Chinese decline is the best thing ever for Australia

As usual, Australia’s second rate band of oligarchic intellects has little idea of what’s going on and even less about what to do about it. Paul Kelly is the exemplar though I could have pointed out one hundred other articles:

The global pillars that have sustained Australia’s security and living standards for decades are now cracking amid a trade, economic and strategic struggle between the US and China driven by two nationalistic, headstrong leaders narrowing their options for compromise.

Australia is caught in a conflict beyond its control with events moving dangerously fast. The Morrison government rightly declares our US alliance is “more vital than ever” — to balance the rise of China — yet Donald Trump’s economic warfare against Xi Jinping’s China threatens to drive a wedge between Australian and American national economic interests.

Put in brutal terms — Australia needs America more than ever yet the strong and astute America it needs is not on display in the world of Donald Trump.

Trump is moving into a comprehensive assault on the wellsprings of China’s success and strength — the trade, technological and strategic arms that constitute China Inc — yet it is this system that has underwritten Australia’s contemporary living standards.

In this complex competition there are two primary realities. First, Trump is right to target the unfair commercial practices, stealing of intellectual property and cyber foreign interference run by Beijing, compounded by its strategy of economic imperialism in the region.

But second and critically, Trump’s solutions are flawed and likely to result in failure or serious unintended downsides. This is because they reflect an “America First” protectionism, a unilateralism and a false zero-sum view of trade balances that misread economic power and cripple America’s ability to mobilise a global coali­tion of forces to prevail and modify China’s behaviour.

This is a false binary. The US remains massively pre-eminent militarily. Moreover, China is nowhere near as powerful economically as being made out. Its development path is in serious trouble.

The IMF released an excellent country report on China on Friday which warned of slowing growth in the near term. But it was another warning buried in the document that is more important, that China will go ex-growth structurally over the next decade:

Over the medium term, growth is expected to gradually slow to 5½ percent as the economy moves towards a more sustainable growth path. Reflecting China’s early stage in productivity convergence, growth is expected to remain strong in the medium term, but slow gradually as the economy shifts further from the industrial sector to lower-productivity service sectors (Box 1). Credit efficiency is expected to improve, but not sufficiently to prevent debt-to-GDP from rising further. Augmented debt is on an upward trajectory and is not projected to stabilize over the medium term. The outlook is also constrained by factors such as petering gains from structural transformation and urbanization, and aging in the longer term.

Box 1. Productivity Convergence and Potential Growth

China’s convergence remains at an early stage and ample rooms exist for further catch-up and robust growth. Nonetheless, the shift from industry to services and shrinking distance to the frontier will likely put sustained downward pressure on GDP growth, which could slow to 4 percent by 2030.

Convergence – Where does China stand today?

China’s labor productivity has converged from 15 percent of the frontier to 30 percent over the past two decades, reflecting both labor reallocation from low-productivity agriculture to high-productivity industry and services, and upgrading within each sector. Since the 1990s, the employment share of agriculture fell steadily from 60 percent to below 30 percent, while the share of industry and services rose to 28 and 46 percent respectively. Within each sector, there has also been fast catching up, though significant gaps remain.

Industrial convergence has been rapid, and China has a highly advanced industrial structure today.

Industrial productivity has converged from 15 percent of the frontier at the end of 1990s to about 35 percent, driven both by the upgrade from low-tech to high-tech sectors and productivity increase in each industry. Notably, China has a more advanced industrial structure than its income level would suggest. The share of high-tech in industrial value-added was 43 percent in 2015 based on 2011 international dollars, similar to the level in Belgium and Spain, where income levels are about three times higher.

Service convergence has been slower.

Service productivity has converged from 10 percent of the frontier in the end 1990s to 26 percent, lagging that of the industrial sector. This reflects both the non-tradable nature of certain services and less opening up of the service sector in China. The degree of convergence also varies, with transportation services most advanced at 40 percent, followed by ICT services at 28 percent benefiting from the high penetration of internet and rapid digitalization in China, but the productivity of wholesale and retail trade remains low at below 12 percent of the frontier, likely due to restrictive regulations.

Convergence – Where is China heading?

Structural shifts are key to understanding China’s future growth trend.

While the previous shift from agriculture to industry and services has boosted aggregate growth, since 2012, China has entered the phase of “deindustrialization”, with labor shifting from industry to services. Given industrial productivity is about 1.3 times high as services productivity, deindustrialization will likely put sustained downward pressure on aggregate growth.

Further productivity convergence is likely, though at a slower pace.

Reflecting its early stage in sectoral convergence, China has the potential to maintain robust growth in the coming decade. Nonetheless, growth will be on a gradual downward trend as the sectors move closer to the frontier and the transition from industries to services continues. Applying convergence speed at sectoral levels based on cross-country experiences in Rodrik (2013) and Bourles et.al (2010), both industrial and service productivity growth are expected to slow to 3–4 percent by 2030, with the level of productivity reaching 57 and 44 percent of the frontier respectively. The shift from industry to services is projected to continue, with service share rising to 65 percent by 2030. Overall, this would imply GDP growth would slow from current 6½ percent to 4–4½ percent by 2030. Faster SOE reform and opening up of the service sector could moderate the pace of slowdown by boosting productivity growth.

Let’s recall that the IMF and similar bodies are the model of politeness to their hosts. So, when they write something of this nature you can be sure that the reality is much worse.

The IMF scenario is the best case. China is not reforming so its credit efficiency is not going to improve. Latent productivity gains for further catch-up growth are impressive, but that has now run afoul of the internal contradictions of a political system that cannot afford slower growth lest it risk its legitimacy. See Hong Kong today.

Thus stimulus has been used over and again to keep growth artificially pumped. Ironically, this has only ensured lower growth comes sooner, either via crisis or stagnation, as capital misallocation has piled up to Himalayan proportions. Servicing the underlying mountainous debt has been made all the more difficult by a trade war that is sucking China’s most efficient supply chains offshore.

China will effectively be ex-growth – that is, growing at Western rates – within five years not ten. And when we consider that China fiddles its GDP calculus by not writing down bad investments, we need to subtract 1-2% from its headline GPD on top of that to get a truer reading of output volumes.

It may never appear in official numbers but China may be struggling to grow volumes at all in five years.

This is the nub of the US/China false binary being furiously rubber stamped by Australian oligarchs. Chinese growth has booked a one way ticket into the middle income trap. This completely blows up the fundamental assumption that inexorably rising Chinese economic power will lead inevitably to irresistible military might.

Moreover, the trade is not the problem here, though that will hasten the end. China itself admitted from 2011 that its economic model was unsustainable. It has convulsively tried to reform it ever since but always ended up hurling still more stimulus into massive over-investment. It is the internal contradictions of the Chinese political economy that are to blame. And its terrible demographics. The only inevitability about it is that that model is going to stagnate and fall away economically.

That means Australia faces two consequences for many years of poor policy making that refused to listen and assumed China would grow forever:

  • first, we will confront a massive income shock as bulk commodities revert to historical means;
  • second, there will be no great lift in other Chinese demand to offset it, as there would have been if it had reformed, and
  • third, as China stagnates economically, the CPC will get more hostile externally to keep its domestic population in order.

Rather than clutch at the pearls at an illusory “crumbling pillars” of Australian prosperity, we should assess how these three forces will impact our national interest:

  • first, the economy will face a structural adjustment as smashed terms of trade demand a very large lift in competitiveness, and
  • second, we will need the support of every strategic ally we can get our hands on, not least the only standing super power, as Angry China rises.

In short, although the Communist Party of China is not going to go away, its relative economic importance was always going to decline as it passed the investment phase of its development. The mistake it has made is not liberalising politically so it could take the next leap into higher value-added growth. In Australia, we made the same mistake, losing faith in our own system, inundated as we were by mining interests. They should have been taxed much more heavily while the Chinese boom lasted, and the money tucked away for when China’s building frenzy passed. Instead we pissed it away on tax cuts for debt-fueled house prices and excess consumption, and now misrepresent an entirely foreseeable unraveling as some kind of shocking, ahistorical external shock.

But let’s not mistake bad policy for the mechanisms of history.

The US is not in terminal decline. It remains the only super power and will increasingly be called upon to manage and mitigate various great power conflicts as middle powers across the emerging world develop into great powers. It’s still the greatest democracy on earth and its economy the most liberal, with a very safe banking system and all kinds of technological leadership. It retains the rock solid reserve currency. Its major issue is a wealth and income imbalance that is undermining its politics and growth prospects. But the fix for that is easy enough once the interests are swept aside. QE for the people will do it.

Donald Trump is obnoxious and corrupt and his methods are crude. But what history will remember him for is a glowing belief in US liberalism, called “America first”. Sure, it comes with various contradictions but, through the lens of history, it is damn near perfect when juxtaposed against the illiberal model of CPC China.

The only binary that emerges from that conflict is sustained US wealth and power as China’s economic catch-up ends and its liberalisation reverses.

That’s what we need to prepare for.

David Llewellyn-Smith

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.

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