Healing China means hurting Australia

Let me say up front that I’m a long term China bull. The production base that China has seized in the past decade is the stuff of super powers. Sure, China faces a much more difficult political economy at home than other super powers before it, and that may lead to a more troubled and shorter reign at the top, but becoming the industrial powerhouse of the world is a pre-requisite for sovereign super power and China is building it.

But that does not mean Australia will benefit in the future as it has done for past ten years. Indeed, the minds that I respect most are becoming very worried about Australia’s relationship with China in the medium term. Some of that concern goes mainstream this morning at the AFR, driven largely by Chris Richardson of Deloitte. There are two articles, one op-ed and one report. From the op-ed:

China wanted to slow: it has relied on cheap credit and galloping property and construction sectors for too long.

…punting on China to achieve yet another round of “stronger for longer” has been the safest bet of the past decade, and the Chinese authorities are already on the job.

Yet there’s more bad news already unleashed in China than many Australians have yet recognised. There is a huge underlying demand for new urban housing as people flock from the country to the city to live.

Even so, the pace of apartment building in China in recent years outpaced the enormous need for it, leaving many apartments empty: the only argument is whether the overhang of empty apartments measures “just” 10 million new homes or as much as 60 million.

Besides, although China’s slowdown is unlikely to be permanent, its economy has to stop being as reliant on infrastructure, factories and exports, and start to drive its growth from families and retail spending instead. That isn’t happening yet, and may well prove a messy gear change when it does arrive – leaving growth permanently below the souped up gains of the past decade.

As usual the AFR focusses on the political angle of Richardson’s argument, bewailing another blow to the ever-delayed Budget surplus. But the importance of Richardson’s argument is the medium and long term, not this year’s tax take. As Michael Pettis argued last week at MB:

Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.

Of course the process will not be easy. Debt levels have risen so quickly that unless many years of overinvestment are quickly reversed China will face debt problems, and maybe even a debt crisis. The sooner China starts the rebalancing process, in other words, the less painful it will be, but one way or the other it is going to be painful and there are many in China who are going to argue that the rebalancing process must be postponed. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.

The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates.

But these measures will necessarily slow growth. The financial repression tax, especially, is both the major cause of China’s economic imbalance and the major source of China’s spectacular growth, even though in recent years much of this growth has been generated by unnecessary and wasted investment. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.

What is so interesting about this argument is that Pettis himself is not at all bearish. Nor should he be. If managed right, it means a reasonably smooth internal transition from fixed-asset driven growth to consumption led growth, which relies upon the fact that even if GDP drops to 3%:

…household income continues growing at 5-6%, this is far from being socially disruptive. Households don’t care what GDP growth is, they care about the growth in their spending power.

Moreover, the incumbent superpower, the United States, would also benefit. A rapidly rising Chinese consumer creates greater net international demand and the US is well positioned to grow its consumer exports to China.

So international politics benefits too.

There is an irresistible logic in this course for the Chinese economy. The only real question is when? How will Chinese leadership juggle it and will the transition be delayed by the interests that are adversely affected by it? But even that question is no longer so vague. Whether Pettis is right that it has begun already, it’s going to happen in the next few years, as Richardson describes.

For Australia, the lesson is simple. Healing Chinese imbalances is bad for Australia’s chosen reliance upon a small set of building block commodities. China will prosper but we will face our reckoning.

Houses and Holes
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  1. Indeed. The policies that will benefit the Chinese people, and put China’s economy on a more sustainable path, are bad for Australian miners. That doesn’t mean it will happen of course. The transition to a consumption led economy has been part of the past two five year plans, and in that time China’s reliance on investment has only deepened.

    Sadly, I expect the MineBot’s cries for stimulus to be answered sometime this year, which will be a bad outcome for China, the Chinese people, and many Australians.

  2. One possible problem for a smooth rebalancing from one economic model (investment/export) to another economic model (consumption) is that it may involve some “creative destruction” in that businesses and industries strong under the old model will be less prominent in the new model.

    No problem with that idea except that in China the political class appear to have become very wealthy under the first model. They may not be that keen on a change in the existing model and as they run politics they may be in a position to resist the change.

    Change may well be inevitable and clearly in the interests of the average Chinese citizen but it may be a lot harder in practice than it would seem in theory when the consequences of change start hurting a few well connected wallets.

    • I agree. Things won’t change in a hurry. The big winners under the current model are property developers, party officials, and Aussie miners. That’s some fine company we keep!

  3. The one problem I can’t figure out is if China goes more consumer, demand for oil will rise along with prices and I see that as a spanner in the works of their rebalancing.

    I also think that China needs to figure out how to make medical care cheaper as that is a big factor in why they save so much. At the moment, even with insurance, a big medical emergency and procedure can wipe out a lot of money.Over medication adds to these costs.

    • +1! (or should I say +$1.00/ltr?)

      Excellent point non-the-less. The era of cheap oil is fading (if not already gone).

        • There is a lot of oil in Bakken, but only a small amount is recoverable with current technology. Around 4 billion barrels out of the 500-odd billion using current technology.

          With world consumption of oil around 30 billion barrels a year, this will keep us covered for 1 month. Nothing to shout about.

          From the 2008 USGS report on the oil formation: “The USGS estimate of 3.0 to 4.3 billion barrels of technically recoverable oil has a mean value of 3.65 billion barrels.”


          Most easily accessible oil reserves are being exploited. Anything else is harder to get and more difficult to process. From oil sands/shale oils and deep sea oil drilling – it’s more expensive, dangerous and environmentally damaging. And with China’s use increasing with world supply flat or declining, the price is not going to go anywhere but up in the medium to long term.

    • Good point. Also there is no social security(pension) safety net in China so they have to save for retirement.

    • Why would a consumption-led economy use more oil than an investment-led economy? I would have thought building stuff you don’t need would be more oil intensive than (say) services.

  4. But isn’t the counter argument that for the Chinese governing authorities to allow a consumer driven society, choice has to be allowed, and it can’t be! ( that’s how consumerism works; more choice, more competition, more companies more consumption etc?)Once the average Chinese is given choice, the control that the State exerts, to influence policy, breaks down. The last thing the powers-that-be want in China is a citizen; a consumer, that has personal choice – one that can abandon State directives, whatever they are.

    • Agree – though often the perception of choice is enough. Soap powder works on that basis.

      The CCP needs to split into two organisations that have differentiating brands but in practice pursue very similar policies targeting the middle of the electorate.

      They might call themselves the the CLP-Lab (Chinese Labour Party) and the CLP-Lib (The Chinese Liberal Party).

      Works well here!

    • The other issue is the lack of a social safety net, which is the major driving factor in the high rate of personal savings.

      Keeping the plebs worried about feeding themselves when they are older (or earning enough to feed mom and dad today) helps in the kowtow as well and leaves them less time to think about politics.

      PS- Heh, I’ve never looked up “kowtow” before today, but it seems quite apropos – http://www.google.com.au/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CHQQFjAB&url=http%3A%2F%2Fen.wikipedia.org%2Fwiki%2FKowtow&ei=cpcMUMKoIseSiQe_sZS1DQ&usg=AFQjCNEcz37OBsgYRFi_xTVCTLcpsK8QiA

    • Can’t agree with you there, Janet. Surely it’s not too hard to characterise the transition to a consumption society as simply swapping one yoke for another. Dangle the Gucci handbag in front of their eyes to quell agitation for meaningful change. A frenzied merry-go-round of keeping up with the Wangs will certainly put off the political reckoning for at least a decade. It’s worked for at least that long in Australia, after all…

    • BakuninMEMBER

      Choice is overrated…notwithstanding the small business sector, with industry concentration at over 80% for every major sector, a two party preferred political system, real choice in this country is an illusion.

  5. Lower tax receipts now, and diving on this report should it play out. Prepare for taxageddon people.

    In the last week I’ve heard small business in my area saying they’d never seen it this bad in 30 years. I can’t say if it is or not, but I see quite a few shops closing.

      • Wouldn’t you love to see that! All they know is how to spend, and bad policy. It’s a trap …

      • drsmithyMEMBER

        There is the other option ie Govt living within it’s means.

        Maybe if the previous 15 years of “lower taxes will fix everything” Government hadn’t shrunk the “means”, we’d still be living within them.

        • Yes, if only we taxed ourselves higher everything would be perfect. Let’s tax ourselves at 100% and we can have Utopia.

          If Govt had respect for other peoples hard earned money, we could then be assuured it is well spent and not used to run up Debt on our tab.

          • drsmithyMEMBER

            Yes, if only we taxed ourselves higher everything would be perfect. Let’s tax ourselves at 100% and we can have Utopia.

            This is what’s called a logical fallacy.

  6. So, the plan is that China increases its wages and allows the renminbi to appreciate in value therefore the Chinese will have enough money to transition to a consumption led economy.
    However during this transition phase their goods would surely become too expensive for foreign countries to afford therefore destroying their manufacturing industry which is based on exports.
    Is there a precedent period in US history where a poor manufacturing export driven society suddenly decided to get credit cards and buy their own goods?
    It seems as though the huge majority of China consists of poor factory working city dwellers and even poorer rural farmers. Are these the ones who they expect to rush to credit to buy new plasma TVs? Was the US ever in a similar situation? Was any country?

    • Just to clarify a bit more. Pettis has since said on his blog that he understands the decade in question to be from 2013 to 2023.

      From comment number 5 in the link below:
      “…I am really talking about the period of the adjustment process, which neither I nor anyone I know believes can possibly happen before 2012. That being the case it would have been better to specify the terms along the lines of my bet with The Economist — the next ten years, or 2013-2023.”


  7. Fitch Ratings: China may Avoid “Hard-Landing” but Rebalancing Postponed


    Persistent calls for rebalancing in China (like those of Richardson and Pettis) ignore the reality that such structural change in the Chinese economy will take years to achieve to any substantive degree.

    Fixed asset infrastructure development will continue to be required for both economic development and social stability via job security.

    Garden variety economists all clamour for rebalance, ideally it will eventually occur but cannot happen overnight. Don’t expect it to.

    – Just thought of another much needed project in China, new drainage infrastructure throughout Beijing, and no doubt, many other major cities. There is still so much fixed asset investment necessary to drive longer term transition in China.

    • I don’t disagree with you that rebalancing is unlikely anytime soon, but please don’t cheerlead more infrastructure spending. Continued imbalances in the Chinese economy may be in your interests, and the Communist Party’s interests, but its not in the interests of the Chinese people.

    • There will still be demand for substantial resources from China years into the future. Very doubtful however that commodity prices will be near these and prior levels.The supply demand equation is shifting.

      It’s about low cost production going forward.

  8. I can see protectionism returning.

    Once the US citizen in particular gets fed up with the hollowing out of the American middle class, that began with NAFTA under Clinton and continued in a bi-partisan fashion (with the assistance of the WTO etc), in conjunction with the growing green movement that won’t just settle with “exporting the destruction elsewhere” since the environment is a globally interconnected concern – then I think there will be a call for more balanced trade agreements.

    Won’t come into full effect until the political dichotomy is broken up by a third party.

    Protectionism that would recognise the massive arbitrage gained by multinational corporations in labour laws, environment laws, taxation law, currency manipulation and corruption between the US/Australia/Europe and China/India is the only solution to maintaining fair work rights such as regular working week, sick leave, overtime, OH&S, compensation, etc etc and a non-terminal current-account deficit.

  9. “China faces a much more difficult political economy at home than other super powers before it, and that may lead to a more troubled and shorter reign at the top”
    The Chinese government is the most popular, trusted, and successful on earth. Pew says so, Edelman says so, and Harvard’s Kennedy School of Government says so.
    They’ve little to fear.