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Steady iron ore price good news for Australian economy and government`

Stephen Koukoulas
Yahoo7 Finance

There’s some good news for the economy with the iron ore price remaining firm.

Australia’s national income and the performance of the Federal government’s budget are heavily dependent on the price of iron ore.

It is striking that one simple, largely unprocessed commodity can mean so much for a rich, modern and advanced economy like Australia.

To be sure and as is the case with most commodities, the price of iron ore is hugely volatile, often driven by news of a new mine opening, an update on Chinese industrial production or bad weather, each of which than might impact shipping flows from the mines and ports impacted by such events. It can rise and fall sharply for no obvious news, such is the fickle and speculative nature of the market.

Haulage truck at the Rio Tinto West Angelas iron ore mine in the Pilbara region of West Australia Wednesday, July 9, 2014. (AAP Image/Alan Porritt) NO ARCHIVING

Since 2002, the iron ore price has ranged between US$12 and US$190 a tonne. Even in the past five years, the range has been between US$38 and US$150 a tonne. It is clearly a wild market.

Currently, the iron ore price is around US$60 to US$65 a tonne, which is roughly double the cost of production for the big iron ore miners in Australia – BHP, Rio and Fortescue.

If the price can average somewhere around this range over the medium term (meaning several years), the mining companies will continue to make strong profits, output will likely remain buoyant and there is some prospect of additional low-cost mines being opened as global demand supports this price range.

In 2016, iron ore exports totaled $54 billion, making up over 20 per cent of Australia’s merchandise exports or approximately 2 per cent of GDP. This means, quite simply, that a 10 per cent shift in export receipts via either price or the volume exported, will impact GDP by 0.2 percentage points.

In other words, if total export receipts were, say, 10 per cent higher, bottom line growth in Australian GDP would be 0.2 percentage points higher.

In the recent budget in May, the Federal Treasury based its modeling of the economy and revenue for the government on an iron ore price of US$55 a tonne from the start of 2018. It noted that for each US$1 tonne difference from this forecast impacted the budget bottom line by a quite remarkable $420 million per annum.

This means that if the price happened to average US$75 a tonne from the start of 2018, there would be a windfall gain of $8.4 billion to the budget each and every year and all of a sudden, the return to budget surplus would be secure. This is clearly what we all should be hoping for.

But such is the erratic and volatile nature of these markets that if some of the more gloomy predictions come to pass, and the price were to average say US$35 a tonne, there would be an $8.4 billion hit to the annual budget numbers meaning the return to surplus would be pushed back a year or two, the triple-A credit rating would almost certainly be downgraded and the economy would flounder.

But for now, with the global economy expanding at a decent pace and importantly, Chinese growth looking to pick up over the second half of 2017, the iron ore price should remain well supported.

This should provide some offset to the still uncertain outlook for the rest of the economy which is being held back by cautious consumer spending which in turn is linked to low wages growth, falling savings and high levels of household debt.

As is often the case with an economy, there are strong and weak parts operating at the same time and this is certainly the case in Australia right now.