Australia faces up to China market blow

Australia’s trade relations with China have rarely been smooth despite the People’s Republic being its largest market accounting for more than 40% of total exports from iron ore to wool.

Beijing is always ready threaten retaliation if it feels in any way slighted; for instance, some Canadian imports were suspended last year when a Chinese businesswoman was arrested. So after being given a warning in August, Australia’s wine producers can hardly have been surprised by the tariffs of up to 212% slapped on their bottles by the communist regime.

If they had taken comfort in believing they were innocent of the charges of alleged dumping or receiving unfair subsidies, it was either mistaken bravado or naive hope that the facts were in their favour.

Australia’s beef, lobster, coal, timber, sugar and cotton producers all claim, like the wine companies, that they have done nothing wrong. Nevertheless, they have all been hit by punitive tariff rises or import obstacles this year. The lobsters are “tainted”, the coal is “substandard” and bug infestations have been found in timber.

But they have all been guilty of underestimating the sovereign risk of exporting to China and the diplomatic trade war that has been simmering beneath the surface.

Such is the “offence” in Beijing’s eyes of  Australia’s questioning its initial response to the Covid-19 outbreak in Wuhan, the banning of Huawei from Australia’s 5G network plus its treatment of Hong Kong and minority muslim populations, that it has effectively ripped up a free trade agreement negotiated with Canberra five years ago.

The Australians may complain to the World Trade Organisation that China’s “aggressive” actions are undermining confidence in the global economic recovery, but President Xi Jinping knows that its processes are glacial in speed and the worst he might face is a slapped wrist. 

Note that the only significant Australian export to China unaffected by the worsened relations of the past year is the millions of tons of iron ore Beijing needs to underpin its domestic economic growth. 

Xi calculates that Canberra will not cut off those shipments in retaliation because it needs the revenue even more than he needs the iron ore, so until he decides to lift the tariffs on his AU$1.4 billion (£775m) market for Australia’s wine, it is effectively closed and producers are left with millions of bottles on their hands.

The largest group, Treasury Wine Estates, has been hit with tariffs of 169%. That will create an immediate 30% (AU$200m) black hole in its annual profits, leaving new chief executive Tim Ford holding an even hotter potato than he envisaged when he took over in August.

Growth in China had been the main driver of Treasury’s profit growth over the past six years. Until 10 days ago 25% of Treasury’s flagship Penfold’s range went into China: now it is zero.

Ford says his immediate reaction is based on China being effectively closed to Australian producers. “A strategy of hope is not a very smart strategy,” he said.

Analysts believe there will be only limited scope for increasing upmarket sales in the Australian domestic market, so increasing other export demand is of prime importance to Treasury.

Yet Ford’s scheme to redirect those now surplus bottles to the United States, Europe and north Asian countries such as South Korea, Japan and Taiwan, is bound to take between two and three years to become fully effective. 

The US has not been a happy hunting ground for Treasury in recent years. True it has been reducing its exposure to the low and middle price shelves where most Australian wines are found, but the overall market is only just emerging from a wine glut so pushing higher priced, quality wines will present challenges.

One Australian commentator has calculated that Treasury sells AU$500 million-plus worth of wine to China, where it generates margins of up to 39.5%, almost double those in Australia and triple those in the US. So replacing profitability will be even harder.

Nevertheless, Ford believes: “It [the US] is the largest opportunity off the lowest base we have globally.” But he is not about to devalue the Penfold’s brand in targeting it. “We are not going to discount the price to move volume,” he said. That will involve inevitable extra costs to hold stock.

Under Ford’s enforced new strategy some high-end grape supply will be re-directed to other brands in the Treasury portfolio including Wynns, Wolf Blass, Seppelt and Pepperjack. The company will also cut its harvest purchases, meaning growers will face painful hits to their income. Many could go under.

In addition, the company plans to broaden the geographic base of its high-end production. In part, that will get around the “produced in Australia” tariffs.

In 2018 it started to produce a Penfold’s range from grapes grown in California’s Napa Valley, the first of which will be released in March. Ford believes that will give impetus to a renewed US push.

Treasury has also previously invested in French wineries and is building a portfolio of French wines to sell into China, with a ‘French’ Penfold’s among them.

Ford also believes that some Penfold’s wines produced in Australia will still have a presence in China through e-commerce sites. Treasury will also look at setting up production in China, where the domestic wine industry is expanding.

Some commentators believe it is no coincidence that Beijing has chosen to hit wine imports from Australia. China’s growing domestic output can only be a beneficiary from the move.

The crisis may well force Treasury to put aside plans to seek a separate stock market listing for Penfold’s. Ford had already rowed back from the proposal when he took the hot seat, saying that in the first instance he would consider making the brand a separate business within Treasury. 

That may continue, but until the Penfold’s brand begins to recover some of the profitability it has lost in China there is little point in going further.

Analysts are divided on where Treasury’s shares go from here. In 2019 they were as high as AU$19, but they slumped to AU$6 on the news of the tariffs and were then suspended for a day to prevent further carnage on the Australian Stock Market. But they have rallied to AU$9, roughly the same level they reached when China first threatened sanctions in August. 

Some calculate that they cannot move much higher until Ford’s recovery plan is seen to be working: others reckon that all the bad news is in the open and so a gradual recovery is possible.

That would be accelerated if Beijing and Canberra stop posturing and China finds a reason to lower or remove its penal tariffs.