With the iron ore price sinking ever lower both the outlook for mining sector profits and budget revenues for the Federal Government remain challenged.

Morgan Stanley analysts this week slashed their 2015 average iron ore price forecast by 28%, down to only $57 a tonne. Considering spot prices fell to only $54.66 last Friday – the lowest level since May 2008 – that suggests not much price upside over the remainder of the year.

To stem the bleeding, there are two hopes on the horizon: firstly, that high cost iron ore producers (largely in China) soon exit the market and, secondly, China’s steel demand lifts, either due to a rebound in the property sector and/or infrastructure spending.

Neither of these scenarios are assured over the near-term at least. What’s more, also hanging over the market is the more certain expansion in iron ore supply from established players such as BHP Billiton and Rio Tinto. Both companies argue that to cut back supply now would only encourage higher cost producers to stay in the market for longer.

In short, it’s a battle of attrition in what is an old fashioned capacity war.

Adding to the angst, China’s HSBC/Markit Purchasing Managers Index dipped to an 11-month low of 49.2 in March, down from February’s 50.7 – suggesting manufacturing production remains soft.

That said, there is some good news in that an analysis of China’s property sector from the Reserve Bank of Australia suggests conditions are already approaching past cyclical lows – suggesting more Government support could soon be in the wings.

China’s property sector now accounts for a considerable share of the economy. According to an article on the sector in the RBA’s March Bulletin, real estate development accounted for around one-quarter of total Chinese fixed asset investment (FAI) in 2014 and around 12% of GDP. Of this, around 70% is accounted by residential development, and the remainder is commercial construction (such as office blocks, shops and factories).

To be sure, China’s housing sector is going through a slowdown, with average residential property prices falling by around 4% in the year to December. In large first tier cities such as Shanghai and Beijing, this downturn is (so far) not out of line with past cycles, though the price correction is somewhat greater this time around in smaller cities.

 

Most residential property is sold by developers, who acquire land at auction and then sell new properties ‘off the plan’ to households.

Unlike in Australia, Chinese households rely on much less debt – with cash deposit requirements around 30% of the purchase price for first homes, and a whopping 60% for secondary or investment properties.

Despite this high hurdle, a dearth of alternate investment vehicles means real estate development remains popular with cashed up households.

Note, moreover, around 40% of residential construction in recent years has been subsidised social housing facilitated by the Government.

Low debt levels suggest household over exposure is not the main source of concern in the property sector. Similarly, the need for affordable social housing places helps place a floor underneath overall housing demand.

For China, the issue is the health of private developers and the extent to which a downturn in land prices affects the hurts the revenues and investment capacity of local Governments. 

Although little data is available about the plight of the vast bulk of non-listed property developers, the evidence for listed developers (which account for only 10% of total sales), suggest inventory levels are so far only in line with past cyclical peaks.


What is more disturbing this time around, however, is the large run-up in leverage by listed developers, which could leave them more exposed – and in turn the banking sector – should property prices decline a lot further and/it becomes harder to shift stock.

What’s more, a lot more financing is coming from the shadow banking sector, where credit controls may be less rigorously enforced.

On the plus side, profitability levels among developers still appear good.


As noted by the RBA, underlying demand for property in coming years seems assured, with the process of urbanisation still some way to run, and average household size also declining due to move toward ‘nuclear’ rather than extended family households.

Until better alternative comes along, property investment is also likely to remain popular for cashed up richer households.

Ultimately, the degree to which the property sector corrects from here also still seems largely in the hands of policy makers. The RBA also noted past housing cycles have been generated by counter-cyclical swings in government policy.

Given we are now experiencing price declines and stock levels in line with past lows in the housing sector, it seems likely the Government will ‘flick the switch’ to greater policy easing over the coming year.

Adding to concern are the higher levels of leverage and greater use of non-traditional financing among private developers.

That said, this need to support the economy will also be balanced against the Government other desire to re-balance growth toward consumer spending and services. 

The Government has recently revised down its growth target to 7%, and has appeared more comfortable with the growth slowdown over the past year than many Western analysts.