Last week at the Australian Journal of Mining, Global Iron Ore & Steel Conference, Ian Ashby, President of BHP Billiton Iron Ore, a subsidiary of BHP Billiton (BHP-NYSE), made cautionary comments about iron ore demand in China. He was quoted as saying that Chinese demand for iron ore was “flattening out” and the growth rate could fall into the “single digits” if it hasn't already. Mr. Ashby showed the slide in Exhibit 1 that caused a negative reaction within the global investment community when coupled with his comments. Actually it is probably an accurate assessment of what is happening currently in China. There have been different interpretations of exactly what message Mr. Ashby was intending to deliver. Importantly, China will be a significant force in the global iron ore market for a long time based on the historical pattern of steel demand and economic growth.

While mineral and energy demand has been strong during the first two months of 2012, the government is determined to slow China's growth in order to reduce inflation and help the country through its economic and political transition. In a speech to the National People's Congress earlier this month, China's Premier Wen Jiabao announced the new target of 7.5% growth, down from the 8% target that has been in place since 2005. The government's inflation target was maintained at 4%. The plan to slow the economy reflects the leadership's goal of reducing inflationary forces at a time it engineers the shift from an investment and export oriented economy to one driven by domestic consumption. To successfully make this shift it will be necessary for the country to undergo a political transition at the same time.

To appreciate the nature of this Chinese transition and the risks it may entail, Martin Wolf of the Financial Times quoted Premier Wen Jiabao's comments from a March 14th speech in Beijing. “The reform in China has come to a critical stage. Without the success of political structural reform, it is impossible for us to fully institute economic structural reform. The gains we have made in reform and development may be lost, new problems that have cropped up in China's society cannot be fundamentally resolved and such historical tragedy as the Cultural Revolution may happen again.” China has already begun the process of transitioning from “extensive growth” driven by rising inputs of labor and capital to one of “intensive growth” driven by improving skills and technology.

China was once a labor surplus economy because of its large rural population. That labor surplus helped keep wage rates low in the industrial sector and aided the country's growth as it became the “low cost” manufacturing center for the world. Economic growth and urbanization have been so rapid that surplus labor no longer exists. Over the past 35 years, China's economy has grown 20-fold, in real terms, and half the country's population is urban. Due to China's low birth rate, the working age population (15-64 years old) will reach a peak of 996 million people in 2015. Labor shortages have become an increasing problem since they first surfaced in the coastal provinces in 2004.

The challenge for China in this transition is overcoming increasing wages while sustaining profitability. That will require China to grow based more on technical progress than cheap labor. However, there likely will be some decrease in profitability but it will be the result of a shift in income distribution within the economy correcting the current inequitable distribution. The challenges in making this shift explain why the Premier emphasized the need for significant political changes. In trying to get to this new economy China's odds of a short-term “hard landing” have increased. This is partly why the government has reduced its growth target to 7.5% for 2012 and to 7% in the current five-year plan. The charts in Exhibit 2 show the history of economic growth by its major components and the country's planned growth profile through 2030.

Eoin Treacy's view This summary is very much in line with our own view that China is migrating towards a consumer led economy. They passed an important Rubicon a few years ago where more economic advantage is gained by promoting the productivity and interests of the population than from infrastructure development. This is leading to an increased focus on labour conditions, social security, healthcare, the environment and the production of higher value added products.

This evolution is unlikely to be smooth. Chinese demand growth for infrastructure focused commodities should slow down while the absolute level of demand will continue to rise, particularly on a per capita consumption basis. I believe it would be unrealistic to expect Chinese consumption to approach the levels of the USA or Europe because of cultural factors. A comparison with Hong Kong, Taiwan or Singapore would be more appropriate and would still represent considerable consumer demand growth from current levels.

The Shanghai A-Share Index is heavily weighted by banks, industrials and materials companies. While reflective of how the economy is currently structured it does not give us an accurate picture of where growth is likely to emerge. The S&P/Citic300 Consumer Staples Index remains a relative strength performer. Nevertheless it has not been immune from the current selling pressure. It pulled back sharply over the last couple of weeks and a clear upward dynamic will be required to suggest a return to demand dominance.