Why China is so Important to Australia & Our Stockmarket

In recent times, countless articles have been written on the growth of China.  We too have written several papers on China:

China deserves our attention given its emergence as an important factor in our domestic prosperity.  The more we learn about China, the greater our understanding of what our relationship may mean for our future.

Some facts on our current relationship with China [1]:

  • 4.6% of Australia’s Gross Domestic Product  is generated by exports to China [2].
  • Over the past 10 years, the percentage of our exports that flow to China has increased from 5% to 25%.
  • Consequently resources now account for 58% of our total exports, up from 35% a decade ago.
  • Of the $58 billion of goods shipped to China last year, $34 billion was loaded onto iron ore ships in the Pilbara region of Western Australia.
  • Australian businesses plan to invest $140 billion on capital expenditure in 2011-12, with $83 billion in the mining sector.
  • Demand for our resources is one factor that contributed to Treasury’s recent budget assumptions that the Australian dollar will hold at US107c for two years, and then decline by US0.9c a year.

The factors above will result in higher government revenue from taxation, but not for a few years yet.  By 2014-15, the Government projects that revenue from income taxes will exceed $300 billion, up from $240 billion today.

As much as we stand to benefit from China’s growth, the flipside is that a significant slowdown in China is likely to have an adverse impact on our economy. As the Reserve Bank of Australia (RBA) and Treasury have stated, there is always a risk of short term volatility in China’s economic growth.  However, they still view a rapidly expanding Chinese middle class as a game changer that will keep economic growth strong.  Nevertheless, it is widely expected that Chinese growth will moderate in coming years.

The biggest risk to China’s economy is that it grows too fast and inflation becomes an issue.  When a country has high inflation, businesses struggle to commit to new expenditure as the expected rate of return is much harder to gauge compared to times of stable inflationary growth.  Foreign companies are also more reluctant to invest into a country with high inflation for the same reason.  The net effect is that economic growth slows.

In Australia, the RBA uses interest rates to control inflation.  In China, there are more novel ways of approaching this problem.  Chinese authorities simply order companies not to increase prices, and fine those that don’t comply.  They also order banks to ration new loans.

The current strength of commodity prices is in large part due to Chinese demand.  Whilst  it costs BHP US$40 to produce a tonne of iron ore in the Pilbara [3], the current selling price is around US$170 per tonne.  In 2007, the price was closer to US$70 per tonne.

China currently accounts for 60% of global iron ore consumption [4] and 52% of coking coal consumption .  Iron ore is BHP’s greatest source of profits, and coking coal, which is needed to make steel, is second.  So BHP’s success is closely aligned with China’s demand for steel.

BHP CEO Marius Kloppers notes that new mines are under development by BHP and other companies, but most will take at least two years to become operational.  This curb on supply should help keep prices high in the meantime.  When the new supply is available, prices are expected to fall, but volumes will also rise.  The net effect may actually be negligible.  Time will tell.

Some are concerned that the resources boom is forcing a major restructuring of the Australian economy, and if the boom passes, our economy’s output potential will be permanently lowered.  This is known as the “Dutch Disease”.  However, many national economies have demonstrated how quickly they can adapt to new market conditions and thus prosper.

The latest national accounts show mining represents just over 9% of our GDP, down from the 10% averaged through the latter half of the 1990s.  Surging iron ore and coal exports have been offset by declining oil sales, whilst liquefied natural gas production is yet to commence.

However, as the capital expenditure plans of the mining sector illustrate, our economy continues to direct resources towards the long term opportunities that mining and China offer our economy.

What are some lessons for investors?

Whilst the future is bright for BHP and its contemporaries, there are always risks.

Today, BHP comprises almost 13% of the Australian stockmarket capitalisation, with Rio Tinto at 3% and Newcrest Mining and Woodside around 2.5% each.  So a well-diversified market portfolio still provides you with significant exposure to the resources sector and, consequently, China’s economic expansion.

But uncertainty necessitates you maintain exposure to other sectors of the domestic and global economy as well.  China still has a communist government that exercises great control over the economy.  We don’t want our clients to position their portfolios so that their retirement income is overly dependent on a small number of Chinese politicians.

And resources haven’t been the only way to generate strong investment returns in recent times.

The following table details the actual performance of the ASX 300 Resources Accumulation Index (a proxy for a portfolio of resource stocks) compared to our Australian Value stock strategy between June 1992 and May 2011 (which is all data available), a period when resource stocks prices have comfortably outperformed the wider market.

Our Australian Value stock strategy usually comprises 40% of our client’s Australian equity portfolios and would typically have a below market weighting to resource stocks.  The results are:

 

The data demonstrates that our Value strategy outperformed the resources portfolio, yet volatility or risk as measured by standard deviation was lower.

So whilst resource stocks have performed exceptionally well over the past 20 years, the risk/return trade off means there is no compelling argument to be substantially overweight your portfolio to this sector.


[1] China Investors Need Nerves of Steel, SMH, John Garnaut, 28 May 2011
[2] GDP is the market value of all goods and services produced by our economy.
[3] Iron Ore Price Train is Coming to a Stop, SMH, Barry FitzGerald 14 March 2011
[4] SMH, 4 June 2011

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.