So-called experts speculating on the future may often resemble a horde of monkeys blindly throwing darts at a board, or so they say. As was the hubbub prefacing the recent financial crisis, the materialization of which literally blindsided nearly every economic extraordinaire. Yet there admittedly were a few prominent economists and financial figures who forewarned of the crash in a timely fashion.
Time and time again, the likes of Peter Schiff had so candidly and explicitly spoke on the poor state of the economy prior to the crisis. But the bullish, or perhaps bullheaded, majority derisively laughed off the gloomy yet prophetic words of wisdom.
And so the present is eerily similar to the past, albeit with respect to a somewhat different matter. There exist many bulls—many of whom have either dismissed or covered their ears to the voices of dissent—that are speculating on the future of commodity prices. Mining Association of Canada president Pierre Gratton effectively concurred when he said he’s “not aware that there is much controversy” over the relatively unwavering future of commodity prices.
But, unbeknownst to Gratton and some of his colleagues, there is controversy. There are indeed a few bears to whose predictions the bulls aren’t paying much heed. There are indeed a few people who actively warn of a black cloud heading toward the commodity market, the effects of which could imperil some of Canada’s industry.
China, the world’s largest consumer of commodities, is said to be undergoing a slowdown and, more pertinently, a structural transition that could lower commodity prices and radically change the mining economy in Canada altogether.
Senior Associate at the Carnegie Endowment Centre for International Peace and finance professor at Peking University Michael Pettis is especially bearish, for he’s warned that commodity prices will have “collapsed” by 2015.
He believes that China must unavoidably rebalance its economy away from commodity-intensive and investment-driven growth, which will profoundly lower the demand for and price of commodities. He said the reason for this rests in China’s growth model.
The model accumulates the savings from the household sector and redirects the capital into what the central government deems necessary investment. Though the model has proven somewhat successful for many an economy at different points in history, there comes a time when the model becomes injurious.
“When you start off with very weak infrastructure and no manufacturing capacity, it’s relatively easy to identify economically productive projects,” said Pettis. “The problem with the model is that, although most of the investments are productive in the early stage, in every single case in history we’ve reached the point where they’ve stopped becoming productive.”
That is true for every single case in history simply because the model inevitably distorts the market. Economic output is only sustainable if it reflects the economy’s demand patterns. If a government allocates resources into a string of investments for which there isn’t a real demand, the market will naturally correct the misallocation through price fluctuations.
And Pettis speaks precisely to that.
“As you keep investment levels very high it becomes more and more difficult to do so, especially since all the pricing signals are distorted,” he added. “That’s when you reach the point where you are no longer making productive decisions economically” and spurring “misallocated investment,” the only remedy to which is economic rebalancing.
Emblematic of those misallocated investments are the massive ghost cities in China—that is, the amenity-filled mega-cities in which virtually nobody lives. But China still continues to develop and build via government action, which, if what Pettis says is true, will only exacerbate the collapse. For the reported unsustainable rise in demand for commodities in China has already triggered an unsustainable rise in production.
Mining is a longer-term venture, for years and years of large investments must go into exploration, extraction, and processing and production. Consequently, there is a time lag intrinsic to mining. In other words, it takes time for producers to respond to pricing signals that guide their activity.
Pettis said that “commodity producers were caught by surprise” when prices began ballooning and hence rapidly ramped up production, despite the unsustainable nature of China’s growth. Accordingly, a lot of new mines are still coming online.
And more production will continue to come online, irrespective of China’s dwindling demand. In confirming this, Pettis drew primarily on anecdotal evidence and an empirically backed presentation that was put on a few months ago by Morgan Stanley Australia chief economist Gerard Minack at a conference in Sydney, Australia.
But Fraser Institute Resident Fellow Fred McMahon, though seemingly a tad bearish, isn’t too worried.
“It’s unlikely that commodity prices are going to take a nosedive, but there’s a strong likelihood that they’ll continue to soften,” he said. “Canada, of course, would suffer, but the advantage of a free market economy is that new economic activity grows to replace declining economic activity.”
“In the short run, I see a continued weakness in the global economy and therefore commodity prices not moving up but not moving much down,” added McMahon. “[But] a big spike or big fall in the short-term is far more likely than a big lasting spike or a big lasting fall in the long-term.”
McMahon, too, stressed the importance of China’s role in the futures of commodity prices and the mining industry.
“One of the issues is that China is moving into a new economic area,” he said. “Regardless of what happens with China’s economy, soft or strong, it’s going to use fewer commodities than it did in the past for the same level of economic activity.”
Gratton, however, remains bullish on commodity prices. China still has to undergo more rounds of urbanization and industrialization, he said.
“The rise in consumer spending that China’s just starting as the middle class emerges still hasn’t really kicked in,” added Gratton. “A lot of the consumables that they want are commodity-intensive because they’re not where we are—they want cars, which involves a lot of metal.”
Still, as was the case in the most recent financial crisis, perhaps only time will definitively tell.