China sneezes, Australia calls an ambulance

To state the bleeding obvious, Australia’s economic fortunes are linked to the Chinese economy.

China is Australia’s largest export destination, with its export share having grown from around 5% in 2000 to 22% in 2009 (see below IMF chart):

And according to GMO, China alone accounts for nearly half of the world’s consumption of Australia’s two largest exports – iron ore and coal (see below chart).

The strong growth of the Chinese economy has sent iron ore and coal prices (amongst other commodity prices) soaring:

Which has sent Australia’s terms-of-trade (ToT) to its highest level for at least 60 years:

In fact, no other commodity exporter has benefited as much from the China boom as Australia:

The surge in Australia’s ToT has significantly raised national income, increased the Government’s tax take, and sent the Australian dollar above the US dollar. It has also led to a significant increase in mining investment, as mining companies look to build supply capacity (see below Australian Treasury chart). This investment, in turn, has also significantly boosted Australia’s GDP.

The importance of the China-led commodities boom on Australia’s GDP was recently summarised by the RBA Governor, Glenn Stevens:

As a result of the mining boom, Australia’s terms of trade have risen sharply, to be about 65% above the twentieth century average level, and about 85% above the level that would be expected had the downward trend observed over the twentieth century continued…

With the terms of trade at their current level, Australia’s nominal gross domestic product (GDP) is about 13% higher, all other things equal, than it would have been had the terms of trade been at their 100-year average level,” Stevens said.

And according to the Australian Treasury:

The terms of trade, and so mining activity, are expected to remain at historically high levels for an extended period…

Driven by the mining sector, new business investment is expected to attain 50-year highs as a share of GDP. This investment boom will be underpinned by a massive pipeline of resources projects planned for the next five years and beyond. The capital expenditure survey of the ABS suggests planned mining investment will reach a record $76 billion in 2011-12 (ABS 2010e). ABARES estimates that this high level of investment is set to continue, with an estimated pipeline of resource investment of over $380 billion (ABARES 2010).

The Treasury sees no end in sight for China’s strong growth and voracious appetite for Australian resources. Whereas China’s economy accounted for less than 5% of world GDP in 1990 and around 13% currently, by 2030 Treasury forecasts that China will account for just under a quarter of the world’s GDP (see below chart).

What could possibly go wrong?

While I acknowledge that China’s (and to a lesser extend India’s) industrialisation may hold commodity prices above their long-run average levels, prices will likely exhibit high levels of volatility.

Certainly, the past 200 years of commodity pricing confirms this view, with every price boom followed by a sharp contraction (see below chart).

And there are now early signs that China’s economy is slowing. On 13 May, UBS Global Economics Research released a report with two charts showing sharp falls in construction activity, steel consumption and electricity usage.

Here’s the first UBS chart:

And the second:

And here’s UBS’ summary explanation of the data:

Two days ago China released official nationwide property construction and sales data for April, as well as figures for sectors like steel and autos … and on a seasonally-adjusted basis many of the latest numbers look downright frightening.

You can see what we mean in the above chart. Total floorspace under construction (whether measured for overall building construction or just for “commodity” buildings) peaked outright in January and has fallen sharply in the past two months. So have auto sales, which are now nearly 20% off November highs. Property sales peaked in November in volume terms and are declining sequentially since the beginning of the year. And after rising steadily for the last three quarters domestic steel consumption is now flat.

UBS’ research appears to be supported by the below chart from Capital Economics (via FTAlphaville) which shows China’s commodity import volumes falling in the face of rising prices:

According to Capital Economics:

There are already warning signs in the recent data. For example, China’s demand for imported commodities has weakened sharply. The value of China’s imports is still growing rapidly, but this is a reflection of higher global prices. Focusing instead on the volume data, China’s imports of many key commodities are actually falling outright. Chart 1 shows the April data, released on Tuesday, but the year-to-date numbers tell a similar story.

Finally, Business Spectator’s Karen Maley on Friday also reported on recent analysis that China’s economy is slowing:

Are fears about a looming slow-down in the Chinese economy about to overshadow worries about rising inflation?

That’s certainly the view of Jim O’Neill, the chairman of Goldman Sachs Asset Management, who believes that “the Chinese economy is probably slowing down more than people realise”…

China’s industrial output growth eased much more than expected in April, causing some analysts to worry that a slow-down in the world’s second-biggest economy is already underway. Other symptoms of slowing growth include weaker exports, a slump in residential property sales, and slowing car sales.

“It’s not surprising at all that commodities prices are coming under pressure,” O’Neill said. “The surprise is that they rose so much earlier in the year”…

Wang Jian, a researcher with China’s top planning agency, the National Development and Reform Commission… said that fixed-asset investment, which has been powering China’s economic growth, would soon run out of steam, because spending on new projects had fallen.

Australia on notice:

While it’s possible that this commodities cycle will continue unabated for an extended period, the weight of 200 years of history is against it.

If a sharp contraction of the Chinese economy doesn’t send commodity prices falling, it’s likely a flood of new supply from competing commodity producers will force prices lower.

The worst case scenario for Australia is a structural slowing in the Chinese economy even as rising supply comes on stream from the massive mining investment currently underway in Australia, Brazil and other commodity producing nations. If this occurs, then the assumed demand volumes that underpin all of those new mines won’t materialise. And even if we are shipping more that will not be enough to offset large price falls. All of the positive effects on employment, incomes, growth and the Government’s fiscal position received by Australia over the past decade would unwind.

As the UBS charts show, there are significant risks in China’s dependence on fixed-asset investment, its shift to a consumption growth model, and its politics.

A slowdown of the Chinese economy is, in my view, the biggest risk to Australia’s ‘miracle’ economy. Hence, authorities should at least entertain the possibility that commodity prices could fall abruptly and plan accordingly. China is not a one-sided bet. There are are grave risks.

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