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China's Steel Folly

Steel demand is looking soft – but that hasn't stopped China ramping up production... 

CHINA is doing its very best to self-destruct in a debt fuelled investment spending frenzy, writes Greg Canavan for the Daily Reckoning Australia.

This will result in a deflation and in a few years' time China will turn to the printing press for a solution. Today's front page of the Financial Review comes with the hopeful headline 'China shield against iron ore price fall'.

The shield in question? An announcement by the city of Changsha to spend $130 billion on 195 projects, many of which will apparently use steel. The article goes on to tell us that the stimulus amounts to 147% of the region's 2011 GDP.

Australia relies heavily on iron ore exports (a key ingredient in the steel making process) and therefore relies heavily on Chinese steel making. But the halcyon days are over for Australia's iron ore players.

That's what the falling iron ore price is telling you. It is now trading around US$115 a tonne, well off its 2011 highs of over US$180 a tonne. In just the past few weeks, the price has fallen from US$135 tonne. We should get a bounce from here (it's been falling for nearly 2 weeks straight) but a sustained recovery is unlikely.

The price collapse is hurting the world's largest iron ore producer, Brazilian company Vale. It just reported a second quarter profit of 52 cents a share, representing a 59% slump on last year. It will soon hurt BHP and Rio's profits too.

Prices anticipate the future, and the falling iron ore price certainly says China's steel output must slow. But according to this recent Bloomberg article, China's steel mills are ramping production up.

'Daily steel production in China rebounded to 2 million metric tons in June, the second highest following a record of 2.02 million tons set in April. Output, already more than twice the combined daily production in Japan, the US, India and Russia, may climb 5.4 percent to 720 million tons this year, further outpacing domestic consumption, according to the median of three analysts surveyed by Bloomberg News.'

That's why China's regions are all scrambling to announce more stimulus measures. Steel production is overwhelming domestic demand. But instead of curbing supply, in China you just create demand for your product and deal with the consequences down the track.

Come to think of it, that's pretty much what the West does as well. But instead of steel, the West produces paper, or more accurately, electronic money. This 'money' then finds its way into speculative trading vehicles like derivatives. Asset prices go up, and people think they are wealthy.

China and the West are really no different when it comes to economic management. They're both following a false model that is doomed to end at some point. That is, continually drag demand from the future into the present. When that model exhausts the supply of additional real demand, you turn to financial demand. When that's exhausted, the game is over.

But in the meantime there's always hope. Hope that China can stimulate itself into prosperity and turn the laws of capitalism upside down. Hope that money printing will solve the world's ills.

Is it hope? Or delusion?

Time to Buy Gold?...

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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