Reproduced with kind permission of David Llewellyn-Smith at Macrobusiness.
Yesterday, the falling terms of trade prompted a couple of readers to ask for a description of the process of a China bust for Australia (if it were to happen). As well, there was a grossly limited effort to do so at the AFR using the same old dial-a-quote economists, so I thought I’d better bring some balance this morning.
To make sense of the question of what happens in the event of a China accident, you first have to define the pop. I offer three scenarios below.
1. Cyclical crash
This week Glenn Stevens dedicated an entire speech to the argument that Australia could sail through a cyclical China crunch relatively unscathed. I agree, more or less. A brief but deep cyclical downturn in China is manageable. I expect authorities would simply replay a more modest version the 2008/9 stimulus as mines closed, borrowing and consumption fell and unemployment rose.
The key, of course, would be house prices. In the AFR article yesterday, most of the focus was on interest rate cuts preventing rising unemployment from hitting asset values and creating a negative feedback loop. That’s happy-go-lucky drivel in my view. There is no scenario in which a serious China slowdown would not increase bank funding costs. And as the banks increased spreads to the cash rate to preserve profits, the efficacy of rate cuts would decline. At best I reckon the RBA could muscle mortgage rates down to 5%, only 1% down from today. That’s some nice relief but pales next to the relative relief provided in 2008 when mortgage rates fell over 3%.
That means we’d have to see another First home Buyer’s Grant to keep house prices up. The evidence from many recent state programs is that such would still work to entice the vulnerable into supporting the rich. It wouldn’t work as well as 2009 but well enough. The mini-me fiscal spending package would probably be in the vicinity of $30 billion with deficits for three years culminating in a near doubling of the Federal debt stock.
One year out from the bust and unemployment is in the the 7 to 7.5% range.
The real issue is what happens next and that’s where we come back to defining exactly what kind of Chinese bust we’re talking about. If Chinese fixed asset investment growth rebounds in a v-shaped recovery its all hunky dory once more. The real fear is of a structural shift in the Chinese growth model.
2. Structural shift in Chinese growth
It is widely accepted (outside of Australia) that the dependence of Chinese growth on fixed asset investment which drives the commodities boom is unsustainable and, indeed, risks a major and enduring debt crisis ala Japan. There is a quite good feature on this at the AFR today that probably draws upon yesterday’s exceptional debate at MB. It would be nice to receive some acknowledgement but the point of the blog is to prod the MSM into action so I won’t complain (too much!) Back to the subject at hand, it was on the question of Chinese structural adjustment that this week’s IMF report on China made Glenn Stevens speech look like a cheap sales pitch.
Obviously, if we know this so do the Chinese. Michael Pettis thinks that China has begun the process of shifting its growth model towards one of internal consumption. And there are reasons to think so. The local and international risks of not doing so are rapidly becoming larger than doing it. And consider, to date we have seen more weakness than consensus expected in Chinese growth yet much slower monetary stimulus as well. As Michael Pettis describes, not cutting interest rates is a key plank in Chinese rebalancing:
Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.
Of course the process will not be easy. Debt levels have risen so quickly that unless many years of overinvestment are quickly reversed China will face debt problems, and maybe even a debt crisis. The sooner China starts the rebalancing process, in other words, the less painful it will be, but one way or the other it is going to be painful and there are many in China who are going to argue that the rebalancing process must be postponed. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.
The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates.
But these measures will necessarily slow growth. The financial repression tax, especially, is both the major cause of China’s economic imbalance and the major source of China’s spectacular growth, even though in recent years much of this growth has been generated by unnecessary and wasted investment. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.
We have also seen a moderate refilling of the infrastructure pipeline and a weakening in the yuan. This could be interpreted as a three-pronged attempt to support the economy with a modicum of fixed asset investment and modicum of external demand boost as a greater role for consumption drivers is grown. If so, there will not be another large infrastructure stimulus package and if it comes can be seen as a sign of panic.
So, if this scenario were the one we faced what’s the outcome? It means no cyclical bust in China. Rather it means a managed transition over the next cycle (barring external shocks). It also means iron ore, coal prices and other minerals down some 30-40% within several years, which is where they’d probably settle for good, all things being equal.
This is a very different kind of shock for Australia. If it were to transpire beginning now, the following is my guess at the outcome.
Some time in the next twelve months, mining capex spending peaks and start detracting from growth. The decline is gradual because the big LNG projects are advanced and proceed. But iron ore, coal and other industrial commodities face big busts. The large capex plans of the mineral miners are consigned to history.
Big mining and associated industries begin to shed labour and do so in fits and starts over the next two years. The bust in speculative miners is bigger and faster. Wage pressures ease and income growth contracts. Unemployment grinds higher across the country. Interest rates fall steadily to 2% and mortgage rates to 5%. The Australian Budget never sees a surplus but its efforts to try, enforced by the ratings agencies’s stated need to see a surplus over the cycle, put more pressure on employment. House prices are supported initially by rate cuts but continue to fall in the slow melt unless Melbournians or the negatively geared more widely wake up in a rush. At some point the dollar regains its mojo, maybe on a warning from ratings agencies, and tumbles. The long disdained non-commodity exports of manufacturing and tourism rebound but export earnings still decline significantly as commodity price falls easily outpace volume growth and the old export industries recover only slowly having been “adjusted” in the previous cycle. Productivity leaps as labour hoarding unwinds, as mineral resource projects reach the export phase and as low margin mines close all over. The current account deficit blows out to 6% on a growing trade deficit, driven by LNG spending and some uptick in dwelling construction. Funding pressures remain for banks as markets burst their “Australia bubble”. These pressures are manageable so long as nobody in the falling housing market panics.
The ASX benefits at the margin as the dollar falls. Profits are helped too by the new productivity boom. Stocks are also aided by the global rebalancing that is being driven by China’s rising imports from the US and EU, which boosts markets via a price-earnings multiple expansion on falling imbalances risk. But falling earnings for the ASX8 retard its progress. On balance, it goes sideways.
We face a tough five years as asset prices, income and wages deflate and unemployment rises into the 8+% range. Government debt balloons above 50% of GDP on infrastructure spending and automatic stabilisers. The AAA rating is a distant memory.
Beyond that, export earnings begin to grow again as the big LNG projects come on line, food exports power on and Australia finds itself once again somewhat wage competitive. In seven years we find a new equilibrium with the dollar at 60 cents. A current account deficit of 3%, a housing market that is still expensive but 30% lower in real terms than today. A debt-t0-GDP ratio roughly where it is but with a proportionately lower ratio of household debt and higher ratio of public debt. In effect Australian standards of living haven’t improved in over a decade but we’re more secure.
3. Throw in a housing panic
Obviously all of that assumes no external bust, which we covered I guess, nor an internal one, driven by a housing panic. In that event it all happens a more quickly, the stats get worse, and it involves the nationalisation of the lenders mortgage insurance industry whose ludicrously low capital levels are exposed by a wave of new bank claims. The LMIs are blamed for the housing bubble (with some justification) and characterised as a failed privatisation. Don’t forget that Genworth’s business was originally government owned.
The nationalised LMIs funnel a backdoor bailout to the banks and prevent their balance sheets from imploding, though they will join their international zombie brethren. That ensures the bust rolls on for a long period. It might be shortened if the banks are bought and recapitalised by the Chinese. But what are the odds of that being allowed by Prime Minister Abbott?
Do I think any of these will happen? Dunno. But China must rebalance, either in control or through crisis, sooner or later.