and West Africa.

This is not news to the Australians, who were expecting that African mines would still take several years to come online before disrupting exports from Australia. And the Aussies had been on-site in Africa for years anyway, with lucrative contracts to develop mines for various African governments. However, progress was apparently too slow and China saw an opportunity to jump in.

In 2012, China imported about 70 per cent of all the world's iron ore transported by sea, or about 680 million metric tons, in addition to its domestic production of about 280 million metric tons. About 60 per cent of the imported ore came from Australia. These days, the estimated total output from fully developed mines in West Africa's Guinea and the Central African republics of Congo and Cameroon is between 400 million and 600 million tons annually - or almost the entire amount China was importing by sea in 2012.

In both African locations, massive infrastructure is needed to move the ore out. Two railway lines, one in each part of the continent, amount to about 550km-600km, and then there are port facilities and the machinery required at the mines themselves. Originally, Australian and British firms were looking to construct this, but they got squeezed out by firms using Chinese investment and contractors, which were rather favoured by the respective African governments. Given that Cameroon and Congo see 70 per cent of their financing requirements covered by the Chinese, new alliances were forged, and the Australians saw their licences revoked and stripped from them.

It's now all over, except for the shouting. Large lawsuits are incoming, seeking damages through international arbitration against the African governments for several Australian and British interests totalling some US$40 billion. But this won't help the Australian economy, even if anything actually gets paid out.

China's property sector will need to adjust and looks likely to end in a property crunch similar to what happened in Japan, which experienced a long period in which property prices held up while transactions stopped - which did nothing to help homeowners or the construction industry and all its suppliers.

This suggests that the Australian government is going to have to think long and hard about what it can do domestically to replace the significant revenue streams that are disappearing as exports falter. In its own way, it may have to do something like China and try to boost domestic demand, or at least figure out another way to make money. Perhaps it can rebuild its decimated manufacturing industry and jump on the global supply chain squeeze? How about making semiconductors? A new strategy is needed, and it must be put in place quickly, perhaps importing manufacturing knowhow from Korea or Taiwan.

Australia's example shows how relying on a single customer is too dangerous in business, be it in finance - where I have been caught out occasionally with a hedge fund client blowing up - or digging and selling dirt. At some point everything comes to an end - even your #1 customer.

Unfortunately, China's warning shot for Australia, over lobsters, timber and soft commodities last year, came too late, and now there is a big hole to fill.

Neil Newman is a thematic portfolio strategist focused on pan-Asian equity markets

This article originally appeared on the South China Morning Post (SCMP).

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