This week’s massive fall in iron ore prices is not only hurting miners, but also Australia’s budget.

This week’s big drop in the iron ore price has come a surprise to many commodity market watchers, including UBS analyst Tom Price.

“Started off the year at about $US135 a tonne landed somewhere in north China and it’s come off about 20 per cent to a low of $104, $105 a tonne landed in north China,” he observed.

“This is a genuine surprise to the market because generally this time of year you’d actually see trade flows lift and the price lift as we come out of winter and the Chinese New Year period.”

There are a number of explanations for the price drop – an unexpected Chinese trade deficit exposing an oversupply of iron ore, as well as the Chinese government’s announcement yesterday that it is tightening credit for underperforming steel mills.

“There’s a third issue too – the government is concerned about levels of pollution, particularly around Beijing, and so they’re actually cutting steel production capacity and all of the raw materials processing capacity that’s going into the industry and that’s hurting the iron ore trade,” added Mr Price.

Thus economic policy changes aimed at clearing the skies over China could send dark clouds over Australia’s mining sector.

“Rio Tinto, BHP and Fortescue, the three big producers here in Australia, have invested an enormous amount of time and money in expanding their production capacity over the last few years and they’re just starting to deliver the biggest lift in those programs last year and this year, so they’d be a little bit troubled by this,” Mr Price said.

Iron ore specialist Fortescue has bounced back a bit on the share market today after two days of large falls.

Rio Tinto and BHP Billiton are still trading lower after being sold down heavily earlier in the week.

Budget woes

Chris Richardson from Deloitte Access Economics expects the mining companies’ pain to eventually be shared by the Federal Government.

“The good news, at least, is that the Government was always worried that the price would fall, so it’s got some fairly conservative price forecasts in there,” he said.

However, Mr Richardson says the National Disability Insurance Scheme and the Government’s proposed paid parental leave scheme are now looking less affordable.

“The basic difficulty Australia has is that both sides of politics went to the election ignoring this stuff, pretending that they could spend a lot more on schools and disability insurance and yet rush the budget back to surplus – you couldn’t have both,” he argued.

“Now it doesn’t mean that Australia shouldn’t have a disability insurance scheme or whatever, but it does say that the totality of the promises we’ve made ourselves doesn’t add up.”

That may have been the case even if the Rudd government’s proposed resource super profits tax of almost four years ago was implemented in place of the Gillard government’s watered-down Minerals Resource Rent Tax.

“The original version of the tax was actually going to refund royalties, so at least the current version of that tax is collecting more than the alternative would have done,” Mr Richardson said.

“If you add in all the taxes – the royalties and the others – they’re paying, the rate of tax that miners pay actually hasn’t fallen over the past decade and more. That’s a bit of a furphy.”

However, Mr Richardson is optimistic that Australia will still get a decent return for the billions invested in mining exploration and expansion over the past decade.

“It may not be shooting fish in a barrel, as it was for a while, but that could never have lasted. People have, I think, not understood the long term implications of the rise of emerging Asia,” he argued.

“Economics says you can only have a boom in two out of three in demand and supply and price and, as China and others boomed, then demand for commodities shot up, prices shot up as well because supply is really slow to get to market, you’ve got to dig new mines and get all the approvals and the rest of it.

“Now demand is a little slower, supply is roaring into those markets. The long term outcome was always going to be a booming commodity demand, a booming commodity supply and rather more sensible pricing.”