The East is in the Red: the white-knuckle ride begins

Australia has been riding the boom created by China's appetite for resources, but the Asian giant is running out of steam.

The trees at West Rock Village are mostly dead and the streets are caked in dust and clogged with gritty factory haze.

But the villagers are not worried about pollution; they are scared that one day soon it might all blow away. They knew well before the outside world that the factory was in trouble and China's steel-driven economy was on the slide.

"If the factory goes down, my daughter, my husband and my son will all be unemployed,'' says 59-year-old grandmother Han Chunwen.

Mrs Han's husband has worked all his life at the steelworks across the road. He maintains the conveyor belts that haul steel-making coking coal to the hot ovens before it is dumped into blast furnaces to smelt the iron ore.

Mr Han still has a job, for now.

His 36-year-old daughter works there as a chemical engineer, analysing the quality of local, Brazilian and Australian ore. In the early years, the rusty state-owned factory was always shutting down and laying her off.

But eight years ago a young entrepreneur called Ding Liguo arrived and transformed the place into a dynamic private enterprise called Delong Steel, now making 3 million tonnes of steel each year for highway barriers, car chassis and oil pipelines.

"When Ding arrived my daughter's salary started to rise," says Mr Han. "He is formidable." On September 1, after eight boom years, his daughter was told to take an extended "rest" without pay. She knew the factory was in trouble.

In March Mr Han's 20-year-old son started work, loading the dust-like iron ore "fines" into compactors so that it did not all blow away when dropped into the furnaces. On September 27 he was stood down on a fortnightly roster of unpaid leave.

"If the factory closes this whole village will have nothing to eat," says Mr Han. "Do they have the money to keep buying the iron ore?"

That is the multibillion-dollar question to which Australia's Reserve Bank governor, Glenn Stevens, needs to find an answer.

In the eight years since Ding Liguo and his Delong Steel company arrived at the village near Xingtai, in Hebei province on the North China Plain, 1.3 billion Chinese have tripled the amount of steel they each consume.

Half of it is used for residential and commercial buildings and infrastructure; the other half goes into machinery, shipbuilding, cars and pipes.

China accounted for 85 per cent of global steel consumption growth in the past five years. It pushed the annualised value of Australia's iron ore exports from $US5.1 billion ($7.4 billion) to $US33 billion today. In that time exports of steel-making coking coal and power-generating thermal coal have jumped from US$10.8 billion to $US48 billion.

Other mineral and energy exports, like natural gas, alumina and copper, have soared to $US71 billion. Minerals and energy now make up 56 per cent of Australia's total exports, compared with the manufacturing industry's 14 per cent and 10 per cent for farming.

The China-driven resources boom shifted the terms of trade massively in Australia's favour. It made Australians about 13 per cent richer without them having to do a thing. While Australia's volume of economic output, or gross domestic product, has risen 19 per cent in five years, higher export prices have meant Australia's gross domestic income has soared 32 per cent. So the country voted for tax cuts, bought cars, rebuilt homes and piled on more debts as if the resources boom would last forever.

The Chinese economy is difficult to read at the best of times. In recent months it has been distorted by shutdowns related to the Beijing Olympic Games. Few people were paying much attention when electricity production growth fell in June and the amount of floor space under construction fell in the year to July, after growing at more than 20 per cent for years. In hindsight, the Government's policies to fight inflation and rebalance the economy were flattening the construction sector. Builders no longer needed so many steel rods and beams, steel mills reduced demand for electricity, power generators lowered their consumption of thermal coal and their future demand for copper by scaling back plans for more generating capacity and transmission wires.

Commodities traders had piled up stocks, expecting China's construction and heavy industry to burst back to life after the Olympics. Instead, the financial crisis reverberated around the world, stockpiles were liquidated, and the five-year resources boom quickly turned to bust.

At Tangshan, the heart of China's steel industry, traders report that dozens of mills are going belly up and a third of blast furnaces have been shut down. "This is the beginning," says MySteel analyst Xu Xiangchun. "So many steel companies have suddenly collapsed and more and more are running out of cash and will go the same way."

For the benefit of an Australian audience, he adds: "This is very good for China in front of the upcoming contract price negotiations."

Traders who had been selling iron ore at around $US200 a tonne on the Tangshan spot market were struggling this week to make a sale at $US80. The Newcastle spot price for power-generating coal has plunged from nearly $US200 to $US110. Copper has fallen more gradually, by one half, and nickel by three-fifths. This week Rio Tinto's chief executive, Tom Albanese, shocked the London and Sydney stock exchanges by being the first major mining executive to warn that China would not recover before year's end.

"No, I did not predict the carnage at the moment," says Jim Lennon, Macquarie Bank's respected head commodities analyst. "Last week was the first time since records began that the Chinese spot market price for iron ore went below the Australian long-term contract price. The freight market has imploded. We've declared force majeure on the global commodities super-cycle."

Resource price rises that directly injected 2 or 3 percentage points of additional income into the Australian economy each year are swinging into reverse. "As the resources boom unwinds it will do significant damage to Australia," says Kieren Davies, a leading economist at ABN Amro. "The fall in national income will flow to weaker company profits and weaker business investment and cascade through the economy."

Most of the hundreds of Australian mining companies that have sprung up at the tail end of the resources boom will not survive. "A lot of the junior miners will run out of cash and go into liquidation as they will be unable to raise funds," says Linda Liu Bearne, an investment consultant whose clients include China International Capital Corporation, China's largest investment bank.

Ms Liu Bearne says she has met a stream of mining hopefuls eager to raise money from China. But even China's cashed-up, resource hungry enterprises have been shocked by the carnage spreading through the financial world. Some private Chinese investors have recently walked away from deals at the point of signing. The sovereign wealth fund investors are paralysed by past mistakes.

Advisers in Australia and China say a number of state-owned Chinese enterprises are still willing to take large stakes in discount Australian assets, but their profits are falling and the Rudd Government's more restrictive foreign investment policies have made them more cautious.

It would have been hard enough for Australia to escape recession with only a global financial crisis. But now the Reserve Bank and the Treasury Secretary, Ken Henry, have had to slash interest rates and pump out cash to counteract a resources bust - something Australia has never previously managed to do. The plunging Australian dollar will help cushion the fall. But it will not be easy to calibrate a rescue when the world is changing so fast.

At Delong Steel, Han Chunwen and her family are closely watching the three large furnaces that remain in operation. The four smaller furnaces have been shut down for early maintenance and can be restarted within weeks if demand picks up again. But the large furnaces take months to cool and then be cleaned out and started up again. That's something no factory owner would choose to do - unless they think their business is going under.

Andrew Forrest at Fortescue Metals Group also has a direct interest in the smoke that continues to billow from the large blast furnaces at Delong. If they shut down he will have to find another buyer.

The two companies signed a long-term contract that helped place Fortescue on the investor map. But now, just five months after its first cargo load arrived in China, Mr Ding has sacked the hapless manager who signed the deal. The Herald understands that Fortescue contracted to arrange freight for the iron ore deliveries and pass the costs on to Delong Steel. Fortescue locked in the freight costs months ago, when freight rates were high. But the deal now looks expensive because spot market iron ore and freight rates have collapsed and Mr Ding's own customers are deserting him in droves. Mr Ding wants Fortescue to wear the cost of expensive freight before agreeing to take more ore. Fortescue says they are flexible, and they might have no choice.

"They contacted us yesterday but we have not renegotiated anything," said Graeme Rowley, executive director of operations at Fortescue metals.

A senior manager at Delong Steel, Lu Bing, says times are tough but all of his 5000 workers remain fully employed. But worker and industry sources say about a third of them have been ordered to take unpaid leave and more will be stood down unless steel prices recover next week. Delong's bankers are banging at the door.

"It's the same for every steel mill in China and across the world," says Mr Lu, the manager at Delong. "The big mills are all cutting production and lots of smaller mills are shutting down. No one knows how long this slump is going to take."

Marius Kloppers at BHP Billiton and Tom Albanese at Rio Tinto are also anxiously watching the smoke from China's largest blast furnaces. Chinese statistics are often unreliable and the slide of China's steel industry has been so sudden that it is impossible to keep pace. Delong, for example, has been laying off workers for seven weeks but nobody outside the village seems to know.

With BHP and Rio's values sharply down, both companies need faster ways to gauge how far this resources slump might go. Last week a team from Rio quietly fanned out across China to survey the mills and and see how many of China's high-cost iron ore mines are shutting down. That's not an easy task.

China has more than 500 steel companies, compared with Australia's two.

The stakes are so high that large mining companies are chartering extra espionage flights to photograph iron ore stocks at each other's ports in Western Australia and Brazil. They are also hiring satellites. And they are desperately waiting for the Chinese Government to come to their salvation. "Neither I nor you can tell what the world is going to look like in four, eight or 12 months from now," says Russell Scrimshaw, executive director at Fortescue. "I hope the Chinese Government does the right thing to stimulate the economy."

Indeed, many in China are surprised that the Government has not yet taken back the 30 and 40 per cent deposit requirements for home buyers, the transaction taxes and the tight credit quotas that it introduced last year to cool the overheated luxury apartment market. They are waiting for the Government to unleash its enormous balance sheet on yet another network of rail and roads.

But the Chinese economy is not as simple as pushing the accelerator or tapping the brake. The President, Hu Jintao, and the Premier, Wen Jiabao, are trying to rebalance investment away from resource-intensive and highly-polluting heavy industry.

Daniel Rosen, director of the China practice at the Rhodium Group in New York, says Mr Hu and Mr Wen want to change China's heavy-industry model that is tilted dangerously in favour of capital at the expense of household income and consumption.

"The manic expansion of steel mills bolstered demand for natural resources . . . over the past half decade," says Mr Rosen. "But only sustainable growth based on maximising the gains to China's 770 million working-age people can sustain the pattern of urbanisation for decades to come."

So far the Chinese economy is rebalancing exactly as Mr Hu and Mr Wen wanted, although the pain threshold for unemployment cannot be far away. China has been the saviour of the Australian economy for five years or more and it will not be too long before it is again. The forces that are driving Chinese people to urbanise, escape from poverty and consume energy and mineral resources are far from over.

Unlike Australia's sprawling cities of brick, China's land-constrained cities have nowhere to go but up. Buildings that are higher than five stories are generally reinforced with steel. Higher buildings require greater concentrations of steel.

Earlier this year a team of 20 consultants at McKinsey & Company constructed a ground-up model of what China will look like two decades from now. By then China will have urbanised and another 350 million people will have moved from the countryside.

They will live and work in more than five million buildings in 200 cities that each contain more than 1 million people. Fifty thousand of those buildings are likely to be skyscrapers - "the equivalent to constructing up to 10 New York cities," says the McKinsey report, Preparing for China's Urban Billion.

The message, studied closely by Australian mining companies such as BHP Billiton and Rio Tinto, is that if you have been impressed by the gleaming towers of Shanghai and Beijing then you have seen nothing yet.

But along the way - and, particularly right now - it will be a white-knuckle ride.