China syndrome

When Australian Prime Minister John Howard first came to power in early l996 he could hardly have annoyed Mainland China more. His foreign minister, Alexander Downer, endorsed Bill Clinton's decision to dispatch two aircraft carriers to the region at a tense time during Taiwan's elections. A couple of aid projects were canceled and, for good measure, Howard held a meeting with the Dalai Lama in Sydney.

But any damaged fences were repaired quickly. The breakthrough came when Australia chose to stop supporting the annual condemnation of China at the UN Human Rights Commission in Geneva. Within a year, diplomatic dividends and trade benefits began to flow.

River of limos
Holiday makers arriving at Perth airport for flights to Bali were surprised to find a river of black limousines in the car park amid heavy security. Soon a 747B aircraft sporting red and gold livery touched down on the tarmac. On board was an 80-strong delegation from Beijing, led by the then Vice-Premier Zhu Rongji.

Zhu promptly jumped on another flight, headed 1,400km up the coast of Western Australia to the tiny mining town of Paraburdoo in the remote Pilbara region. He came to inspect what was China's first investment in the Australian resource industry, a 40% stake in the Channar iron ore mine, operated by the Hamersley unit of the Rio Tinto group. Trained as an electrical engineer, Zhu would have had a better grasp of mining techniques than most visiting politicians.

Since then successive Chinese economic planners have been figuring out how to put their foot on enough raw materials to underwrite China's dramatic infrastructure expansion.

Australia boasts almost unlimited supplies of the commodities China needs to buy. The only problem now is digging the stuff up fast enough and shipping it out through clogged rail links and ports.

Top of the shopping list is the coking coal and iron ore required to feed the voracious furnaces of what is now the world's largest steelmaker.

Chinese steel production has doubled since the economy went into overdrive in 2000. This year it is expected to top 300m tonnes. That will require imports of 260m tonnes of iron ore to make up the shortfall from domestic output. Almost 40% will come from Australia, which is the biggest country supplier, followed by Brazil and India. The bulk of the business will go to Rio Tinto and BHP which, together with CVRD of Brazil, account for nearly 80% of the billion – tonne seaborne iron ore trade.

China is increasingly taking stakes in Australian mining ventures. Baoshan Iron and Steel has a joint venture with Hamersley in a new mine that will produce 10m tons a year for 20 years. Four of the other leading steel mills have acquired 40% of BHP's Jimblebar mine in Western Australia and signed a 25-year contract to take 12m tons of ore a year.

Although comparatively small, these investments offer the triple benefits of locking in long-term supply and access to financial and technical information – and, in theory, an inside track on upcoming price rises.

That did not pan out this year. Analysts had been anticipating a major boost for iron ore prices at the annual round of negotiations between the big miners and the major Japanese mills, which are traditionally taken as the benchmark level for the next year. But nobody expected the stunning 71.5% hike announced in late February, which means importers will pay an average US$80 a tonne for ore, up from US$46 a tonne. It seems Japan's steelmakers were desperate to head off the shortages which hit their customers last year when auto manufacturers, including Nissan Motors, were forced to cut production.

Up, up and away
Coming on top of a 120% rise in coking coal contract prices to US$125 a tonne, and consistently strong natural gas prices, a once-ina- generation shift is under way.

Government forecasters flag total commodity exports to rise 16% to a record A$115bn (US$90.79) in 2005-06. Coking and steaming coal sales are likely to be up 51% at A$25.8bn while iron ore exports will climb a similar percentage at A$13bn.

The economic and financial effects of this on Australia are profound. For more than two decades, bulk commodity prices have been falling. Bar a few flurries, the sector has been ignored by investors. That has all changed.

At a time when 14 years of successive economic expansion is under threat from chronic capacity restraints and rising interest rates, the shift is very welcome. The price increases for coal and iron alone will boost Australia's terms of trade by 10%, the sharpest increase since the early 1970's. The Australian stock market has soared 48% in the two years to March, and resources have handsomely outpaced the broad rally.

Citicorp argues the case for a "super cycle" which means metal prices staying stronger for longer. It lifted its long-term price targets by 30% – great news for market bulls, but dire tidings for steelmakers, their customers, and perhaps the global economy.