Elephants in rooms

So, the story of the week is that the Australian Treasury is becoming concerned about the bubblicious runup in Australian property prices over the past several years:

A SENIOR Treasury official has sounded the alarm over Australia's property market. He has warned that the prospect of a sudden and dramatic drop in prices is "the elephant in the room" and should not be ignored by the federal government.

 
It's nice that somebody in Canberra has finally cottoned on, but I don't expect this to change the head in the sand attitude of the current government and the RBA. We can only hope that the bubble deflates while Australia still has the cushion of strong commodities export growth to China. But on this front, too, there is reason to worry. From Bloomberg today:

China’s reserve-ratio increases for banks and threats of price controls on essential goods are likely to prove insufficient to tame inflation, and the central bank will have to raise interest rates further, economists said. 

All of which is likely to dampen China's growth.  China expert Michael Pettis has been arguing for some time that China's economy is set to slow down sharply in the next few years as the country rebalances it's overly export and investment-led economy. 

Over the next five years or more Chinese economic growth will necessarily be lower than growth in Chinese consumption. The massive but unsustainable investment in infrastructure and new production facilities that characterises the Chinese fiscal stimulus package will not be able to change this fact. From its dizzying heights during the past two decades, the world needs to prepare itself for a decade during which, if all goes well, China grows at a still respectable but much lower rate of 5-7 per cent.

Of course this type of view has been largely ignored by the mainstream press, which continues to assume that like Australian housing prices, China can keep growing at 10% a year until the year infinity. What would the implications be for Australia if China was to slow to 5-7% growth?

Keep in mind that according to this RBA paper, China now accounts for an astounding two-thirds of world iron ore demand, around one-third of aluminium ore demand and more than 45% of global demand for coal. Thanks to this voracious demand, China's importance to the Australian economy has risen exponentially over the past decade. See the chart below from Business Insider, which shows that Australia now exports almost SIX times as much to China as to the United States, although as recently as 2004 both export markets were roughly of equal importance.

Which brings us back to our heroic Treasury official.

"The elephant in the room is house prices or more specifically the risk of a precipitous drop in them, perhaps from an external shock or perhaps from their own internal dynamics when affordability constraints or capacity debt levels see prices and expectations of house prices start to move in the opposite direction," Mr Morling wrote on June 15.

Now, there are several signs that the bubble is simply starting to deflate under it's own weight, but an external shock such as a sharp slowdown in China would severely hamper Australia's ability to deal with the fallout of a real estate crash. It was only dumb luck that we escaped the worst of the GFC, and we have allowed the imbalances in our economy to grow even larger since.

2011/12 could be very messy indeed.