Australia's China Dependence and Whether India Could be the Next Big Thing

"No country will ever replace China at number one in economic importance to Australia". So says Geoff Raby, a former ambassador to China. One could imagine an Australian High Commissioner in the United Kingdom saying the same thing in the 1930s or perhaps even the 1950s. Perhaps they might have said it about Japan in the 1970s or 1980s. The difference, many point out, is that China is a considerably larger entity than the UK ever was. For a very long time - since the beginning of the industrial revolution - population size was not the most important variable for economic power. Now that China has unleashed its economic potential, however, the consensus seems to be that China will soon become (and remain) the world's largest economy.

As China becomes richer, optimists argue, it will demand more than just Australia's resources, moving onto tourism, education and business services. They might even buy environmental services form Australia if we could find a way to encourage the industry's development in Australia.

Whatever the future possibilities, China's growth hitherto has benefitted Australia significantly. As the chart below shows much better to have been China dependent since 2007 than dependent on 'growth' in Europe or the United States.

No doubt Australians could have benefited further if there were a decent mining tax regime on a Australia's 80 per cent foreign owned mining industry. But such good news comes with a little bit of bad news if you worry about the impact of the associated high exchange rate on other areas of the tradeable economy or the vulnerabilities that come with an over-reliance on resources and on a 'single' country. And reliant we are on both.

Australia is now the most China dependent economy in the world. This is mainly because Australian resources have helped to generate a Chinese growth rate of around 10 per cent a year for 30 years. For the mathematically inclined among you that means its economy has doubled in size every 7 and a bit years. If it could just keep doing this for another 10 years then Australia's economic vulnerabilities would surely be a thing of the past.

Indeed, our policy-makers appear to be true believers in the China dream. There is widespread faith in the economic policy skills of Chinese Communist Party leadership and their ability to keep managing their economy to benefit Australia. And why not I suppose. It's worked so far. I can't help but feel, however, that the CCP leadership has produced an economic structure of over-investment and under-consumption that will eventually have to rebalance. Picture a rubber band being stretched further and further. The question is really about when it snaps and who it recoils on most. Just because it hasn't broken yet doesn't mean it won't. Eventually.

These charts got me thinking: who could be our next great trading partner? India is often mooted as a likely candidate but the relationship has long been seen as either 'emerging' or 'underperforming'. Policy-makers and commentators like to talk about the 'potential' of the Australia-India relationship, before arguing that 'much needs to be done' and that the relationship shouldn't 'be taken for granted'.

For Australian exports to India to increase rapidly in the near future, India would need to embark on a massive infrastructure spend like China has done in recent years. There is considerable scope for infrastructure development in India, but not the funds nor the inclination. It's important to remember that China's long-running economic growth and export prowess provided the wherewithal for its amazing investment surge (that may now be on the wane).

The most recent trade data on Australia's exports to India have not been encouraging, with exports declining by 12.9 per cent. However, the trade relationship has improved markedly over the past ten or so years. Coal and gold exports have declined in recent years. Copper has increased from 2008-09, but dropped off last year. Vegetable exports have also increased and could be a future possibility for major growth. Service exports are an important source of growth in trade between Australia and India, especially education. According to DFAT: "there were 37,400 Indian students studying in Australia as at the end of March 2012: India was the second largest source country for overseas students in Australia, after China.

In 2012-13, Australia's biggest exports to India were:

• Coal $4.75 billion
• Gold $2.98 billion 
• Copper ores & concentrates $1.12 
• Education-related travel $1.2 billion
• Vegetables $404 million

Major imports were:

• Personal travel excl education $555 million
• Medicaments (incl veterinary) $183 million
• Passenger motor vehicles $180 million
• Information technology $177 million
• Pearls & gems $173 million
• Jewellery $141 million

Australia was India's 31st most important export destination and the 14th largest source of imports in 2012-
13.

Our biggest overall export by far these days is iron ore and concentrates. In 2012-13 we exported nearly $42 billion worth to China. Australia only exports a relatively small amount of iron ore to India because it too has significant reserves of iron ore. In recent times, however, Indian iron ore production and exports have been negatively affected by a series of bans aimed at cracking down on illegal mining. This has been good news for Australian producers.

Australia ran a massive surplus with India of around $10 billion in 2012-13, down from over $14 billion in 2009-10. Total exports to India were $11.5 billion in 2012-13 compared to $78 billion for China. We run a surplus of $33.5 billion with China up from $2.3 billion in 2008-09. 

The following tables show recent key merchandise (goods) trade items with India and China. 

India is Australia's 7th most important destination for services exports. It is the 17th most important source of services imports. The trend over the last 5 years has been a decline of 8 per cent.

The latest trade in services publication covers transactions up to the end of 2012. The most important services export, education-related travel expenses fell from $3.01 billion in 2009 to $1.28 billion in 2012.

The graph below shows recent trends in Australia's key trade relationships as a point of comparison of Australia's trade with India. The dotted lines represent imports, the continuous lines are exports.

India might become Australia's most important trade relationship in the future, but it is unlikely to happen anytime soon. Despite recent economic growth and increasing trade, India remains a poor country with a low level of trade compared to China.

Continuing economic growth will be most important for the future of bilateral trade. Increasing wealth in India would translate into increased services exports, especially travel and education, and perhaps financial and business services. Increasing growth would also mean greater incentives to spend on infrastructure, which would benefit the Australian resources sector. There would also be an enlarged marker for Australia's agricultural producers. 

Australia's Terms of Trade in Historical Perspective

The Reserve Bank has recently published a historical comparison of the terms of trade in Australia entitled "Macroeconomic Consequences of Terms of Trade Episodes, Past and Present" by Tim Atkin, Mark Caputo, Tim Robinson and Hao Wang.

Now while such articles may make many people's eyes glaze over, there are few concepts that are more important in understanding the Australian economy than the terms of trade and Australians could learn a lot by reading this excellent paper. The authors' conclusion (quoted below) is on the optimistic side of the debate about Australia's economic future and it doesn't canvass the possibility that the extended duration of a high terms of trade and exchange rate have caused significant damage to non-mining sectors of the tradable economy.

The terms of trade is the 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.

Basically Australia has been lucky enough to have a high terms of trade for an extended period of time, but the ratio is now on the way down, with the consequence of declining income for Australians. The extent and rapidity of the descent will have a very large bearing on the economy and by extension on all of us.

The mid-1980s' low point for Australia’s ‘terms of trade’ provided an indication of the extent of the structural crisis of the economy. This terms-of-trade crisis spurred Australian policy-makers to quicken the pace of liberalisation and to make a conscious effort to globalise the economy. The most famous statement about the supposed end of Australian resource prosperity was Labor Treasurer Paul Keating’s “banana republic” radio interview in May 1986. It is worth quoting at length to show how much the rise of China has changed Australia’s economic circumstances. 

We took the view in the 1970s – it’s the old cargo cult mentality of Australia that she’ll be right. This is the lucky country, we can dig up another mound of rock and someone will buy it from us, or we can sell a bit of wheat and bit of wool and we will just sort of muddle through … In the 1970s …we became a third world economy selling raw materials and food and we let the sophisticated industrial side fall apart … We must let Australians know truthfully, honestly, earnestly, just what sort of international hole Australia is in. It’s the price of our commodities – they are as bad in real terms since the Depression … If this government cannot get the adjustment, get manufacturing going again and keep moderate wage outcomes and a sensible economic policy, then Australia is basically done for … If in the final analysis Australia is so undisciplined, so disinterested in its salvation and its economic well being, that it doesn’t deal with these fundamental problems … Then you are gone. You are a banana republic.

Keating used the sense of crisis to further the case for economic reform. The subsequent financial, trade, competition and labour reforms of the 1980s and 1990s helped Australia deal with the current boom, providing a flexibility to adjust to externally derived price shocks. 

Keating was wrong, however, that the era of resource wealth was over. He was not alone. Many commentators believed that the era of resource wealth was over. Arguments about the rise of the information economy seemed to preclude the possibility that resources - apart from oil - could once again substantially increase in price.  

Form the 1960s, the rise of Japan, followed by South Korea and Taiwan, Singapore, Malaysia, Thailand and other non-communist countries of Southeast Asia had provided significant expansion of export markets for Australian commodities, but had not led to a sustained structural increase in their prices.

Then along came China, changing everything. Not only did rapid Chinese demand increase the prices Australia received for its exports, but also Chinese manufacturing production helped to decrease the price of Australian imports. Manufactured goods made (or assembled) in China became significantly cheaper. Chinese competitive pressures also helped to keep in check the prices manufacturers throughout the world could charge for their goods. Interestingly, the prices of food and raw materials have not reached their 1970s peaks.

In 2000, Australia was pilloried as an ‘old economy’ too reliant on resources and unable to take advantage of the coming technology boom. The tech boom, however, soon turned into a tech wreck and Australia benefitted from two other booms – a resources boom fuelled by China and a credit boom that went largely into increasing the price of Australian houses.

Before we make the mistake of going too far back in the other direction away from the possibilities of information technology, the internet is now sparking another structural change that will profoundly affect the retail sector as consumers increase online purchases. While the technology boom got ahead of itself at the turn of the millennium, the impact of technological change will accelerate over coming years. Thus far, however, the level of online sales remains relatively small, even if it is growing rapidly from a low base
Betting on China

The major story of recent years, however, has been the rise of China. It is possible that China, India and most of the rest of Asia will continue to grow rapidly as the authors suggest for the next decade or so, but it is unlikely that this growth path will be smooth. China is actively seeking to diversify its sources of supply of the key resources it imports from Australia. Price increases eventually produce supply increases, which often then lead to oversupply and falling prices. And so on. This is the nature of the commodity cycle. China currently appears to be slowing and restructuring its economy away from commodity-intensive development. The debate over the extent of these changes is controversial but the outcome will be very important for us. 

The paper provides many excellent graphs that show the significance of change in the Australian economy. 

The historical snapshot of the terms of trade reveals important periods of boom and gloom in the economy. Especially important is the period from the early 1970s to the mid-to-late 1980s, which caused Keating's despair.

The graph on Australia's goods exports shows just how significant the transformation of exports has been from rural to resource exports. It also highlights the short period of adjustment in the 1990s towards more manufactured exports, which was overtaken in the 2000s by the continuous increase in the value of resources particularly iron ore and coal. Iron ore prices, for example, increased from $12.68 in 2001 to a high of $179.26 in 2011. 

This graph captures not only the extent of the shift to Japan, the rest of East Asia and China since the 1950s, but also the massive dependence on the UK before this. 

The next graph shows the correlation between the real exchange rate and the terms of trade. The manufacturing and tourism sectors will be hoping that the terms of trade declines and that the real exchange rate declines with it. 

Consumer price inflation has been subdued during the latest sustained rise in the terms of trade. 

A long-term look at public debt shows that the current situation is relatively benign when compared with the past, despite continual scare-mongering by policy-makers and commentators. According to the authors: "The primary reason for the large size of public debt in the past was the legacy of major conflict and the ‘settler nature’ of the Australian economy, the latter requiring high rates of social and economic infrastructure. In contrast, public debt in the current episode is at low levels. It could be argued that there is significant room to move to build the physical and mental (health and education) infrastructure to make Australia an economic powerhouse in the 21st century. But this certainly can't happen when public debt is seen as bad regardless of how it is used.

Another major difference of the recent boom was that earnings did not increase in tandem with the increase in commodity prices, as they had done in previous episodes. Undoubtedly, this helped macroeconomic management. Given the hefty wage increases in mining related industries it begs the question as to who was keeping the average down. Obviously some workers were not doing quite so well! According to the authors

The institutional structure of the labour market during the current episode has been the most flexible over any expansion since Federation; a considerable increase in relative wages in the resources sector and a more decentralised industrial system facilitated a relatively low unemployment rate during the upswing in the terms of trade without creating substantial inflationary pressures. 

The authors conclude:

Australia’s current terms of trade cycle has parallels with earlier episodes. Historically, large movements in the terms of trade were mainly driven by changes in export prices, particularly wool, which reflected strong demand from industrialising economies, coupled with adverse supply developments, such as drought. Upswings in the terms of trade have generally boosted domestic demand, usually with a sizeable contribution from investment, probably reflecting both a direct response to higher commodity prices and the associated improvement in wealth and confidence. In some episodes, growth in immigration and pent-up demand following war also supported growth in investment. Typically, net exports have contributed little to economic growth during the upswing in the terms of trade; sluggish supply responses are exacerbated by the real exchange rate appreciation, which dampens growth in other exports and supports imports. Many of these features have been present in the current episode.
The current episode, however, has some distinct features. One is that it has been mostly related to bulk commodities, instead of rural commodities. Consequently, the sluggish response of supply partly reflects the characteristics of resources investment – namely long periods to plan and gain approval for projects and the need to develop infrastructure. However, just as Australia was the world’s major source for internationally traded wool throughout previous episodes, today it is the world’s largest exporter of steel-making materials and it is likely that Australia will also become a major source of liquefied natural gas exports in the coming years. A decline in the terms of trade is therefore, to some extent, the result of new supply from Australian producers coming on-line.

The most recent upswing was the largest sustained increase of the terms of trade on record, and the Australian economy is likely to continue to be a beneficiary of strong growth in Asia. Indications suggest China’s industrialisation and urbanisation process, which has underpinned the increase in demand for steel-making commodities, is likely to continue for a number of years, although it may well grow more slowly than in the past. Chinese infrastructure needs remain large; an example is that steel demand for residential construction is not estimated to peak until around 2024 (Berkelmans and Wang 2012). While the path of economic development is not always smooth, it is important to remember that this is not the first episode during which one country and a narrow range of commodities have been of particular importance to the Australian economy; rather, that is the norm.

Another stark difference is that despite the unprecedented movement in the terms of trade, the macroeconomic adjustments in Australia have been relatively smooth. Inflation, for example, has remained contained, in contrast to many previous experiences, such as the Korean War wool boom. Furthermore, inflation expectations have remained relatively low and stable. Factors facilitating this include the greater flexibility present in the labour market, the inflation-targeting regime adopted by the RBA, and the flexible nominal exchange rate, which has enabled the necessary appreciation of the real exchange rate to occur in a less disruptive manner.

Historically, for several years following a peak in the terms of trade, growth in investment and output per capita tends to be below average. As we have emphasised, the real exchange rate and the terms of trade generally move together.

Consequently, the expected easing in the terms of trade, reflecting growth in the global supply of the bulk commodities, may be accompanied by falls in the real exchange rate. More generally, an increase in Australia’s competitiveness would help facilitate the macroeconomic adjustments necessary during the transition from the investment to production phase by providing support to sectors outside of the resources sector, thereby helping to rebalance growth in the economy. Reflecting the unparalleled magnitude of the expansion, the transition necessary is considerable and is likely to pose challenges to both firms and policymakers. The current policy frameworks and institutional structures, which were important in facilitating better macroeconomic outcomes during the upswing than occurred historically, may also assist this transition.

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