By Manolo Serapio Jr
SINGAPORE (Reuters) - Iron ore could soon become a leading economic indicator in emerging markets such as China, since the absence of speculative froth makes the sandy steelmaking raw material a better gauge of demand than industrial metals like copper.
With the uses of steel nearly as diverse as copper, from manufacturing to construction and power, the volume of iron ore consumed by developing economies shows whether their industrial expansion is on track or if they are curbing fixed-asset investment amid weakness in key export markets in the West.
Iron ore prices, governed chiefly by supply and demand conditions, offer a glimpse into the health of fast-growing emerging economies, including top buyer China and big suppliers India and Brazil, at a time when the United States and Europe are on shaky ground.
Emerging markets comprise 75 percent of global iron ore demand and 90 percent of that is Chinese demand, estimates Citigroup analyst Daniel Hynes.
Unlike copper and other metals, substantial parts of which are re-exported in the form of electrical goods, nearly all the iron ore that China consumes ends up as steel invested in fixed assets such as bridges, roads and houses.
"It's definitely a building block of the Chinese economy," said Hynes.
"It does indicate the underlying domestic demand in that country as opposed to copper and other metals which have a bit more export-driven component to that demand."
The lack of a strong futures market also frees iron ore of the speculative premium that masks fundamental supply and demand conditions, said Ben Westmore, commodity economist at National Australia Bank .
"Which is a really, really good attribute if you're looking for an indicator," he added.
The increased transparency in iron ore pricing boosts its credibility as a demand indicator. In April 2010 the industry ditched a 40-year system of pricing the raw material annually in favour of a more flexible quarterly arrangement.
That spawned even shorter pricing schemes, including monthly, as miners including BHP Billiton cashed in on rising spot prices that hit record levels near $200 a tonne in mid-February, further increasing price transparency.
A big driver of the price surge is China, buyer of around two-thirds of the world's seaborne iron ore. With its daily steel production at a record pace this year, China is importing as much iron ore as it can because its domestic mines churn out low-quality ore.
IRON ORE VS COPPER
China is the top consumer of both copper and iron ore, although its share of the global iron ore market is much bigger, linking the steel-making raw material more tightly to the world's No. 2 economy, so making it more resilient to downside pressure outside China.
China accounts for more than 30 percent of the global copper market.
During this month's rout, when a downgrade of the United States' credit rating and a crippling debt crisis in the euro zone fueled a sell-off in equities and commodities, spot prices of iron ore were relatively unscathed while copper slid to eight-month lows.
Spot iron ore has risen 1.8 percent in August, while copper has fallen around 7 percent.
"The biggest question we've had over the last few weeks is what's changed in the fundamentals. Equities have been destroyed and exchange-traded commodities have come under quite a lot of pressure," said Graeme Train, commodity analyst at Macquarie in Shanghai.
"But when we look at iron ore, prices are holding up, therefore there is still real demand for commodities just as much as there was a month ago."
Because of the speculative element in exchange-traded commodities that becomes more pronounced during episodes of extreme volatility, Train said, non-exchange traded commodities like iron ore and coal become better indicators of real demand.
Copper prices, for example, now at more than $9,000 a tonne now, or easily triple their lowest level during the 2008 global financial crisis, are well above what is justified by real demand, analysts say.
Iron ore may be a more appropriate demand indicator among developing economies hungry for steel to feed their urbanisation. Copper and other base metals may remain a better measure for the developed world.
"But everyone knows how weak the United States and European economies are so I don't think that's really more important to gauge at the moment than a China-centric indicator like iron ore, especially if you're in the Asian region," said NAB's Westmore.
But iron ore's attribute of being free of the speculative element may be short-lived, with the market in its derivatives gradually gaining traction.
Volumes in iron ore swaps surged to more than 4 million tonnes in July, an all-time high, while turnover at exchanges in India and Singapore offering futures contracts has been picking up.
The iron ore derivatives market, however, is still very much in its infancy, with the world's first futures market, in India, only debuting in January. Credit Suisse and Deutsche Bank launched the swaps market in 2008.
Analysts say trading in both swaps and futures is still dominated by producers and consumers rather than investment clients which means there's still a significantly smaller amount of speculative interest versus other commodities.
A better indicator of global or industrial demand would be a basket of commodities that includes iron ore, said Vishnu Varathan, economist at Capital Economics.
"The idea is look at a few indicators and then interpret it with some cognizance of what's going on in the global dynamics.
"There's always a danger in overly relying on any one indicator -- it's a bit like the three blind men feeling the elephant," said Varathan, referring to the tale in which the men drew conflicting conclusions about the animal's appearance, depending on the parts of the elephant they touched.
(Editing by Clarence Fernandez)