Predictions of Doom 1

This one from Eisuke Sakakibara via William Pesek.  Sakakibara argues that “the world is set for a long-term structural slump reminiscent of the 1870s” meaning that he thinks that there will be a return to recession in 2011 lasting until 2018.

Pesek argues:

recent data in the US and Japan and financial turbulence in Europe suggest a fresh global recession is a distinct possibility in 2011. If that happens, what levers are realistically available to revive demand? Interest rates are already at, or close to, zero. That leaves increased government spending as the only real way to stabilize things.

The trouble is, there’s little support for opening the fiscal floodgates in a meaningful way.

One reason is that there’s already loads of public debt out there.

What worries lots of doomsters is that the world might be heading for 1937 again where Roosevelt and many others felt the recession was over and relaxed only for the US economy to go backwards the following year.

As with my previous post a real question for coming years is how long China can continue to grow without expanding demand for its exports from the US and Europe.

If Sakakibara is right, the global economy is in deep trouble. He envisions a broad slowdown that might drag on for seven to eight years. China can live a couple of years without US and European growth, but eight?

To head it off, governments need to up spending. And, for the most part, they aren’t. Yet the US can, and should, borrow more. To do that, it just needs to become a bit more Japanese, says Richard Duncan, author of the “The Corruption of Capitalism.”

There’s a single reason why Japan’s 10-year bond yields are below 1.3 per cent and Asia’s No. 2 economy isn’t being downgraded. Since about 95 per cent of Japan’s debt is held domestically, there’s no risk of capital flight. Japan borrows from its companies and people, an arrangement that’s roughly the mirror image of the US.

The problem for the US on the other hand is the extent of financial vulnerability due to foreign holdings of its bonds.

That so many Treasuries are held in China and elsewhere makes the US highly vulnerable. Duncan, chief economist at Blackhorse Asset Management in Singapore, says the US needs another FDR-like New Deal to restore growth and competitiveness. Funding one means greater borrowing and the way to do it is by tapping private-sector cash, Japan-style.

Such suggestions are likely to fall with a mighty thud on Capitol Hill, which is moving in the opposite direction. Lawmakers calling for Ben Bernanke’s head forget why the Fed chairman is taking US monetary policy into uncharted territory. It’s because Congress failed to pump enough money into the economy in the first place.

Japan is a cautionary tale. On the surface, the 4.5 per cent annualized increase in third-quarter gross domestic product looked promising. The detail, however, showed that deflation is worsening no matter how many yen the Bank of Japan churns into the economy. This is anything but a typical recession, and world leaders are too distracted to see it.

In the US, the focus is on China’s currency. While a stronger yuan would be in the best interests of the global economy, it’s not the answer to all the US problems. Japan is even more obsessed with exchange rates. And Europe is linearly focused on convincing investors that the euro zone won’t unravel.

In our time of currency fixation, perhaps a guy called Mr. Yen is the ideal messenger. Too bad his message is one of economic gloom as far as the eye can see. Perhaps even to 2018.

For a more local prediction of possible doom see one of my favourite bloggers Leith van Onselen, who highlights China's empty cities and what they might mean for Chinese demand for Australian resources when the Chinese have to EVENTUALLY stop building stuff no one is buying.

The fall and rise of world trade

The IMF's Finance and Development Journal is a good source of information and data on the world economy. And despite what some on the Left might think it's fairly balanced as well.

The latest edition provides some data on the fall and rise of exports of the top 10 exporters and provides some info on why Australia has done better than many other countries.

Before the crisis - from 2000-08 - China's exports grew by 700 per cent.

But as the graph shows, its exports dropped substantially during 2008-09. For the top 10 exporters, which account for 50 per cent of world trade, exports dropped by 34 percent between October 2008 and March 2009. But by "the second quarter of 2010, the top 10 exporters had recovered 55 percent of their decline during the crisis."

Indeed, China's exports have nearly recovered their 2008 peak.

Perhaps of more interest for Australia is the import side of the equation, which shows that China's imports have surpassed their 2008 peak. The US, however, stuck as it is in its financially induced mire has recovered, but still has a long way to go before it regains its 2008 peak.

The real question is whether this disparity will eventually matter for the world economy and for China (and Asia) in particular, i.e. can China's trade continue to boom if the US and Europe continue to lag with imports. Overall the recovery in imports of the top 10 has been substantial. According to the IMF:

During 2000–08, the top 10 importers—who bought about 50 percent of world imports—increased their foreign purchases by 51 percent, with the United States the clear leader. As with exports, the financial crisis caused a significant drop in imports of 35 percent during the same six-month period—October 2008 to March 2009. But there was a similar sharp rebound in imports. By the second quarter of 2010, the top 10 importers had recovered 58 percent of the crisis-induced decline.

Another interesting visual from this graph illustrates that the US has once again surpassed Germany as the second biggest exporter with the German export recovery faltering slightly in early 2010.

Keep on Booming

I don't know about you, but whenever I read headlines like "20 year boom", my bullsh-t detector comes on hard and fast. While there can be no doubt about the current status of the boom as one of the biggest in Australia's history, the real question is whether it is going to be sustained into the future. While I think the Australian economy is travelling fairly well at the moment, I just don't have the faith that many seem to have in the projections of endless prosperity.

The last week or so has seen the Head of Treasury and the Reserve Bank Governor both talk about the possibility of a long-term China boom. Students of the Australian political economy wanting a snapshot of official thinking could do far worse than review the recent words of Ken Henry and Glenn Stevens.

So what did Australia's two most important economic bureaucrats actually say?

Henry was at a Senate Hearing into the government's mining tax and the exchange went like this (my emphasis in bold):

Senator HUTCHINS—Can I ask you to give a view about the uneven growth across the economy at the moment.

Dr Henry—It is quite uneven. Certainly there are some sectors of the economy that are growing very strongly and we would expect to see them continue to grow as strongly over the next several years. There are other sectors of the economy that are being affected, particularly by the high exchange rate, who are finding conditions more difficult. There are businesses also that if not affected by the high exchange rate are feeling the impact of rising interest rates and the dampening effect that those rising interest rates are having on demand. So there is some dampening of demand evident in the Australian economy currently. We would expect to see those trends continue for some time—for quite possibly several years.

So it is likely that we will see an Australian economy characterised by unprecedentedly strong rates of growth in some sectors of the economy, particularly in mining, mining investment and mining related construction activity, with other sectors of the economy growing somewhat slower than their historical trend rates of growth as the economy’s factors of production, principally labour but also capital, move from the slower growing sectors to the faster growing sectors of the economy. In this uneven pattern of growth the Australian economy is being restructured, if you like. There is a period of structural change that the Australian economy is going through. I have said publicly on a couple of occasions recently that the external shock to which the Australian economy is adjusting, and by that I am referring to historically high commodity prices and the high terms of trade that come with those historically high commodity prices, will quite possibly prove to be the largest external shock ever to hit the Australian economy, and it is causing quite a deal of structural change. To date, not a lot of that structural change has occurred—some has—but over the few years ahead, we should expect to see quite significant structural change in the Australian economy.

Senator HUTCHINS—So the non-mining sectors appear to need some sort of assistance — not assistance, but maybe they need to be recognised?

Dr Henry—It is not clear that assistance is what is required. After all, what could appear to be assistance to a particular sector that is finding the going a bit tough could translate into even higher interest rates and an even higher exchange rate and could make life even more difficult for those sectors that are struggling now and that would not be in receipt of assistance. I think it is important to recognise that the pattern of growth will definitely be uneven in the next few years and recognise the challenge that poses for the conduct of both macroeconomic and structural policies. It has to be recognised, but you have to be careful that in constructing any form of assistance you do not actually make the problem worse.

Senator HUTCHINS—Would cutting company tax be of assistance to these non-mining sectors?

Dr Henry—Yes, and it is one of the reasons—it is not the only reason—the tax review document recommended a cut in the company tax rate. Another reason was to reduce the cost of capital in Australia in order to provide a more attractive destination for investment. That was a long-term view that was being taken in the tax review. Another reason for the tax review recommending a cut in the company tax rate, in association with a resource super profits tax, was to rebalance the pattern of growth somewhat to provide a lower cost of capital for those sectors of the economy that are feeling the pressure that is being exerted by this very rapidly growing mining sector of the economy.

Senator HUTCHINS—One concern that has been expressed to the committee has been about this so-called Dutch disease, which you may have heard Professor Garnaut comment on in our hearing on Friday. What appropriate measures should be taken? Should they be similar to the measures taken by Norway? Are there other areas that should be explored or are we going down the right track at the moment?

Dr Henry—I have not had the advantage of seeing Professor Garnaut’s comments that he made to this committee on Friday. I think I can anticipate what he would have said in respect of Dutch disease and that is actually what I was referring to earlier when I was referring to the strength of the Australian dollar and the pressure that is putting on other sectors of the economy, particularly the trade exposed sectors of the economy. As to policy responses to so-called Dutch disease, without addressing particular policies I would say that in general terms it might be helpful to reflect on whether the increase in the exchange rate is considered to be only temporary or whether the increase in the exchange rate might reflect a medium-term or even a long-term change in Australia’s terms of trade. Typically the Dutch disease label attaches to instances in which the appreciation of the exchange rate is considered to be temporary but the economic effects of that appreciation are long lasting.

I think it would be sensible on this occasion to contemplate the prospect that there has been a structural change in our terms of trade not a short-lived change in our terms of trade and that that structural change in our terms of trade will have to be associated with any change in the structure of the Australian economy. If that is the case then in general terms, again without talking about a particular policy option, policy would do better to focus on what could be done in order to support the structural change that is going on in the economy in a way that does least damage to people’s lives. That might mean, for example, avoiding temptation to offer support to a particular business which, with these terms of trade, does not really have a long-term future in the Australian economy but to focus instead on programs that would support the transition of workers from that business to other businesses in the Australian economy which do have a longterm future with the sorts of terms of trade that we are confronting. That is a generalisation, I am conscious of that and you asked me about particular policies, but I would not want to at this stage get into arguing the merits of particular policies. I am happy to talk about policy approaches, but I would not want to get into a discussion of the merits of particular options.

The gist of Henry's Senate statement is that the boom will be structural rather than cyclical, which would mean considerable adjustment for Australians as capital and labour move away from other sectors of the economy towards mining. (This is a bit of a problem given mining's low employment to output ratio) It's also a non-too-subtle, even if indirect suggestion that Australia should not offer assistance to the manufacturing sector!

Australia's terms of trade are approaching the highest ever level as this excellent graph from RBA Governor Glenn Stevens' speech "The Challenge of Prosperity" shows. (For those interested I published an article in the Griffith Review entitled "The Politics of Prosperity" dealing with similar themes ... for a similar article but with graphs and tables see "Between Luck and Vulnerability")

I've spent a good deal of the year trying to explain to students in my Globalisation, the Asia-Pacific and Australia class the importance of the terms of trade. Indeed, I asked them in their exam why it mattered. I told them that if they fell asleep Rip van Winkle style for 20 years and wanted to get an immediate picture of the state of the Australian economy one of the best things they could do would be to call: "Get me the terms of trade!!"

It is worthwhile defining the terms of trade because it it is a fundamental measure of boom and gloom. The terms of trade is an index-measure ratio of the average price level of exports to the average price level of imports. It effectively reflects the capacity of a given quantity of exports to pay for a given quantity of imports, and provides an important indication of the strengths and weaknesses of the economic structure. A rising or falling terms of trade indicates the possibility of improving or declining living standards, because if what we sell earns relatively more than what we buy, we will be relatively wealthier. Because the terms of trade is a ratio, increases can be a result of export prices increasing at a greater rate than import prices, or export prices increasing while import prices are declining, or export prices declining at a slower rate than import prices. Of course, a rising terms of trade doesn’t stop us from buying more things than we sell, which we have made a habit of for much of our history! Improvements in the terms of trade are not reflected in GDP figures, but improvements do contribute significantly to increases in national disposable income.

Why it is important is, as usual, lucidly explained by the Governor.

You may have noticed the Reserve Bank saying a lot about the terms of trade in the past few years. Before I describe the chart, why is it important?

Our terms of trade have a big bearing on national income. In economic commentary, there is typically a very strong focus on GDP – the value of production – as a summary of national material progress. There is also quite rightly an emphasis on lifting productivity – real GDP per hour worked – as the source of our growth of material living standards.

For open economies, though, our standard of living is affected not just by the physical output we can obtain from our resources of labour and capital, but also by the purchasing power of that output over things we want to have from the rest of the world. This is what the terms of trade is measuring. It is the relative price of our export basket in terms of imports. At the extreme, if the economy were open to the extent that we exported all our production and imported all our consumption, then the price of exports relative to imports would determine our living standards entirely, for any given level of productivity per hour worked. As it is, Australia is not that open, and not as open as many smaller economies, but it is considerably more open than the really large economies like the United States, the euro area or Japan. So the terms of trade matter.

When the terms of trade are high, the international purchasing power of our exports is high. To put it in very (over-) simplified terms, five years ago, a ship load of iron ore was worth about the same as about 2,200 flat screen television sets. Today it is worth about 22,000 flat-screen TV sets– partly due to TV prices falling but more due to the price of iron ore rising by a factor of six. This is of course a trivialised example – we do not want to use the proceeds of exports entirely to purchase TV sets. But the general point is that high terms of trade, all other things equal, will raise living standards, while low terms of trade will reduce them.

He then argues that there are 3 key features of the long-term chart of the terms of trade.

The first is the degree of variability in the terms of trade through the middle parts of the 20th century, from about World War I to the aftermath of the Korean War. This was, of course, a period of considerable instability in the global economy, with the attempt to return to the Gold Standard after the ‘Great War’, followed by the 1930s depression, the Second World War, the post war expansion and then the Korean War. I might add that, in those days, with the attempt to maintain a fixed exchange rate, these swings were very disruptive to the economy. Typically, a rise in export incomes would result in a rise in money and credit, a boom in economic activity and a rise in inflation. Then the terms of trade would fall back and the whole process would go into a rather painful reverse. The advent of the flexible exchange rate in the early 1980s made a great difference in managing these episodes.

The second feature is the downward trend in the terms of trade, particularly noticeable from the early 1950s to about the mid 1980s. This was the period of resource price pessimism, the ‘Prebisch Singer hypothesis’ and so on, which held that primary products would tend to decline in price relative to manufactured products. The latter part of this period was the one in which the realisation became widespread that the (apparently) easy gains in living standards of the post-war boom were gone, and in which pessimism about Australia's economic future was probably at its most intense. It was also the period when, under strong political leadership backed by a highly capable bureaucracy and an economically literate media, our determination to press on with various productivity-increasing reforms was greatest. That these two phenomena occurred together was probably not entirely a coincidence.

The third feature is the current level of the terms of trade relative to everything but the all-time peaks over the past century. Measured on a five-year moving average basis, and assuming (as we do) some decline in the terms of trade over the next few years from this year's forecast peak, the terms of trade are as high as anything we have seen since Federation.

To give some perspective on how important this is, let me offer one back-of-the-envelope calculation. The export sector is about one-fifth of the economy. The terms of trade are at present about 60 per cent higher than their average level for the 20th century, and about 80 per cent higher than the outcome would have been had they been on the 100-year trend line. This means that about 12–15 per cent of GDP in additional income is available to this country's producers and/or consumers, each year, compared with what would have occurred under the average or trend set of relative prices over the preceding 100 years (all other things equal). That will continue each year, while the terms of trade remain at this level.

Of course, part of this income accrues to those foreign investors who own substantial stakes in the mineral sector. In this sense, the current boom is a little different from the early-1950s one where most of the income went first to Australian farmers. Nonetheless, a good proportion accrues to local shareholders and employees, and to governments via various taxes. A non-trivial part of it is available to consumers as higher purchasing power over imports, as a result of the high exchange rate.

... On all the indications available, we are living through an event that occurs maybe once or twice in a century.

Stevens then moves onto what should be done. This, he argues, depends on whether the higher income that accrues from a higher terms of trade is long lasting or fleeting.

If the rise in income is only temporary, it would be desirable not to raise national consumption by very much. Instead, it would make sense to allow the income gain to flow into a higher stock of saving, which would then be available to fund future consumption (including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future). Moreover, it would probably not make sense for there to be a big increase in investment in resource extraction if that investment could be profitable only at temporarily very high prices (and which could come at the cost of reduced investment in other areas).

If the change is likely to be persistent, then income is likely to be seen as permanently higher. Households and most likely governments will probably see their way clear to lift their consumption permanently, both of traded and non-traded goods and services. Structural economic adjustment will also occur as the sectors whose output prices have risen, now being more profitable, will seek to expand, in the process attracting productive resources – labour and capital – away from other sectors whose output will decline as a share of GDP. Australia's floating exchange rate, which tends to rise in line with the increase in the terms of trade, helps the reallocation of labour and capital by giving price signals to the production sector. The higher exchange rate also speeds the spread of the income gains from the terms of trade rise to sectors other than the resources sector, by directly increasing their purchasing power over imports. The resulting rise in imports spills demand for tradable goods and services abroad, which helps to reduce domestic inflation.

All sounds hunky dory, but there is of course a sting in the tale as I summarised in an earlier post.

What most of the boomers forget is that price increases encourage supply increases, which then lead to oversupply and falling prices. This is the nature of the commodity cycle. No one knows this better that economist Bob Gregory, who adapting ideas about the so-called "Dutch Disease" - the negative impact resource booms can have on manufacturing sectors largely through a temporary rise in the exchange rate - to Australian conditions in the mid 1970s and which was then designated the "Gregory Thesis".

Gregory's major concern (as Henry argues above in relation to the Dutch Disease) is with a temporary rise in the exchange rate. This is a problem because the rise in the exchange rate may be long enough to force businesses in other sectors of the economy to the wall so that in the wash-up, resource demand is not sustained and important sectors of the economy are then diminished. In contrast, a sustained rise in the terms of trade will lead inevitably to a change in the structure of the economy as investment and people shift into mining and associated industries. This may still cause problems in the future as the economy becomes less diverse and less able to deal with an eventual collapse in the terms of trade.

As Stevens notes in relation to structural change:

It is easy, of course, to speak in the abstract of ‘reallocation of productive resources’, but this means that some businesses and incomes become relatively smaller; jobs growth in some areas slows even as in others it picks up. Some regions struggle more than others. Some sources of government revenue are adversely affected even as other sources see an improvement. This process will be seen, not unreasonably, as costly by those adversely affected, even though the overall outcome is that the country as a whole is considerably better off. (It is also obvious that, if the terms of trade change really is only temporary, it may not be worth paying these adjustment costs from the perspective of the overall economy.) The policy challenge for governments will be whether to help these sectors resist change, or to help them adapt to it.

In other words, interpretation of the sustainability of the current boom matters a lot!

Stevens argues we could try to keep the structure of the economy the same and resist changes, but correctly points out that would be stupid. We wouldn't want an economy dominated by agriculture as it was in the immediate post-war period and for a most of the time before that (gold booms notwithstanding). Remember the fate of wool, which was for so long our most important export and that now is not even in the top 25!

So if the terms of trade do remain fairly high for a lengthy period, the task is going to be to facilitate structural adjustment so as to make it occur in as low cost a way as possible. But that ought to be feasible given that overall income is considerably higher.

Of course we cannot know whether the terms of trade will be high for a long period. History certainly would counsel caution in this respect. We do know that supply of various resources is set to increase significantly over the years ahead and not just from Australian sources. It is for this reason that we assume some fall in commodity prices over the next several years. The assumption underlying the Bank's forecasts published a few weeks ago is that iron ore prices fall by up to about 30 per cent over the next several years. Even if they do, the terms of trade will remain quite high by the standards of the past 100 years in the near term.

Is that assumed fall realistic? There is no way of knowing. Larger falls have happened before. In fact they have been the norm. On the other hand, experienced people seem to be saying that something very important – unprecedented even – is occurring in the emergence of very large countries like China and India. If the steel intensity of China's GDP stays where it is already, and China's growth rate remains at 7 or 8 per cent for some years to come, which appears to be the intention of Chinese policy-makers, then the demand for iron ore and metallurgical coal will rise a long way over the next couple of decades. If India's steel intensity goes the same way as most other countries have, that will add further. Even with allowance for supply responses by other producers and considerably lower prices than we see today, that seems to point to a prominent role for the resources sector, broadly defined, over a longish horizon.

So the most prudent assumption to make might be that the terms of trade will be persistently higher than they used to be, by enough that we will need to accommodate structural change in the economy, but not by so much that we shouldn't seek to save the bulk of the surge in national income occurring in the next year or two, at least until it becomes clearer what the long run prospects for national income might be.

Stevens then explains that Australians are indeed currently saving more than they have for quite some time (hence the poor retail figures out today). "The net saving rate is now seen at some 9–10 per cent of income over the past year or two, up from about −1 per cent five years ago." There's nothing like a crisis to make people more cautious, especially given the fact that Australian households are more indebted than most other countries in the world and certainly vastly more than they ever have been in history.

Stevens speech makes clear that Australia and much of the rest of the world economy are increasingly dependent on China. Why this is not seen as more of a problem never ceases to amaze me! The assumption appears to be that China's growth will continue onward and upward and that India will join China and then surpass as it is better suited demographically for longer-term growth (i.e. more young people).

Given China's growing importance for the much of the world economy and certainly for Asia, there are also increasing indirect effects of Chinese growth on Australia. Our second biggest export market is, like us, more and more tied into Chinese growth. As Rintaro Tamaki, Japan's Vice-Minister of Finance for International Affairs, said: "We are not suffering from excess Chinese imports. We have a complementary relationship. We export parts and China re-exports the assembled products. So when China's exports increase, Japan's exports to China also increase." What this also means is that when China's exports decline, Japan's exports will decline helping to exacerbate the impact of a China slowdown on Australia. The same goes for South Korea as well, which also is increasingly tied into Chinese growth.

Now I don't want to sound too much like a negative vibe merchant here. While Australia remains vulnerable to changes in international demand and to international financial supply (just as it has done throughout its history), the most likely scenario for Australia over the next 20 years is, unsurprisingly, a variable (but higher) terms of trade, meaning a variable national income. Stevens thinks this too:

In the longer term, the economy's increased exposure to large emerging economies like China and India (these two now accounting for over a quarter of exports) – assuming that continues – may also pose important questions. If these and other emerging economies continue to grow strongly on average, but also, as with every other country, still have business cycles, the result may be the Australian export sector, and therefore the Australian economy, having a potential path of expansion characterised by faster average growth in income, but with more variability. That possibility has been noted by some observers. It is worth recording that such concentration would hardly be unprecedented – think about the dominance of Japan in Australia's trade in the 1970s and 1980s, or the dominance of the United Kingdom in an earlier era. Nonetheless, the degree of concentration could be higher than we have seen in the past decade or more, which was a time of considerable stability for the Australian economy overall.

Its probable that China and India will continue to grow rapidly for the next few years and at a slowing rate over the medium term, but it is unlikely that this growth path will be smooth. Capitalism generally means booms and busts. To think that growth will be smooth shows an enormous faith in the ability of the Chinese Communist Party to manage China's state capitalist economy. There is a beautiful irony in the faith that many economic liberals have in Communist economic managment skills! The thing that I think is unlikely is a 20 year boom, which implies no busts. For this to occur would mean that Australian history holds no lessons for Australia whatsoever. It would also mean that economics would have finally trumped politics. If I was a gambling man (and I am) I wouldn't bet my house on it (fortunately I don't own a house). There are just too many potential intervening variables for Chinese and Indian growth to be smooth! Maybe it's because I'm a poli sci major, but ultimately politics rules.


Given the likeliness of variability what should Australian policy-makers do? One solution would be to simply accept variability and deal with the fall out. Indeed this is probably the most likely outcome given the seeming inability of recent Australian governments to think beyond the short term.

But trying to save some of the income would be a better solution, using the proceeds of the boom to fireproof the Australian economy into the future. This would be a good solution regardless of whether the boom is temporary or more long-lasting or a series of boom-busts.

One of the ways of doing this would be to create a sovereign wealth fund like Norway has, which would mean the proceeds of the boom would be invested offshore. The foreign investment out of Australia achieved by a SWF would also help to slow the rise in the Australian dollar from a booming economy and would provide a store of savings for when the terms of trade were lower.

Stevens expresses the case slightly more esoterically:

Another approach would be to reflect the higher income variability in our saving and portfolio behaviour rather than our spending behaviour. We could seek to smooth our consumption – responding less to rises or falls in income with changes in spending and allowing the effects to be reflected in fluctuations in saving. In the most ambitious version of this approach, we could seek to hold those savings in assets that provided some sort of natural hedge against the variability of trading partners, or whose returns were at least were uncorrelated with them. Of course, such assets might be hard to find – the international choice of quality assets with reasonable returns these days is a good deal more limited than it used to be.

It is possible that this behaviour might be managed through the decisions of private savers. There might also be a case for some of it occurring through the public finances. That would mean accepting considerably larger cyclical variation in the budget position, and especially considerably larger surpluses in the upswings of future cycles, than those to which we have been accustomed in the past. There would also be issues of governance and management of any net asset positions accumulated by the government as part of such an approach, including whether it should be, as some have suggested, in a stabilisation fund of some sort. [He means here a SWF].

Of course if the China boom turns to a bust in the short- to medium-term then I get the feeling all talk of SWFs will be soon forgotten. Let's hope that we keep debating whether it'd be a good idea.

Rethinking World Trade

In a recent speech, rather dully titled "Globalization of the Industrial Production Chains and Measuring International Trade in Value Added", the Director General of the World Trade Organisation Pascal Lamy made some points that I've been talking about with students in my course Political Economy of East Asia (a title I want to change to "Power in East Asia" to get more students!).* Lamy is concerned that traditional trade statistics skew the real picture of international trade, particularly the bias towards the country where the final product is shipped from, even if it is simply assembled there. He uses the example of the iPOD to make his case.

What we call “Made in China” is indeed assembled in China, but what makes up the commercial value of the product comes from the numerous countries that preceded its assembly in China in the global value chain, from its design to the manufacture of the different components and the organization of the logistical support to the chain as a whole. ... If we continue, in this context, to base our economic policy decisions on incomplete statistics, our analyses could be flawed and lead us to the wrong solutions.

For instance, every time an iPod is imported to the United States, the totality of its declared customs value (150 dollars) is ascribed as if it were an import from China, contributing a bit more to the trade imbalance between the two countries. But if we look at the national origin of the added value incorporated in the final product, we note that a significant share corresponds to reimportation by the US, and the rest to the bilateral balance with Japan or Korea which should be allocated according to their contribution to that added value. In fact, according to American researchers, less than 10 of the 150 dollars actually come from China, and all the rest is just re exportation. In the circumstances, a re evaluation of the yuan — a topic which is very much in vogue these days — would only have a modest impact on the sales price of the final product and would probably not restore the competitiveness of competing products manufactured elsewhere.

Similarly, the statistical bias created by attributing the full commercial value to the last country of origin can pervert the political debate on the origin of the imbalances and lead to misguided, and hence counter-productive, decisions. Reverting to the symbolic case of the bilateral deficit between China and the United States, a series of estimates based on true domestic content cuts the deficit by half, if not more.

He then goes on to make an important point about the US trade deficit with Asia rather than particular countries.

This impression is confirmed by other figures, if we accept to “debilateralize” them: if we look at the US trade deficit with Asia rather than its bilateral deficit with China, we note a remarkable stability over the past 25 years at something like 2 to 3 per cent of the United States’

Increased trade with China has replaced trade with other parts of Asia, but this hasn't necessarily been as negative for the rest of Asia as this simple statement might imply. This is because the rest of Asia has also increased its exports with China, developing what is an increasingly important global production structure.

One of the remarkable facts that proponents of the argument that a higher Yuan will rebalance US-China trade need to think about is in relation to US trade with Japan. Though the Yen strengthened remarkably against the Dollar, from 360 yen to the dollar in the 1970s to as low as 80 to the Dollar in the mid-1990s, the trade deficit with Japan just kept on increasing.

JPY-USD Exchange Rate
http://en.wikipedia.org/wiki/File:JPY-USD_1950-.svg

For a  discussion on currency issues see Yipang Huang "A Currency War the US Cannot Win". (See also Martin Wolf "Why America is Going to Win the Global Currency Battle".)

Huang makes the point that:

Experts who are interested in Plaza II should first study carefully the experiences of the original Plaza Accord. The yen/dollar rate dropped from 250 in early 1985 to 150 in early 1988 and further to about 80 in mid-1995. But Japan’s current-account surpluses did not disappear.

Likewise, the real effective exchange rate of the US dollar fluctuated during the past three decades, but the US current-account deficits continued to climb, especially during the ten years preceding the global crisis. If the Plaza Accord did not achieve its original goal, why all of a sudden people became interested in this old idea again?

Now Lamy's brief is to encourage world trade liberalisation and so he has an agenda here, but it's worth thinking about his analysis, especially in relation to employment.

As for the impact on employment — understandably a rather sensitive issue in these times of economic crisis — once again the result can be surprising. Reverting to the case of the iPod, another study by the same authors estimates that on a global scale, its manufacture accounted for 41,000 jobs in 2006 of which 14,000 were located in the United States, 6,000 of them professional posts. Since American workers are more qualified and better paid, they earned more than 750 million dollars, while only 320 million less than half — went to workers abroad.

In this example, case studies have shown that the innovating country earns most of the profits; but traditional statistics tend to focus on the last link of the chain, the one which ultimately earns the least. Don’t get me wrong, I am not saying that this is always the case and that relocations always create more jobs than they destroy. ...

I simply wanted to highlight the paradoxes and the misunderstandings that arise when new phenomena are measured using old methods. Statistical survey experts know very well that “if you ask the wrong person, you will get the wrong answer”. Similarly, if you analyse a phenomenon using the wrong “measurements”, you will reach the wrong conclusions.

What Lamy proposes is a new research agenda to rethink the analysis of world trade.


*The political economy of East Asia course is part of the Bachelor of Asian Studies and Bachelor of International Relations at Griffith University.

Bubble, Bubble, Toil and Trouble

The recent disclosure through a freedom of information request by The Australian on Treasury warnings about the risks of a housing market collapse have stirred the pot on house prices once again. I, and many others, have discussed this great debate regularly in recent times (a marker, perhaps, of Australia's obsession with house prices). For previous posts see here and here.

According to The Oz:

Phil Garton, the manager of Treasury's Macro Financial Linkages Unit, sent colleagues a draft paper on the rise in household debt, prospects for further growth in the debt-to-income ratio and the potential implications of slower household debt growth.

His email prompted an exchange with Steve Morling, currently the general manager of the Domestic Economy Division, who argued the paper should "make a bit more about the risks".

"The elephant in the room is house prices or more specifically the risk of a precipitous drop in them, perhaps from an external shock or perhaps from their own internal dynamics when affordability constraints or capacity debt levels see prices and expectations of house prices start to move in the opposite direction," Mr Morling wrote on June 15.

"(I) know there are very supportive fundamentals, but prices rose by 50-60 per cent in three to four years in the early part of this decade, with largely unchanged fundamentals, so they can have a life of their own.

"And given what's happened elsewhere I'm far less sanguine about this - and the interplay with debt - than in the past."

I'm happy to admit that I just don't know what the outcome will be. My position over recent years has been to focus on the concept of vulnerabilities, rather than the certainty of either boom or gloom.

I still think the most likely scenario is a gradual decline (maybe just in a real sense i.e. via inflation, rather than by a marked nominal decline) but with different results for different cities and definitely different results for different market segments i.e. high-end versus first home valuations. Unfortunately that's a moderate position that is not particularly exciting.

But if I had to have a bet, I must admit I find the arguments of the bubblistas (the doomers) more persuasive. That may be because I have been a bit of a negative vibe merchant over the years, especially after the financial crisis. But be warned although I thought the longer-term prospects for the Australian economy were good, I was surprised by the vigorous and quick return of the boom for Australia. We might be right in the long run, but a s a famous economist once said we may have passed away before that long-run comes around.
But not pretending to think that I have the answers is not necessarily a poor position. What it should encourage is a hedging of bets.

We are no doubt in a period of great uncertainty. For risk-takers this means that the time is ripe for gambling on either side of the debate.
For those wanting to gamble on a fall, one position to take would be to short the banks (meaning effectively selling borrowed bank shares in the hope that they will be of lesser value when you have to pay them back). In a fall, this would be a good strategy, not only because banks are so exposed to the housing sector, but indeed because any collapse of house prices might be directly related to problems associated with bank debt! That is to say that the banks overseas borrowing means they are vulnerable to global financial developments. (see David Llewellyn Smith's post a while ago here based on this story.)

According to Clancy Yeates from The Age, the Treasury advised the incoming Gillard govt that

"A key risk for the Australian economy is our reliance on short-term external debt, largely intermediated through the banking system ... Among Australian financial institutions there has been some shift away from short-term funding since the crisis, but exposure to financing risk remains significant.

''Among Australian financial institutions there has been some shift away from short-term funding since the crisis, but exposure to financing risk remains significant."

''Highly indebted households, together with high dwelling prices, further heighten the vulnerability of the economy to shocks. While household finances are in good shape overall, and arrears rates and other financial stress measures remain much lower than in the early 1990s, households are more exposed than previously to adverse shocks.''

There's a recent Goldman Sachs report called "A Study On Australian Housing: Uniquely Positioned Or A Bubble?" by Tim Toohey that I'd like to read but it's not freely available. Reports of the study are located here and here. According to this report overseas hedge funds are (were?) shorting Australian banks.

Toohey argues that the banks are 25-35 per cent overvalued. The main risk factor is Chinese growth, which would negatively affect our export earnings. Yeates argues that the Treasury advised the incoming government that  

the rise of India and China were providing a hefty boost to national income, but Australia's increasing exposure to commodity prices were a risk and presented their own dangers. The terms of trade - export prices relative to import prices - are now at record levels, but Treasury pointed out that this could change quickly.

''While the terms of trade may continue to surprise on the upside, there are also downside risks if the global supply of resources responds more quickly than expected or if international market volatility persists. And even if those downside risks do not materialise, it is sobering to reflect on the fact that we have not managed previous commodity booms well.''

China's withdrawal of stimulus also threatened to limit investment spending in the world's most populous country, posing ''particular risks'' to Australia's resources industry, it said. In an attempt to prepare the government for managing the resources boom, Treasury also reiterated predictions that mining's expansion would force other industries to give way, a challenge known as the ''two-speed economy''.

Both the warnings about housing and the view of risks associated with China show that there is substantial disagreement between Treasury and the Reserve Bank of Australia about future economic prospects. While the Governor, Glenn Stevens, is more circumspect, Ric Battellino has long been a boomer. In a recent address he points out just how bad the US housing market is at the moment. (For a longer analysis of Battellino's views see my previous post).

Compare this to the situation in Asia, where house prices are rising reflecting strong economic growth and some bubble action.

Dwelling prices in the Australian house market have been expanding rapidly in recent years, although there was significant growth before this index series from Battellino starts.

Battellino is a housing market bull based on the under-supply theory.

Investment in new dwellings has increased over the past year, though growth in the number of dwellings is still falling short of growth of the population. As a result, rental markets are tightening, with vacancy rates falling and rents rising at a solid pace. At the same time, however, households now seem to be less inclined to increase their gearing in order to trade up to better housing. Auction clearance rates have fallen back to around long-run average levels and house prices have been relatively flat over recent months. This is in keeping with the more financially conservative approach that Australian households have taken recently. These trends are probably most pronounced here in Perth, which is going through a period of adjustment after the euphoria of 2006 and 2007.

Anyone wanting a counter-argument to this should read Leith van Onselen's excellent case for an Australian housing market bubble (especially the section on supply-side arguments). It's hard to go past this analysis.

Especially interesting is the argument for why housing investment is a elaborate Ponzi scheme based on this fabulous graph from the RBA itself (via Leith's blog).

The divergence between house prices and rental yields means that real yields from housing have been falling rapidly and that any gain must be made through capital gains. In other words you must sell your investment property at a higher price to make the investment worthwhile because income is was less than you could get from putting your money in a term deposit.

The graph is from a 2008 article (speech) called "Some Observations on the Cost of Housing in Australia". The author, Anthony Richards, Head of Economic Analysis Department, argued: 

One clear fact is that in the 35 years since 1972, nationwide house prices have risen significantly faster than average household incomes, house-building construction costs, and average rents. Most of the increase in real house prices occurred in two episodes, in the late 1980s boom and the subsequent boom in the late 1990s and into this decade. Growth in prices has been broad-based across the different states and territories. The run-up in prices is likely to mostly reflect an increase in the price of land. 

The increase in housing prices has been a mixed blessing for Australians. At one level, rising housing prices have made many people feel wealthier and have contributed to higher levels of consumer spending than might otherwise have occurred. But they have also resulted in concerns about housing affordability.

The difference in views reflects the fact that housing is not just an asset but also a consumption item. When housing is thought of purely as a consumption item, it would seem that in aggregate we would be better off if its price were lower. Because we all need to consume some level of housing services, either rented or purchased, a higher level of housing prices and rents allows less spending on other items.

But housing is also a long-lived asset, and there are distributional aspects to changes in housing prices and rents. Renters will be worse off when housing prices rise whereas those who own rental property will be better off. Owner-occupiers may be largely unaffected, since they can be thought of as being ‘hedged’ against increases in the cost of housing. There are also generational differences. Younger people who have not yet bought homes will be hurt by higher housing prices. Older owner-occupiers may benefit from an increase in prices if they are intending to extract part of the increased value of their homes. Of course, if older people pass on some of their increased wealth to younger relatives, the gains and losses of these two age groups will be reduced. Indeed, the biggest difference may be between those who benefit from transfers from older relatives and those who do not. Both home ownership and ownership of rental property tend to rise with incomes (Graph 2), so it is lower income households that tend to suffer from rising housing prices and higher income households that tend to gain. (my emphases)

So we can see that there are multiple interests at stake here and it might be the fact that you are now even more confused! But remember a bit of confusion, is probably better than misplaced certainty (unless of course you are a gambler).

For me, as I argued in The Vulnerable Country, debt is the big worry. Not public debt, but private debt and particularly household debt. See my earlier posts on debt. The question I ask myself is just how indebted we can be over the long-run. What level of debt is unsustainable?

Household debt as a percentage of household disposable income is a key variable to watch as are mortgage defaults (which are still very low). A major crisis in the world economy that affects Chinese demand would require a reassessment of my moderate fall story. If house prices fall it'll probably be due to some external shock although it is possible that a price precipitous fall is possible based on the sectors own dynamics as the Treasury memo argues.

The World and Australian Economies: The State of Play

There are a series of big debates going on in Australia's economic policy bureaucracy about the economy, house prices and the resources boom. Generally the Reserve Bank of Australia has been much more optimistic than Treasury, whose recent Red Book briefing to the incoming government highlighted a series of Australian economic vulnerabilities. A key optimist in the debate about the economy is the RBA's Deputy Governor, Ric Battellino. The RBA provides a wealth of information on the Australian economy and a fantastic amount of economic data. (see, for example, the Monthly Chart Pack)

In a recent address Battellino begins by pointing out how divided the world economy is at present.

He then goes on to show the appalling state of the US housing market with foreclosures accounting for almost 1 in 20 mortgages.

Household net wealth in the US as a percentage of disposable income has fallen enormously and is back at the levels of the late 1980s. This highlights why financially-induced recessions are often so long lasting and recoveries so weak as households deal with the fact that they aren't as rich as they were even quite recently!

As Battellino points out:

the reaction of households to all this has been to stop borrowing, cut back on spending and increase savings, all of which means that US households are not going to be the driving force of the global economy that they were for much of the period since the mid 1990s.

Highlighting why so many in the US are so angry but without mentioning it, Battellino points out that "the US corporate sector, on the other hand, is in pretty good shape".

Profits have recovered strongly and the arrears rate on loans to US corporates has peaked at a level that is quite moderate by historical standards; it is no higher than in the 2001 recession, which, as I have noted, was quite mild. ...

Also, holdings of cash by US corporations are at record levels – almost US$1½ trillion or equivalent to over 20 per cent of corporate debt. This means that US corporations are in a strong position to increase investment when confidence returns.

According to Battellino, the objective of the Federal Reserve's efforts to stimulate the economy through monetary policy (according to Bernanke) or quantitative easing (according to most others) is

to put downward pressure on market interest rates, so as to encourage households and businesses to borrow, and to provide banks with extra liquidity, so as to encourage them to lend. As noted, however, US households have little appetite for debt at present, US corporations are flush with cash and have little need to borrow, and banks appear to be quite happy to leave their extra liquidity on deposit at the Fed, rather than lend it. US banks are currently holding about 8 per cent of their assets on deposit with the Fed, while their loans to households and businesses are falling. (my italics)

With Asia doing so much better than the US or Europe, inflation, especially in food prices, is causing wider concern amongst monetary authorities. Never one to argue that house price rises should be seen as a problem, Battellino argues that they simply reflect "the favourable economic and financial climate" of many countries in Asia. Battellino is a true bull about the sustainability of house pricces and household debt.

 

One of the major factors behind Australia's excellent economic performance has been rising commodity prices. As the figure below shows after a significant fall during the global recession, iron ore prices have returned to pre-crisis highs, while coking coal prices have also recovered.

Battellino reports that:

As a consequence, Australia's terms of trade – the ratio of export prices to import prices – have surpassed the 2008 peak, and are pretty much at unparalleled levels. The increase in the terms of trade over the past year has added around $25 billion to the Australian economy.

But as he notes, the real issue for Australia is the question of the sustainability of this elevated terms of trade. Historically the terms of trade (see below) has fallen rapidly after booms and it was the continuous decline in the terms of trade from the 1970s to the mid-1980s that made many policy-makers worried that Australia had a third world economy (culminating in Keating's banana republic warning). It was also a major factor in pushing policy-makers to restructure the Australian economy.

Terms of Trade 1901-2009

Source: Treasury

The most recent figures for the terms of trade show just how well Australia has been doing. According to the ABS:

The strong growth in terms of trade over the past ten years reflected over 38.2% growth in Export prices and a fall in Import prices of 12.6% ...  In 2009-10, the Terms of trade decreased by 4.8%.

Terms of Trade ABS 5204.0

But the stats from 5206.0 show that the decline was all in the first part for the year.



Terms of Trade ABS 5206.0

Battellino argues that the RBA has long forecast a gradual decline in the level of the terms of trade and that this remains the consensus, but he also notes that "recent commodity price outcomes have caused us to revise up our forecasts".

Beyond the next couple of years, it is hard to predict what will happen. Both China and India, however, are going through a phase of their development that is very intensive in the use of steel. In the past, other countries have taken up to 20 years to move through this phase. It is likely that China, and more particularly India, will have strong demand for steel for quite some time yet. This, of course, would be a very favourable global environment for the Australian economy.

The India one is most interesting suggesting that if India can continue its development process (with associated urbanisation) then demand for Australian coal and iron ore will continue for sometime (even if its at reduced prices because of increasing supply).

Battellino then turns to the Australian economy and notes that the downturn in Australia was relatively shallow. The year ended growth figures don't go into the negative reflecting the fact that Australia had just one quarter of negative growth (i.e. not a recession) as it did in 2000.

There is, however, a question mark over the Australian consumer.

Consumer spending has grown by a little below trend over the past year. It seems that even though consumer confidence is high, consumers remain cautious in their spending. The household saving ratio has picked up noticeably from the low levels it fell to earlier this decade. As we have said before, a period of consolidation by Australian households, after 10–15 years of fairly robust increases in spending and gearing, is probably no bad thing.

Battellino is a housing market bull based on the under supply theory.  

Investment in new dwellings has increased over the past year, though growth in the number of dwellings is still falling short of growth of the population. As a result, rental markets are tightening, with vacancy rates falling and rents rising at a solid pace. At the same time, however, households now seem to be less inclined to increase their gearing in order to trade up to better housing. Auction clearance rates have fallen back to around long-run average levels and house prices have been relatively flat over recent months. This is in keeping with the more financially conservative approach that Australian households have taken recently. These trends are probably most pronounced here in Perth, which is going through a period of adjustment after the euphoria of 2006 and 2007.

Anyone wanting a counter-argument to this should read  Leith van Onselen's excellent case for an Australian housing market bubble.

Business investment has been strong, particularly in the mining sector.

According to Battellino "information published by the Australian Bureau of Statistics, as well as our own liaison with companies, suggest that it will pick up sharply further over the next couple of years". This will help to sustain Australian growth if it eventuates.

The major weakness in investment is in non-residential building:

Following large increases in gearing and commercial property prices in 2006 and 2007, the commercial property market has since deleveraged and prices have fallen. The bulk of that adjustment is probably now over, though the availability of finance for commercial property development remains very tight.

While lending to households remains moderate, business credit remains weak. This is mainly for big business as lending to unincorporated business has continued to grow.

We have spent a fair amount of time at the Bank looking at the question of why business credit is so soft. It is clear that banks had tightened lending standards sharply following the onset of the global financial crisis, which no doubt contributed to the slowdown in business lending. This has been most acute in the area of commercial property, where there has been a sharp cutting back, particularly by foreign-owned banks.

More recently, there are signs that banks are becoming more willing to lend, at least in areas other than commercial property, but demand for loans, in aggregate, is not very strong. It seems that the investment that is taking place in Australia, particularly in the case of the mining sector, is largely being financed outside the banking sector, either from retained earnings, direct investment from overseas or capital market raisings. (my italics)

Another issue constantly in the news at the moment is the level of the Aussie dollar. A much better indicator of the strength of the Aussie and that is more relevant to Australia's international trade is the Trade Weighted Index.  A higher value for the dollar negatively impacts Australian exports as they become more expensive in overseas markets and also affects import-competing buinesses as imports become cheaper. It also negatively impacts Australian overseas profits that need to be repatriated. (Just ask any Australian with money in English or American banks whether they want to bring their money home at the moment!)

On a 'real' basis (that is allowing for inflation) the effective "exchange rate remains below the levels recorded in the resources boom of the early 1970s", when Australia did not have a freely floating currency (instead the RBA set the value).

According to Battellino there are positives and negatives to a high exchange rate. 

A rise in the exchange rate is a natural consequence of a resources boom and, at the aggregate level, is helpful in allowing the economy to adjust. Nonetheless, some sectors of the economy are adversely affected. A notable example at present is the tourism industry, where there has been a sharp increase in the number of Australians travelling abroad rather than taking holidays domestically. This is having a severe effect on traditional holiday destinations in Queensland, areas which are also suffering from overbuilding in the pre-crisis years. Given this double impact, it is not surprising that these areas are currently experiencing among the highest rates of unemployment in the country. The Bank is monitoring developments in these areas closely.

Overall Battellino argues that the economy is travelling well:

While there are differences between sectors and between regions, the Australian economy overall is doing well. We expect that the economy will continue to grow at a solid pace over the next couple of years, with growth picking up to an above-trend rate towards the end of this period. This will be accompanied by further increases in jobs and falls in unemployment.

With the economy now having grown more or less without interruption for about 20 years, it is understandable that spare capacity is limited. This means that the economy cannot grow much above its potential rate without causing a rise in inflation. With a large amount of money continuing to flow into the country over the next couple of years as a result of the resources boom, the challenge will be to manage the economy in a way that keeps economic growth on a sustainable path, with inflation contained. This is what the Bank is trying to do.

At present, inflation is broadly in the middle of the target range. Over the medium term, though, as growth of the economy picks up, the pressures on inflation are more likely to be upward than downward. This is reflected in the forecasts the Bank recently published, which see inflation tending to rise after a period of near-term stability.

The Irish troubles and why they could matter to us

A friend of mine posted this on my FB:

"So what is all the fuss about Ireland, the population is about that of greater Sydney, who cares if they go broke, wouldn't the sums involved be just a fart on Wall St?"

Admittedly the first thing I thought about was Greater Western Sydney's new AFL team and how much better it would be to have an Irish team entering the competition!! But seriously ...

He could be right that it's overblown. Indeed, he probably is. The global media is now hyper-sensitive to vulnerabilities (although the Australian media might think the opposite given our stellar performance during the crisis).

Remember the sub-prime property market. How could a small segment of the US property market cause such chaos - it was only poor people's houses after all? How could that affect the global financial system (I mean how did Iceland get involved!)

The word to remember here is contagion. If credit freezes again then solvent borrowers can't rollover their debts and then they get in trouble, meaning they can't buy things and then other businesses can’t sell things, can’t borrow and so on. Around and around we go! This is how a credit crisis spreads way beyond the original problem.

If the crisis spreads again, the problem will be that this time, many governments won't have the ability to bail out investors (although in Australia the situation is different).

Now the Euro could be in trouble with some commentators arguing that it's only a matter of time before the Euro is disbanded ... it means that Ireland can't operate an independent monetary policy ... under the old system, the Irish Pound would be devaluing

The globalisation of finance means it's all connected now (I wrote about all this stuff in 1996 in an article called "The Politics of International Finance" .... what surprised me was that it took so long before the whole edifice got into trouble). But what we've seen over the past 20 years is a series of rolling crises with each one progressively worse than the next.

Most people thought the last one was the big one and I hope they're right, but as Wayne Swan used to say: "we're not out of the woods, yet". We still operate in a global economy and we're still connected to it as is the rest of Asia.

The worst decisions being made now do not involve not the printing of money in the US (so-called quantitative easing), but the premature shifts to cut govt spending.

Australia's Dependence on China

The Economist in "The indispensable economy? China may not matter quite as much as you think" argues that while dependence on China is significant and growing, it might be overrated.  

It is hard to exaggerate the Chinese economy’s far-reaching impact on the world, from small towns to big markets. It accounted for about 46% of global coal consumption in 2009, according to the World Coal Institute, an industry body, and consumes a similar share of the world’s zinc and aluminium. In 2009 it got through twice as much crude steel as the European Union, America and Japan combined. It bought more cars than America last year and this year looks set to buy more mobile phones than the rest of the world put together, according to China First Capital, an investment bank. ...

China is now the biggest export market for countries as far afield as Brazil (accounting for 12.5% of Brazilian exports in 2009), South Africa (10.3%), Japan (18.9%) and Australia (21.8%).

But given that exports are only a little bit over 20 per cent of GDP in Australia exports to China as a percentage of GDP "are only 3.4% of GDP in Australia, 2.2% in Japan, 2% in South Africa and 1.2% in Brazil." It's important to remember that domestic spending matters most. While production for exports has a multiplier effect through the wider economy, this should not be exaggerated:

these “multipliers” are rarely higher than 1.5 or 2, which is to say, they rarely do more than double the contribution to GDP. Moreover, just as expanding exports add to growth, burgeoning imports subtract from it. Most countries outside East Asia suffered a deteriorating trade balance with China from 2001 to 2008. By the simple arithmetic of growth, trade with China made a (small) negative contribution, not a positive one.

Multipliers in Australia derivative from Chinese demand might be larger than this in Australia however. What this attempt to downplay the China boom  doesn't capture is the confidence effect of a booming China and the huge expansion of investment in Australia aiming to cater not only for Chinese demand but the considerable increase in demand in Asia as a whole. Let's not forget that Japan and South Korea remain vital sources of demand for Australian exports and India and Indonesia are growing rapidly as well.

There are some countries, however, considerably more trade dependent than Australia as the graphic below shows.



China plays a larger role in the economies of its immediate neighbours. Exports to China accounted for over 14% of Taiwan’s GDP last year, and over 10% of South Korea’s. But according to a number of studies, roughly half of East Asia’s exports to China are components, such as semiconductors and hard drives, for goods that are ultimately exported elsewhere. In these industries, China is not so much an engine of demand as a transmission belt for demand originating elsewhere.

The share of parts and components in its imports is, however, falling. From almost 40% a decade ago, it fell to 27% in 2008, according to a recent paper by Soyoung Kim of Seoul National University, as well as Jong-Wha Lee and Cyn-Young Park of the Asian Development Bank. This reflects China’s gradual “transformation from being the world’s factory, toward increasingly being the world’s consumer,” they write. Gabor Pula and Tuomas Peltonen of the European Central Bank calculate that the Philippine, South Korean and Taiwanese economies now depend more on Chinese demand than American.

Trade is not the only way that China’s ups and downs can spill over to the rest of the world. Its purchases of foreign assets keep the cost of capital down and its appetite for raw materials keeps their price up, to the benefit of commodity producers wherever they sell their wares. Its success can boost confidence and productivity. One attempt to measure these broad spillovers is a paper by Vivek Arora and Athanasios Vamvakidis of the IMF. According to their estimates, if China’s growth quickened by 1 percentage point for a year, it would boost the rest of the world’s GDP by 0.4% (about $290 billion) after five years.

The Economist argues contrary to the general opinion in Australia that a major downturn in the Chinese economy would not be devastating.

Since the crisis, China has shown that its economy can grow even when America’s shrinks. It is not entirely dependent on the world’s biggest economy. But that does not mean it can substitute for it. In April the Bank Credit Analyst, an independent research firm, asked what would happen if China suffered a “hard landing”. Its answer to this “apocalyptic” question was quite “benign”. As it pointed out, Japan at the start of the 1990s accounted for a bigger share of GDP than China does today. Its growth slowed from about 5% to 1% in the first half of the 1990s without any discernible effect on global trends. It is hard to exaggerate China’s weight in the world economy. But not impossible.

Given that so much of the optimism of Australia is based on the view that China (and India's) rise will continue long into the future, I'm not so sure that the impact on Australia would be so 'benign'. Australia would have benefited in the 1990s if Japanese demand had continued to expand. But I might just be a negative vibe merchant, with a vested interest in the concept of vulnerability!

For further commentary on this article see the always insightful Mark Thirwell on the Lowy blog site.