What if China cracks?

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On Friday, S&P released a series of scenario analyses looking at what the outcomes will be for the Australian economy as China seeks to land its economy this year. Let’s start with the good news. In S&P’s baseline scenario, Australia sails along:

Under our base-case scenario, the Australian economy continues to record moderate growth of 3.3% and 3.0% of GDP in fiscals (year-ended June) 2012 and 2013, respectively. This assumes that there will likely be no abrupt dislocations in Australia’s economy in the foreseeable future.

Broad features in this scenario include weaker prices (but not necessarily lower demand) for Australia’s resources exports (such as coking coal, iron ore, mineral sands, aluminum, copper, nickel, zinc, and gold) as China’s growth slows modestly. Elsewhere, the ongoing switch by the rising “middle class” toward higher-protein food in emerging developing countries is expected to support the rise in global food prices and demand for Australia’s “farm” exports (beef, wheat, and wool).

In the non-mining sector, households remain distinctly cautious, most notably illustrated by below-average confidence and spending. While caution among households is a feature of the economic recoveries in other advanced countries, it is unusual in Australia given the country’s high employment and income growth, and low unemployment (currently 5.2%). We see Australia’s retail sector continuing to feel the brunt of household-spending caution and rising savings. Elsewhere, our baseline assumption is that the education, health, public housing, communications, and transport sectors will perform modestly well, reflecting the residual effects of previous government stimulus. But other sectors, such as tourism and manufacturing, will likely encounter a more difficult environment, particularly if the Australian dollar (66% higher against the U.S. dollar and 20% higher in trade-weighted terms since February 2009), stays strong.

Allied with the cautious household sector, Australia’s housing (and related credit) markets will likely continue to adjust to lower property prices. That said, house prices are expected to avoid a sharper downward correction while there remains significant unmet demand for housing, evidenced by low residential-vacancy rates and above-average growth in rents. Improving affordability, reflecting a combination of high income growth and generally lower mortgage rates, is also likely to underpin prices in the year ahead. Strongly supportive conditions in Australia’s labour market, illustrated by a comparatively low unemployment rate, are also likely to sustain household debt-servicing and overall housing market conditions.

Fair enough. Though I’ll take the under on house prices and GDP growth. But my real problem is that my base case for China is below 8%. Recent signals, Chinese New Year notwithstanding, are indicating a rapid slowdown is under way. Whether it’s credit, exports, imports, electricity, house or car sales, the direction is down. I’m not calling it yet because of the unknown effects of Chinese New Year but very respectable analysts are looking green about the gills at some of these statistics.

I expect 7% growth and less than that for some of the year. Luckily for us, that level of growth corresponds with S&Ps second scenario, the moderate landing:

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This scenario for Australia is allied with our “medium” landing scenario for China, which features 7% growth in GDP and a one-in-four likelihood of that occurring. Under that China scenario, there is a deep weakening in prices for Australia’s resources exports, accompanied by weak volumes of exports.

Business confidence and spending weakens below trend, and there is a deferral of capital expenditure in areas relating to economic infrastructure. Consumer sentiment weakens in line with softening employment conditions, which see the unemployment rate rising to 6.5% in the second half of 2012. Without the support of higher commodity prices and interest rates, the Australian dollar depreciates, allowing other export sectors (such as education and tourism) to become more competitive.

Despite lower borrowing costs and rising affordability and household savings, the Australian housing market weakens further, with nominal house prices falling annually by 7.2% over 2012 and 2013.

With fiscal and monetary policy stimulus being insufficient to offset the weakening in domestic private sector demand, GDP growth halves to 1.5% and 2% in fiscals 2012 and 1013, respectively.

This is probably fair enough. Though the risks would have to be to the downside. It’s possible housing would fall faster as a renewed savings impulse swept through households.

But S&P saves the worst until last. Here is it’s take on the hard landing scenario:

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This next scenario draws on our one-in-ten chance of a worst-case hard landing in China, commensurate with GDP growth weakening to 5% in 2012. It results in a range of disorderly dislocations in Australia’s economy.

While the channels of effects are essentially the same as for the “Soft Downside Scenario”, the magnitude and reach of this external shock on domestic activity are greater. In this setting, there are deep falls in commodity export prices, and either weak or moderately falling export volumes, of Australia’s resources exports. Capital expenditure projects would be halted or deferred and sectors allied to mining (such as transport and manufacturing) would weaken significantly. While job losses in the capital-intensive mining sector would be relatively contained, significant job losses would likely follow plummeting business sentiment and expenditure in the broader economy.

Consumer confidence and spending would sharply weaken as jobs and income growth falls, spreading the slowdown to sectors exposed to households (wholesale and retail trade, accommodation, cafes, and restaurants). Under this scenario rising skilled and unskilled vacancies would push the unemployment rate above 11%.

As a result, household debt-servicing ability would recede sharply and housing market prices, auction clearance rates, and turnover would fall significantly. We would expect the plummeting commodity prices (and thus,

Australia’s terms of trade) and expansionary monetary policy settings would push the Australian dollar significantly lower. Under this scenario, we would assume that any improvement to competitiveness to export exposed sectors (such as education and tourism) from the weaker currency will be offset by sharply weaker demand in export markets.

Under this scenario real GDP contracts by 3% and 1% in fiscals 2012 and 2013, respectively.

The unspoken dimension of this scenario is surely a housing bust. And if you’re wondering, then following is the assumed stimulus context for all three scenarios:

…the Australia’s government’s response is a key feature of the outlook for Australia. For all three forecast scenarios, we look out over the next two years and presume a near-term economic slowdown will prompt policy responses by Australian governments (both the central and, to a lesser extent, state) and the Reserve Bank of Australia (RBA) to buttress growth and stimulate recovery. We assess the central government and RBA as having the willingness and capacity to respond timely and effectively to varying degrees that depend on the circumstances. While we also assume that, given its sound financial profile, the Australian banking system should be able to withstand pressure from the Euro debt crisis, a more severe global and economic downturn that exceeds our current expectations may lead us to reconsider this view

For the central government, such steps would follow a similar pattern of the fiscal stimulus extended over 2009 and 2010 (then almost 5% of GDP) on transfer payments to low-income earners, and capital and related spending on education, health, public housing, and other economic infrastructure (such as roads, ports, and other transport projects). While the stimulus might not (by choice) be as substantial as in 2009 and 2010, the government’s fiscal flexibility to extend it remains comparatively strong, supported by low debt (we estimate the general government debt burden will peak at a comparatively low 22.6% of GDP in 2012) and modest–and falling–fiscal deficits. The RBA has already lowered its policy rate–by two 25bps steps in November and December 2011 to 4.25%–in response to weak domestic and global conditions, and has substantial capacity for further easing.

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Again I agree, except in the case of the final scenario. In that event I suspect the banking fallout would potentially be much worse and the Australian government’s capacities absorbed much more quickly by bailouts, as well as stimulus. The cash rate would go lower than the projected 2%. Thankfully that is not my base case but a 10% risk is pretty uncomfortable:

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.