The continued strength of the iron ore price is surprising, given the collapse of oil, which traders have recently been willing to pay buyers for if they’ll agree to offload full tankers.

Oil and iron ore are the two most basic commodities of industrial economies and, through much of their history, their prices have moved in tandem along with the underlying health of global industrial production.

But iron ore has been holding comfortably above US$80 a tonne throughout the Covid-19 crisis, delivering a continuing run of fabulous profits to Australia’s big miners, BHP, Rio Tinto and Fortescue, which can all dig it up at a cost of less than US$15 a tonne.

The current price is about 35% higher than the federal government expected when it cast its mid-year budget outlook last December.

The short explanation for iron ore’s strength is China. China buys almost three-quarters of all seaborne iron ore and is the dominant influence on prices. China is seen to have emerged from the public health crisis and there’s an expectation the government will respond to lingering weakness in its economy with public spending on infrastructure that will boost steel demand.

By contrast, China accounts for only around 14% of the global oil market, which has abruptly contracted. The International Energy Agency estimates oil demand globally will be down 6% this year, equivalent to subtracting India’s entire consumption.

With the Covid-19 crisis still acute across the major Western economies, it is too soon to know what the global economy will look like on the other side of it.

It may be that once social-distancing restrictions are eased, everyone will go back to eating at restaurants and then, once travel is allowed, resume their long-delayed holidays and business trips. It will all pass like a bad dream. A pointer in that direction is that cruise ship operator Carnival, which in many ways epitomises the reputational damage from the Covid-19 crisis, is taking bookings for ships departing Sydney in August.

But a more pessimistic scenario of a long-lasting downturn in global demand cannot be discounted. Unemployment will remain high, banks will face large debt write-offs and will be reluctant to lend, and companies will defer investment decisions.

The backlash against globalisation that has been building since the 2008 financial crisis may intensify, with the renewal of hostilities between the United States and China and pressure on companies to repatriate their supply lines. The World Trade Organization has forecast ^[1] a fall in trade this year of anywhere from 13% to 32%. The post-Covid-19 world could be more like it was in the 1930s, when trade halved as a share of global GDP.

The resilience of the Chinese economy and its demand for commodities would be severely tested. The modernisation and development of the Chinese economy over the past 30 years has been driven by globalisation and the rapid growth of world trade. China has had some success in reducing its dependence on exports and fostering domestic consumption, but trade still underpins its manufacturing industry and it looks troubled.

In the first three months of the year, China’s exports to the US were down by 25% and its sales to the European Union were down 16%. Bigger falls are likely in the second quarter.

To some extent, the strength of the iron ore price relative to oil is a function of the leads and lags in the respective supply chains. Oil storage is limited and, if the producing nations keep pumping it at a faster rate than consumers are using it, the available space fills to the brim. The oil market is at that point.

By contrast, China’s manufacturers, construction companies, traders and producers all keep stocks of steel, and prices have been supported by buyers adding to inventories in anticipation of a revival in economic demand. The latest readings on Chinese industrial production for April show that, while businesses are slowly getting back to work, the loss of export markets is reducing overall output.

As is well understood, China’s appetite for Australian commodities has underwritten our prosperity for the past 16 years. The resource sector now accounts for almost a quarter of all business capital stock, double its share in 2004 when the great boom began.

This has made Australia the pre-eminent supplier of mineral and energy resources to the world. The high cost of Australian labour has been more than offset by the world-beating efficiency of our resource companies, by the intrinsic quality of the reserves they exploit and by the strength of Australian governance. Those attributes have been rewarded with prices that have been higher for longer than at any point in Australia’s history.

An economic variable that has a big impact on living standards is the ‘terms of trade’, or the prices we receive for our exports versus the prices we pay for our imports.

During the technology boom of the late 1990s, the prevailing wisdom was that Australia had backed the wrong horse: the technology we imported would go up in value while the resources we exported would go down. As treasurer, Peter Costello was advised to subsidise the construction of an Australian microchip plant to shift the balance.

But the China-led resource boom meant that the average price for Australia’s exports since 2004 has been about 60% higher relative to the average cost of imports than was the case over the preceding 20 years. This has helped to sustain strong growth in living standards in Australia despite relatively poor productivity.

The long-term history—and there’s good data going back to the 1870s—is that booms in the terms of trade are followed by busts. Export prices drop well below their long-term average (relative to import prices) before returning to it.

Reserve Bank of Australia analysis ^[2] of terms of trade booms and busts over the past 150 years shows that downturns are associated with weak per capita income growth and high unemployment and that it’s typically around five years before income growth recovers.

While the future is in flux, policymakers should be considering this as one of the potential outcomes from the crisis.

One point that should be made is that a sustained fall in iron ore prices would not be accompanied by a reduction in China’s demand for Australian supplies, which have the lowest production costs. In any commodity, prices will only fall as the highest cost producers are knocked out of the market. In iron ore, the highest cost producers are China’s own.

If China’s demand falls, it will be China’s iron ore mines that are rendered uneconomic and forced to close, while its dependence on seaborne trade will increase.