India Vs China - Coal Production

The increase in coal production is truly stunning. And this does not take into account the imports. The sheer ability to quickly ramp up production a few times over is the most amazing thing about China's top-down economic growth story.

Sustainable growth and the resource productivity challenge

The spectacular growth in the demand for energy, water, food, and commodities has ressurected the Malthusian spectre of a world running out of these resources. In this context, a new report by the McKinsey Global Institute brings some cheer claiming that this resource challenge can be met through a combination of expanding supply and resource productivity improvements (ranging from capping water supply leakages to building energy efficiency).

It claims that it is possible to save $2.9 trillion by extracting and using the world’s resources more productively. With carbon dioxide emissions priced at $30 a tonne these saving rises to $3.7 trillion. Resource productivity improvements - change in the way they are extracted, converted, and used - are the focus of the report, and it writes,

"Such resource productivity improvements, using existing technology, could satisfy nearly 30 percent of demand in 2030. Just 15 areas, from more energy-efficient buildings to improved irrigation, could deliver 75 percent of the potential for higher resource productivity."

The report advocates action by governments on three fronts to expand supply and improve prodcitivity. It writes,

"Policy makers should consider action on three fronts: unwinding subsidies that keep prices artificially low and encourage inefficiency; ensuring that enough capital is available and that market failures associated with, for instance, property rights and incentives are corrected; and bolstering society’s resilience by creating safety nets to help very poor people deal with change and educating consumers and businesses to heed the reality of future resource constraints."

As national incomes rise, as is happening at a swift pace with China and India, per capita resource consumption increases.



A reflection of a resource crunch is the steep increase in the prices of commodities...



... and also the price volatility of these resources.



Fifteen resource productivity improvement opportunities represent 75% of all such opportunities.



Developing countries account for 70-85% of these resource productivity opportunities.



Fortunately, considerable gaps exist between different countries on these productivity areas. This also means there exists considerable catch-up opportunity for the lagging countries.



See this post in Free Exchange which describes the findings of the report as a summary of market failures, whose correction would result in the promised resource productivity improvements.

Commodity bonds to hedge price volatility

Commodity exporters have always been vulnerable to the vagaries of global commodity price volatility. Jeffrey Frankel suggests the use of commodity bonds by both commodity exporters and their buyers to hedge against price risks.

Exporters of a particular commodity would issue debt denominated in terms of the price of that commodity (say Aluminium bonds by Jamaica), rather than dollar or any other currency. The interest rate paid on this debt will increase or decrease depending on whether the commodity prices are rising or falling respectively. This will ensure that the cost of debt service adjusts automatically (and debt-to-export ratio does not rise) in case of a decline in the price of the underlying commodity. The purchasers of this debt could include the major buyers of these commodities, whose (price increase) risk can be mitigated by the increased returns from higher commodity prices. He writes,

Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. This pooling function would be particularly important in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.

The meaning of the gold price surge

Conventional wisdom on the surging gold prices has been that it is in indicator of inflation wary investors fleeing to a traditional safe asset. Accordingly, conservatives have invoked the recent spike in gold price in support of their advocacy for fiscal consolidation.

Paul Krugman has an interesting post, where he argues that contrary to conventional wisdom, deflationary fears may be driving gold prices. He points to the famous Hotelling Rule which says that people have an incentive to hold onto an exhaustible resource (by storing it or keeping it unextracted) because of rising prices. Economically this means that "a mineral deposit in the ground has the same significance as a bond, and is in some sense interchangeable with such a financial instrument".

A consequence of this Rule is that, assuming negligible storage costs and the major part of the stock has already been extracted (so the choice is between storing it for the future or selling it now), the "real price must rise at a rate equal to the real rate of interest". If the real rate of interest is lower, as is the case now, people have an incentive to "hoard gold now and push its actual use further into the future" because the lower rates reduces the return on investment of the sale proceeds. This translates to higher prices in the short run and the near future. Krugman writes about its implications,

"(T)his... 'real' story about gold, in which the price has risen because expected returns on other investments have fallen; it is not, repeat not, a story about inflation expectations. Not only are surging gold prices not a sign of severe inflation just around the corner, they’re actually the result of a persistently depressed economy stuck in a liquidity trap — an economy that basically faces the threat of Japanese-style deflation, not Weimar-style inflation... And if you view the gold story as being basically about real interest rates, something else follows — namely, that having a gold standard right now would be deeply deflationary. The real price of gold 'wants' to rise; if you try to peg the nominal price level to gold, that can only happen through severe deflation."

In other words, since interest rates are low and rational expectations are for an extended period of low rates (and therefore low inflation), people prefer to hoard or store gold, thereby boosting gold prices in the short-run. This analysis would see the increase in gold price as a signature of deflation.

In another post Krugman also makes the distinction between gold and other commodities, in so far as their applicability to this hypothesis. Unlike gold, most other natural resources, including oil, does no conform to atleast one or both of the assumptions - negligible storage costs and most stock has been extracted out.

Australia's "Dutch Disease"?

The outback economy of the world, Australia, has been one of the strongest performing economies in the developed world for nearly three decades now, even managing the buck the Great Recession. But the strength conceals some areas of concern, which have been amplified by economic trends of the past decade. The biggest concern, as a recent FT op-ed suggested, may be the possibility of an affliction of the Dutch disease, driven by its recent commodities export boom.



The Dutch disease refers to the phenomenon, which has origins in Holland following the discovery of natural gas in the North Sea in the 1960s, wherein the domestic currency appreciated dramatically in response to a surge in exports of gas, thereby making the other exports extremely uncompetitive and adversely affecting the long-term health of the country's economy.



The FT has an excellent analysis which writes that Australia may be facing much the same situation, on the back of a commodities export boom driven by China's insatiable appetite. The share of commodities in merchandise exports have ballooned since the middle of the last decade, with the source of this demand being East Asia, mainly China (it takes up 26% of Australian exports).











It does not require much analysis to detect signs of concern from this trend, especially for a less diverse economy like Australia. There are several signatures of imbalances creeping in. It is estimated that though the natural resources sector only represents 10% of the economy, it sucks up 70% of capital expenditure. Mining projects worth A$ 832bn, or 60% of GDP are currently under execution or consideration. The structural impact of these investments could be staggering. And finally, there is the big external risk that such dependence, especially to one country, poses to the Australian economy. The FT writes,

"Booming sales of iron ore and coal have meant the country has hitched its fortunes to China like no other developed nation. That intimacy exposes it to the whims of a communist Asian power that could readily dump Australia if cheaper commodities were to be sourced elsewhere.



In the immediate future, the China-fuelled boom and the growing might of the mining industry are destabilising Australia’s economy by propelling the currency upward, squeezing trade-exposed industries ranging from manufacturing to tourism and boosting inflation. A shortage of workers for big resources projects has led to wage spikes that threaten to spill over into less buoyant industries.



Just ask manufacturers trying to export and those industries trying to compete with imports made cheap by the local dollar, which – long weaker than the greenback but this year bouncing either side of parity – reached a nearly three-decade high last month of US $1.10."

The graphic below shows that Australian dollar has been appreciating steadily against the US dollar since the turn of the millennium, coinciding with the spectacular growth of demand for commodities from China. After the recession indiced blip in 2007-08, it has been rising again since January 2009.







The rising Australian dollar is starting to impact manufacturing and agriculture, apart from the country's other major source of revenues, tourism. Recently, BluScope Steel, the nation's largest steel manufacturer, closed down "one of only three of the nation’s blast furnaces as part of an overhaul to cope with a surging local currency". Interestingly, for a country which is among the largest iron ore exporters, Australia does not have a strong steel industry.



Another area of concern is the apparent lack of plan to take a share in the windfall profits that are coming out of this boom and filling the coffers of mining giants like BHP and Rio TInto. Unlike the example of Norway and many Middle Eastern economies which have established rainy day funds or sovereign Wealth Funds financed out of resource booms, Australia does not have any and proposals to impose some windfall taxes on the minerals extracted have fallen by the wayside. In fact, and in a testament to the power wielded by the increasingly dominant mining lobby, a proposal to introduce a mining super tax was among one of the reasons for the exit of the previous government of Kevin Rudd. The watered down version proposed by the Gillard government is still awaiting Parliamentary nod.

Dollar Quietly Losing Status as Safe Haven During Crisis

Eric Blair
Activist Post

It used to be that during times of perceived global crisis institutional investors rushed into the dollar as a safe haven. U.S. Treasury bonds were once considered as good as gold when uncertainty gripped the world. However, it now seems that the weight of fundamentals have finally surpassed prevailing perceptions where the dollar is no longer king of crisis investing.

In October, 2010, the dollar reached a 5-month low against the Euro during the fierce debate leading up to the $600 billion quantitative easing by the Fed.  Following the final passage of QE2 in early November, the mainstream media hyped it as victory and promptly pivoted to begin pounding out headlines about the Eurozone debt crisis.  Almost immediately the dollar turned the corner against the Euro.

2-month Dollar/Euro Chart 2010

It was easy to predict such a turnaround because perception at the time was clearly driving the currencies, while fundamentals were largely ignored.  As I pointed out in October:

The fundamentals suggest that it (the dollar) should be finished, but just as the world is about to declare it dead, miraculously a global storyline seems to emerge just when needed and foreign investors rush back in for 'safety.'

And, indeed, investors flocked back into the dollar on the hyping of the Eurozone debt crisis 2.0.  However, this cycle only lasted until the first week of January, 2011 where talk of the Euro crisis was noticeably absent from the headlines, and America's financial woes once again took center stage.

Now, as the world is gripped by authentic crises with mass civil unrest in the Arab world, and the devastating earthquake/tsunami in Japan, large institutional investors are continuing to abandon the traditional safe-haven dollar.

Bloomberg reported last week that "Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., eliminated government-related debt from his flagship fund last month as the U.S. projected record budget deficits."

Despite the global turmoil, the dollar hovers near its 52-week low on the Dollar Index.  Perhaps the timing of these crises coinciding with American lawmakers threatening a government shutdown over its escalating debt has deterred investors from their normal behavior.  Instead we are seeing far more money moving into commodities, as currencies and government debt are being increasingly exposed as unreliable.

The world seems to be finally realizing that commodities such as food staples and oil are the genuine currency of our society, and the only true safe haven during global uncertainty.  In fact, it appears that the fiat U.S. dollar is actually measured by oil (and other vital commodities), not the other way around.  As tangible and necessary resources, oil and food are now kings of the crisis.

RELATED by Eric Blair:
Economy Hit with the Ultimate Smokescreen: Biflation
5 Collapse-Proof Investments with Tangible Fundamentals




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Oil price rise update

Events across Middle East, especially the rebellion in Libya and resultant disruption of oil extraction, and expectations of similar events in other major oil producers have naturally increased market uncertainty and put upward pressure on oil prices. Last week crude oil prices breached the psychologically important $100 per barrel mark.



There are widespread fears of a repeat of the $147 peak in 2008, which would adversely affect recovery in the developed economies. However, unlike then, when spare capacity was just 2% of daily production, it is now at a more comfortable 6%, or 5 million barrels per day. But there are also market specific factors that puts pressure on prices. For example, Libyan "sweet" crude, with its low sulphur content, is not easily replaced with the "sour" crude produced elsewhere since many European and Asian refineries are not equipped to refine "sour" crude. The resultant increased demand for "sweet" crude from Algeria and Nigeria will invariably push prices up.



If oil prices remain high for long, it is feared that the already weak economies of the developed world will slip further into recession. It is estimated as a thumb rule that every $10 increase in the price of a barrel of oil reduces the growth of the GDP by half a percentage point within two years. Its ripple effect on the developing economies, in terms of reduced exports and resultant lower economic activity, can be considerable.

In a reiteration of its critical, albeit less appreciated, role in stabilizing global oil prices, Saudi Arabia has responded to higher prices by increasing its crude output to more than nine million barrels a day, roughly 700,000 barrels more than at the end of 2010. Saudi Arabia has a total production capacity of 12.5 million barrels per day (bpd) and uses its 3.5 m bpd excess capacity to cushio the global oil market from supply shocks. Its officials are also asking European refiners, who are most directly affected by the drop in Libyan exports, how much and what grades of crude they need for quick shipment.

Update 1 (9/3/2011)

See this NYT Room for Debate which discusses why oil prices have are going up.