Friday, December 31, 2010

Australia's unhealthy dependence on China

Debate is raging over whether China's massive boom in construction and real estate -- which is fueling Australia's commodity exports -- is a bubble waiting to burst. This is a critical question, because Australia's economy has become increasingly dependent on China for growth in its mining exports. In the chart below you can see that Japan, our biggest export market for much of the postwar period, is in a slow and steady decline. In contrast, China's share of our exports is growing exponentially.

Like it or not, our economic future is now inextricably linked to that of China. 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, according to this recent paper by the RBA.  Thanks to this voracious demand, our terms of trade -- or the ratio of our export prices to import prices -- is the highest it has been since the 1950s.

But is this enormous growth in demand from China sustainable? Many economists think not. My favorite China watcher, Michael Pettis of Peking University, has been arguing for some time that China is running up against the limits of it's investment and export-led growth model, and that the days of double digit growth rates will soon be a thing of the past. In a recent blog post, he says:
By the end of next year, I suspect that the consensus will be that for the rest of the decade we should expect growth rates in the 6-7% range for China.
Pettis describes even this forecast as being "optimistic", and dependent upon China being able to maintain consumption growth of 8-9% a year. 
If GDP growth slows so substantially, it seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range... Non-food commodity exporters will be badly hurt.
What would the implications be of such a drop in China's growth rate? Fitch Ratings recently performed a "stress test" of what would happen if Chinese growth slowed to 5% in 2011. Their conclusions are very interesting, so I am going to quote at length from the report. Firstly, as you can see below, Fitch expects that such a growth slowdown would cause a major crash in Asian stockmarkets, and a 20% fall in commodities prices.

And which countries are most vulnerable to such a slowdown? The chart below confirms that Australia's economy is one of the most commodity-dependent in the world.

Not surprisingly, Fitch identifies iron ore exporters as amongst the biggest potential losers:
Iron ore – used as a key raw material in the steel industry – would be the commodity most affected by a slowdown, with Australian commodity producers in particular being impacted...
But perhaps the most interesting section of the report is Fitch's expectations of what would happen to banking systems and financial markets in the event of a sharp slowdown in Chinese growth. Again, I will quote at length, because some very interesting points are raised.  
It is also worth noting that the domestic banks in those overseas countries that provide financing to corporate exporters to China could face potential deterioration in the credit quality of their loan books in the event that demand for their customers’ products declined. This could affect banks in countries such as Hong Kong SAR, Taiwan, Japan, Korea and Australia.
Investor risk appetite would likely reduce, increasing volatility in financial markets and resulting in capital flight from perceived riskier assets... Certain types of asset with high levels of correlation to the China growth story could be particularly badly hit, given investors’ ongoing initiatives to gain exposure to China through indirect routes such as commodities (especially copper), correlated currencies (the Australian dollar) and equities of multinational companies with global brands and a China presence...
Fitch anticipates that a material slowdown in the Chinese economy would have a negative effect on the willingness of global banking systems to continue providing credit... Those countries with the heaviest reliance on China as a destination for exports (Hong Kong SAR, Taiwan, Japan, Korea, Singapore, Malaysia, Australia, Brazil, Chile, Peru and Russia) could potentially see a retrenchment of their banking systems, with credit availability reducing...
This impact could be exacerbated by negative developments in the real estate markets of those countries with strong trade links to China, particularly those where property prices have risen strongly over the past 12–18 months, such as Singapore, Hong Kong, Taiwan and Australia.
So let's summarize the implications for Australia of a sharp growth slowdown in China. Firstly, our miners will be heavily hit as Chinese demand contracts and commodity prices drop significantly. The Australian dollar will probably fall sharply. International investors will become risk averse, and may be unwilling to refinance the massive external liabilities of Australian banks without demanding a large risk premium. As credit dries up, Australian property prices will inevitably fall. This is an ugly scenario all round.

China's massive boost to our terms of trade has undoubtedly been a huge boon. Along with the government's massive stimulus, it helped us dodge the worst of the global financial crisis in 2008. But this once in a generation boost to our trade is not going to last forever. We could have spent the last decade prudently running large budget surpluses to create a buffer for when the boom ends. We could have invested more in infrastructure and tried to boost the productivity of the non-mining sector through economic reforms. We could have introduced a sensibly designed tax on the mining sector and invested the proceeds in a fund for Australia's future. But instead, in a decade of what economist Ross Garnaut calls "The Great Complacency", we have inflated a massive housing bubble based on an unsustainable rise in household debt, partly financed by foreign investors who will bail at the first sign of trouble.

Now, even Fitch says it doesn't expect it's "stress case" of 5% growth in China to eventuate in 2011. China's economy is still in the relatively early stages of industrialisation and it's obvious that there is still a lot of growth to come. But there are clearly limits to the pace of this growth, and the growth to come is definitely not going to be in a straight line. The question is: are we prepared for when China inevitably hits a speed bump?


  1. Do you think BHP already knows this? If so, i would also have tried to buy the Agricultural aligned Canadian company,Potash Corp.
    BHP trying now purchase US based Potash company Anadarko.

    Hhmm, do you think BHP could see the China position being unsustainale a while ago and realised they need to diversifiy into agriculture.

    I wonder if Swanny is also up with the program. I doubt it if he continues pursuing the mining tax.

  2. Anon -- I'm sure BHP is well aware of the risk of being too reliant on iron ore exports to China, and they've publicly stated they want to diversify their business further. From a recent news story:

    "If BHP Billiton succeeds in its Potash bid, it would move the company even further away from industrial metals. Agricultural fertilizers track completely different economic cycles than do iron ore, copper and aluminum, which largely follow manufacturing activity.

    The company’s CEO, Marius Kloppers, says, “We are interested in commodities with different growth profiles, [whose prices] kick in at different stages of the economic cycle.”

  3. This is why I have been looking to get put optons on RIO and NAB. I think this is a good bet.

  4. Have been following your site for a while now and really appreciate the consistent quality of your articles. A big thank you.

    Anecdotally - here in Western Australia - Christmas and New Year BBQ chat - participants mostly involved in resources sector in senior legal and major project management roles...all aware there are major agreements in place for multi-billion dollar projects - yet the momentum just not there - little concrete is taking place just a lot of tweaking around the edges - consensus - serious concerns by the majors re future China growth/demand and a subsequent reluctance to fully commit. As I said, just BBQ chat. Fuelled by the odd cold beer and occasional glass of bubbly!

  5. Anonymous -- Glad you like the blog and thanks for the interesting bbq chatter!