China’s economy was already slowing before the outbreaks of the Omicron variant of COVID now sweeping through some of its largest cities. Its modest, by historical standards, target for GDP growth this year of about 5.5 per cent was already looking extremely ambitious before it started locking down key industry centres.

For exporters of commodities - particularly iron ore - China’s response to its economic challenges is as important, if not more important, than whether its GDP growth is above or below 5 per cent.
It is doing what it historically has done in response to economic threats and is trying to put a floor under growth with both fiscal and monetary policy stimulus.

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Stimulus in China has historically been directed at infrastructure investment and the property markets. The implosion in its property sector after a crackdown on leverage within the property development sector last year has resulted in attempts this year to stabilise the sector through lower interest rates and incentives for prospective buyers.

That ought to mean iron prices remain elevated for some time, although COVID, given China’s “zero-COVID” approach to the pandemic, remains a wild card.

Similarly, Russia’s invasion of Ukraine proffers both good news for Australian commodities producers, both resource commodities and agricultural commodities, and a threat.

The prices of most commodities, particularly energy, have spiked since the invasion and the West’s imposition of the toughest financial sanctions ever inflicted on a major economy. Russia is a globally significant force in energy, metals mining and agriculture.

Disruptions to the flows of commodities generated by the conflict in Ukraine and the sanctions probably generate more upside than downside for Australian miners, farmers and government revenues but those impacts and their duration are uncertain, as are the longer-term implications of Europe’s efforts to shed its dependence on Russian energy or the impact of the sanctions in driving Russia and its resources base closer to China.

In the near term, the combination of China’s stimulus and the impact of the sanctions on Russia on commodities could have very material effects on the federal government’s revenues.

In the budget papers Treasury says that, if iron ore and coal prices remain elevated until the end of the September quarters (rather than falling back over the next six months) and then subside over the six months to end-March next year to their long-run levels, the value of nominal GDP would be $135.2 billion higher between 2021-22 and 2024-25 and tax receipts $29.5 billion higher.

The inherent volatility of commodity prices and the volatility of the geopolitical environment provide good reasons for Treasury to use very conservative forecasts of commodity prices. The broader uncertainties in the global economy – beyond China and Russia – make that caution even more appropriate.

Before Omicron the global economy was powering back from its pandemic lows, fuelled by unprecedented fiscal and monetary stimulus. The supply chain bottlenecks the pandemic had generated were starting to be resolved, consumers were spending their government’s largesse and companies were generating strong profit growth.

Inflation was, however, taking off – the rate is almost 8 per cent in the US – interest rates in developed economies appear likely to rise rapidly, financial markets have been quite fragile and volatile and there have been growing concerns that sharply higher global interest rates, a slowing China, the spill-over effects of the war in Ukraine, Omicron and the sanctions on Russia will undermine the recovery.

A global economic slowdown could pull the rug from under commodity demand and prices and remove that prospect of windfall revenues for companies and governments from continuing high commodity prices and a materially better budget outcome in 2022-23 than Treasury is forecasting.

The range of variables to consider and the scenarios that could develop, even in the short term, make the task of predicting commodity prices – or budget outcomes with any precision – near-impossible.

Hoping for better - which actually looks the more likely scenario for commodities - but planning for worse, as Treasury does, is the only rational approach.

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