Ref: MPML/PMS/130/2008
Date : July 12, 2008
STEEL SPILL
INFLATIONARY EXPECTATIONS CAN LEAD TO PRICE SPIRAL
"Increasing export duties on iron ore may reduce domestic steel prices in the short run, but this may set in motion another round of inflationary pressure for the metal sector"
"In its worst form, the 'inflationary expectations' can lead to an 'inflationary spiral'"
"Global demand for iron ore has been caused by China's steel growth."
"The incremental capacity addition in China each year is more than India's total steel capacity."
"Price of steel in the world is not impacted by the cost structure of the marginal Indian steel industry but by the marginal cost structure of the Chinese steel industry, which is not only the largest, but also relatively high on the cost curve"
"Hence, policies to reduce inflation will have to factor in the impact not only on the domestic segment, but on the world cost structure (and world inflationary expectations) also."
Increasing export duties on iron ore may reduce domestic steel prices in the short run, but this may set in motion another round of inflationary pressure for the metal sector, says Navin Vohra
AS per the chaos theory, a small butterfly flapping its wings in the Pacific Ocean impacts the monsoons season in India. Certainly, policy makers in the world do not believe in this theory, otherwise they would not have been following policies of using export duties to control inflation. In a globalised world, these policies may actually help push inflation to other countries, which, after a lag, comes back to haunt you.
To understand this better, one has to appreciate the role of 'inflationary expectations' in causing inflation. In its simplest form, the theory runs like this: Suppose employees expect inflation to be high next year. To protect their interest in such a scenario, they would demand an increase in wage. Similarly, manufacturers are likely to be faced with the demand for increase in wage, which they will factor in the form of increase in product pricing from their customers. Thus, each segment of the economy will modify their behaviour to factor in the expected inflation. Sooner than later, this expectation will lead to a self fulfilling prophecy and inflation will actually shoot up. In its worst form, the 'inflationary expectations' can lead to an 'inflationary spiral'. The monetarist solution to break the inflationary expectation is for a central bank/monetary authority to build strong credibility that they would not let inflation to rise. This is typically done by building specific inflation targets for central bankers, and ensuring independence of central bankers. One of the key reasons for a fairly long period of low inflation in the world (prior to the current boom) was the strong credibility built by central bankers over the years.
Now, let us look at the scenario in iron ore, and consequently in steel. Global demand for iron ore has been caused by China's steel growth. China now accounts for more than 400 million tonnes of steel production, about 40% of the total world production. The incremental capacity addition in China each year is more than India's total steel capacity. The result is an ever increasing requirement for imported iron ore, as China is very deficient in the mineral. What makes the iron ore sector more interesting is the significant consolidation among the suppliers. Between themselves, Vale (Brazil), BHP Billiton (Anglo-Australian) and Rio Tinto (Australian) account for more than 75% of the seaborne iron ore supply. The joker in the pack is the Indian iron ore supply (spread over many small suppliers) which account for about 90-100 million tonnes - not a small amount in the 700-million-tonne industry.
Now, let's look at the price behaviour over the last few years. Iron ore prices, like other metals, have been steadily rising in the last few years. This is simply on account of demand-supply timing mismatch. While demand from China increased linearly, supply increase could happen only with a lag, as it involved large mining, railway and port infrastructure to come up, which has a long set up period. Thus, prices increased substantially in 2004 and 2005, but the increases started tapering off thereafter, with price increases in 2005-06 and 2006-07 being only 10% and 5%, respectively. There was genuine expectation in late 2006 and early 2007 that prices would start declining in the near future from their peaks.
However, in 2007, two unusual events happened. One, for the first time, the Indian government imposed an export duty on iron ore. More than the quantum of increase, it sent a directional signal to the Chinese. Second, there were floods in Australia, which impacted the supply of iron ore. So, by the end of 2007, if you were a Chinese steel maker looking to increase your import of iron ore, the scenario looked grim. On the one hand were the three giants, who had suffered infrastructure bottlenecks and production shortages, and obviously demand a higher price. On the other hand, was the Indian supply, of which you could not be sure of the costs (as it could change significantly based on export duties to be announced in the Budget) or even the quantum of supply (what if there was an export ban from India, which always looks like a very real possibility). Thus, you braced yourself for a high cost increase in your raw materials (which happened) and as much as possible, increase the price of steel (which also happened). The price of iron ore increased dramatically, pushing up the price of steel.
Why should the travails of a Chinese steel producer be of any importance to anybody in India? Because the price of steel in the world is not impacted by the cost structure of the marginal Indian steel industry but by the marginal cost structure of the Chinese steel industry, which is not only the largest, but also relatively high on the cost curve (and as basic micro economics teaches us, equilibrium price is achieved where price equals the marginal cost of the equilibrium output). In the long term, it is not possible for the price of steel in India to diverge from the world prices - finally the prices will have to catch up. By increasing export duties now, the policy makers may certainly help reduce the domestic steel price in the short term. However, there is a fair chance that it may have set in motion another round of inflationary expectations for the metal industry.
To conclude, the world (of steel) is now very globalised and is difficult to keep a domestic industry insulated. Hence, policies to reduce inflation will have to factor in the impact not only on the domestic segment, but on the world cost structure (and world inflationary expectations) also.
(Source: - Economic Times)