Can China save us a second time?

In Sunday’s weekly Economic Note, Australian Treasurer, Wayne Swan, reaffirmed his belief in the underlying strength of the Chinese economy and expressed his confidence that China can continue growing solidly even in the face of sluggish growth in the US and Europe [my emphasis].

I’ve been asked a number of times in the past week whether China’s economy will likely be dragged down if its export markets in Europe and North America dry up. Of course like Australia, China is not immune from global developments. But I think there are good reasons to be optimistic about the continued growth of the world’s most populous nation. The image of China as the world’s factory churning out goods for the rest of the world overlooks many of the changing dynamics inside the economy.

Firstly, as it proved during the GFC, China has the policy flexibility to fire up its domestic engines of growth if external conditions fall sharply. Secondly, what’s often not appreciated is that capital investments, rather than exports, are increasingly driving China’s economy. In fact, in recent years about half the nation’s growth has come from building things like roads, bridges and homes. In the past 30 years, investment as a share of GDP has risen from 35 per cent to almost 50 per cent. And thirdly, rising living standards are creating new ranks of middle-class consumers that are driving demand. In 1980, the income of the average Chinese citizen was 2 per cent that of an average American. Today it’s closer to 16 per cent. And that will only continue to increase. This has implications not just for China’s economic growth, but for Australia’s as well.

The new ranks of middle-class consumers in China and the rest of Asia will increase demand for more than just our mineral wealth. It will also benefit Australia’s tourism operators, education providers and manufacturers of high-end goods. A staggering fact is that the middle class in Asia is expected to be bigger than that in the rest of the world combined by the end of the decade. It won’t be all smooth sailing from here, and certainly China has more work to do to further increase domestic demand, but the underlying trends in our region are positive not just for the next few years, but the next few decades.

Mr Swan’s unwavering optimism about China’s ability to engineer growth irrespective of the external economic environment is understandable. Like it or not, Australia has hitched itself to the fortunes of the Chinese economy, and any significant slowdown will hit the Australian economy particularly hard, ensuring significant voter backlash against the incumbent government.

The problem for Mr Swan is that China’s ability to once again stimulate growth in the event of another protracted global slowdown appears to be limited.

According to Richard Martin, managing director of Singapore-based business analysts IMA Asia:

“China can’t deploy the fiscal and monetary firepower that it unleashed in late 2008 with its 4 trillion yuan ($600 billion) spending campaign.”

Its first big stimulus left some messes, he said, including a property bubble, overspending on infrastructure, heavily indebted local governments and a jump in non-performing loans.

He said China could not correct those issues while at the same time unleashing a new stimulus.

“Under these conditions, China’s growth may drop towards 6 per cent, although it is unlikely to acknowledge anything under 8 per cent,” he said.

Mr Martin warned Australia could take a big hit, with housing, infrastructure and lending likely to suffer from China’s corrections.

“The first two of these will cut demand for iron ore and the third will make life difficult for China’s private sector firms.”

Similar sentiments were expressed recently by Reuters’ Emily Kaiser and Koh Gui Qing:

China is still nursing a hangover from its 2008 stimulus spending spree and may be reluctant to kick off another big round, leaving less potent options on the table should the global economy tilt toward a cliff…

China’s fiscal firepower is not in doubt. With $3.2 trillion in reserves and low public debt, China could afford to kick up spending, but the side effect would be worsening inflation when prices are already rising too fast for comfort.

Beijing is particularly sensitive to inflation because relentlessly rising prices can stoke social unrest, which could be dangerous for the Communist Party.

Besides, the last round of stimulus in 2008 caused more than a few headaches that linger today. Beijing encouraged banks to lend freely to government projects such as railways, airports and roads. Some of the loans have soured, and local government defaults now pose one of the biggest threats to China’s growth.

Local government liabilities amount to nearly 27 percent of China’s total annual output, so if the state is forced to mop up those bad loans its deep pockets would look a bit more shallow.

That means China would most likely rely on more modest measures if the economic outlook deteriorates. Possible steps include cutting taxes for small- and medium-sized businesses, ramping up investment in affordable housing, altering bank lending rules to get more money into the hands of smaller companies, and lowering interest rates.

“We are still digesting the mess of the 2008 stimulus package,” said Yu Xuejun, local head of China’s banking regulator in Jiangsu province. “It’s unrealistic to hope that China will come to the rescue of the global economy this time”…

Finally, Professor Barry Eichengreen last week expressed similar reservations about China’s ability to undertake another round of mass stimulus in the event that the global economy slows, as well as the dire implications for commodity suppliers, like Australia:

How worried should Asia be [about a global slowdown]? The situation is far less manageable than it was in 2008–9. Then it was possible for China to pull out all the stops and unleash a massive fiscal stimulus. To support investment spending, it could instruct the banks to lend like there was no tomorrow. Today Chinese policy makers have less room for maneuver. With inflation already running at 5 per cent, they are anxious to rein in bank lending. Credit policies that inflated further an already expanding property bubble would not be helpful. Then there are worries about the balance sheets of financial institutions, like the credit cooperatives that financed local government’s infrastructure projects. Standard & Poor’s has already warned that a third of their loans may have to be written off. More generally, analysts are concerned that the public-sector debt burden, considering all levels of government, is higher than suggested by the headline figures and higher than is healthy for an emerging economy.

Add it up and it is clear that the Chinese authorities will not be able to respond as vigorously as in 2008–9. Were China’s exports to the West to drop off as sharply as they did then, there would be no way that the government could substitute a commensurate amount of domestic spending. Chinese growth would fall. The implications of other economies that sell parts, components and, above all, raw materials to China would not be pretty.

As shown by the below chart, the last time Western nations were in recession, declining exports lopped almost 3% from China’s GDP. Thankfully, the Chinese Government was successful in stimulating its economy via fixed asset investment, which peaked at a whopping 90% of GDP in 2009:

Obviously, if the global economy takes another turn for the worse, and the Chinese authorities are unable to undertake another massive stimulus program, then China’s growth would slow significantly, reducing demand for Australia’s commodity exports. And with this reduced commodity demand, Australia’s terms-of-trade – which has risen longer and harder than other commodity producers (see below chart) –  could fall precipitously.

There are a number of possible implications arising from a sharp fall in commodity prices (terms-of-trade) for Australia, none of them favourable. First, national income would fall, reducing the Government’s tax take, and sending the Australian dollar sharply lower (see below chart).

Mining investment – which is now at record highs and expected to grow further (see below chart) – could also dry up, crimping Australia’s GDP growth.

Finally, Australia’s banks, which have borrowed heavily offshore to fund the housing market, might once again find it extremely difficult to roll-over their maturing foreign borrowings. Only, unlike in 2008, the Australian Government might not be in the position to guarantee their debt given the significant other drains on the budget from diminishing tax receipts and rising welfare payments from increasing unemployment. Obviously, any contraction of credit would also have an adverse effect on house prices.

Put simply, all of the positive effects on employment, incomes, growth and the Government’s fiscal position received by Australia over the past decade could unwind dramatically.

For the sake of the Australian economy, we should all hope that Mr Swan’s unwavering optimism about the Chinese economy is not misplaced. Otherwise the Australian economy could face an extremely challenging period ahead.

[email protected]

Leith van Onselen


  1. Keep at it Leith. Don’t let up. These posts will prove to be prophetic and no doubt used in economics courses of the future.

    Economics 2020: Australia — How we f*cked up.

    Sadly, Swannie (like Craig Emerson on the weekend) is running the line that Australia is likely to benefit from exports to Chinese consumers:

    The new ranks of middle-class consumers in China and the rest of Asia will increase demand for more than just our mineral wealth. It will also benefit Australia’s tourism operators, education providers and manufacturers of high-end goods.

    This is complete and utter nonsense. The mining boom and rampant Australian dollar has completely destroyed our competitiveness in these markets.

    Would a Chinese consumer prefer an over-priced Australian made product or a high-end, but cheap, European made product?

    Would a Chinese parent send their child to be educated at an over-priced little-known Australian university or a world-class, but cheap, university in the US?

    Would a Chinese traveller prefer to fly to Australia and pay through the nose for accommodation, food and tours, or see the great sights of Europe and America far more cheaply?

    The answers are obvious and irrefutable. Makes you wonder WTH the boffins in Treasury are tripping on.

    • More to the point, where are these Chinese consumers?? Figure 3 above shows consumption as a portion of GDP to be flat at best (it looks to have fallen over the last few years to tell the truth).

      Yet all we hear from Swannie is the same line, with the odd “but consumption is in the 5 year plan” nonsense.

      I agree with Lorax; we’ll look back on Leith’s posts in a few years time and shake our heads at how the obvious somehow escaped our fearless leaders.

      • Chinese consumption is falling in terms GDP share (hence the economy is becoming more unbalanced, not less) but its definitely growing rapidly in absolute terms. So there’s a growing market there for other countries to sell into, but Australia won’t be one of them.

        The rest of the world is engaging in a war of competitive devaluations in an attempt to revive their economies. Does Swannie honestly think the Germans (for example) haven’t noticed the potential of China as an export market? What’s an aspirational Chinese consumer gonna buy, a Beemer or a Holden Ute? Honestly, people overseas must be rolling around laughing at Swan and Emerson’s recent comments.

        • I have to dispute your views about the export potential. The Chinese are strong believers in good luck so with the right marketing we can export there good luck Koala poo charms. Japanese students apparently love it, see so with a little bit of marketing this can be our fallback export market in case mining goes to sh%#. Picking up Koala poo is very labour intensive so there is a pretty good employment potential for our nation.

    • “Would a Chinese parent send their child to be educated at an over-priced little-known Australian university or a world-class, but cheap, university in the US?”
      I think your premise is incorrect – The dirty little secret is that it is much harder to get a Permanent Resident visa for students after they have finished studying in the US.
      It is a mystery wrapped in an enigma as to why Chinese parents want their children to flee a country that is about to have 20-years of uninterrupted boom. Maybe they know a thing or two about China that our fanbois don’t.

      • Well that’s the kind of thing we’ll have to do to compete. Give away residency or citizenship, because there’s no frickin’ way we can compete on price or quality. MIT or ANU? What would you choose?

        • ANU – at least you can go to Raiders games ; )

          Na joking – I think any close analysis of Swan would reveal that he has nothing to offer in terms of insightful comments.

          Seriously – look over his speeches for the past 3-4 months, the same basic points repeated at nauseum:
          – The fundamentals of the Oz economy are strong
          – We have low public debt (compared to other developed nations) and low unemployment
          – We have a massive investment pipeline that is coming voer next decade
          – Every other Treasurer in the developed world would want to swap positions with him

          If you go back to 2008, he was saying the exact same things…the man is dangerous and MB should really scrutinise him closely.

          • I agree, but at the moment, I’m not sure what else he should say….consumer sentiment here is low already and people are (apparently) paying down their large piles of debt. Telling them there are some real risks out there on the near horizon would drive down consumer sentiment even further. I never really take notice of what he says…..I would rather he and the govt focussed on the salient issues like tax reform. But as far as I can see all pollies are now caught in a trap of their own making here in Oz where new policies are only acceptable if nobody is worse off. We will not be able to fix anything while that attitude is deeply entrenched.

          • What you skip over is that the Joe Hockey-Chris Joye shadow treasury tag team have even less to offer, by way of meaningful fiscal policies.

    • Can anyone remind me of the average income/wealth levels of these supposed “middle class” Chinese?

      From memory, the vast majority of the country is working for peanuts.

      Even if we still had a competitive manufacturing sector (refer to The Lorax’s posts above for more on that topic), do we really expect these people to suddenly start consuming bucketloads of our “stuff” when they’ve got low income levels to begin with, plus have to grapple with sky-high property prices and soaring food prices?

      • You’d be surprised at the levels of wealth in the “middle-class”. Mind you, these are effectively just well connected party people, but still, there are plenty of them, and the freer markets China has in place these daysmeans they can spend to their hearts content.

        The problem is though that while they are abundant in absolute terms (as Lorax states above), as a proportion of the population they are but a blip. As such, I can’t see how they can help the Chinese economy steer toward a consumption model. To do so would require a massive boost to lower income households to lift them into an income band that allows for greater discretionary spending.

        Another problem I’ve seen is the desire for all things prestige. If you ever find yourself in Shanghai, take a look around at the way brand positioning is done, and how everyone seems to desire the best (or what they perceive to be the best). How on earth can Australian companies compete if they are not perceived as luxury or prestige? And even if they can, there is always the risk that some IP ripoff will take place and a similar (read identical) brand will appear overnight (don’t laugh, I was at a Shanghai wine expo last year and there was a stand promoting a brand called “Benfolds” that was for all intents and purposes identical to our own Penfolds brand. For a relatively less educated consumer, the difference was so minor that an innovative, quality focused brand could easily be confused with its shady rip-off. I nearly choked when I saw that))

  2. There was a dude (from CMC I think) on Sky Business this morning saying with a straight face that China (and hence Australia) “will be fine because the Chinese consumer is driving growth”.

    Couldnt believe my ears. I guess they’re hoping if they repeat it enough times it will come true.

    Truth of the matter is that you cant lift ~ 800M people out of abject poverty and into consumer paradise in a few short years. It will probably take 50-100. But people dont really want to hear that.

  3. Sandgroper Sceptic

    Swan is hopeless, he parrots his talking lines like a robot. His Chinese middle class consumer line is patently wrong as Chinese consumption is actually falling as a percentage of GDP. Professor Pettis has been pointing that out for over two years now.

    One thing that I picked up here is that even if Chinese growth slows to 6% we would still see a massive slowdown in Australia. That last chart of Australian mining investment is a heart stopper.

    • Yep, that last chart is hilarious. I’m only surprised that they didn’t extend it to 2020 and have mining investment at over 100% of GDP.

    • Swan’s opinions are considered but no doubt coloured for electorate consumption. But it is not much different to a lot of financial planners and analysts who are not pollies. But I suppose because he is merely a politician we can heap the usual aussie abuse on to him for that.

      Thanks for lifting the debate. Not.

    • Amazing the commentary that comes from access to the Internet and some government statistics.
      I suppose if Chinese “growth” slows to 5% we will see ships returning to Oz full of iron-ore for us to bury.
      Personally I would love a “slow down” here. The place has been “booming” for ages and has turned into a rathole. Perhaps a decent slow down might make it nice to live here again.

  4. you must remember that Swan is a politician and hence has a very different job from an economist. A politician that didn’t try and influence sentiment would be a very poor politician indeed.