Not when but if China slows down

THE International Monetary Fund projects that within five years, China will overtake the United States to become the world's biggest economy. Yet investors are nervous that long before then the world's most astonishing growth engine might run off the rails.

In consecutive falls since the middle of last week the Shanghai Composite Index shrank by 4.75 per cent in six days, amid fears that the People's Bank of China might overreach in its campaign to rein in inflation.

The index is now more than 10 per cent below its peak, mainly because China's inflation rate climbed to 5.4 per cent in March (BHP and Rio, take a bow) and in just seven months, the central bank has tightened quantitative controls eight times and raised interest rates four times.

So it should be no surprise that recent figures have shown growth in manufacturing output slowing, or that analysts such as Goldman Sachs are edging down their forecasts of China's 2011 growth (in Goldman's case, just from 10 per cent to 9.4 per cent), or that Standard & Poor's should highlight the possibility that in a worst case scenario, 10 per cent of loans by Chinese banks could be non-performing within three years.

Does that mean China's extraordinary run is ending? And what are the risks for us if our main customer should stumble? Like most of us, I'm no China expert. But over the years, we've all seen warning after warning that China's record growth is about to end. So far it hasn't, and the institutional wisdom is that it won't.

This year the IMF estimates China's GDP will be 20 times what it was in 1980. That's right: twenty times. Australians think we've done pretty well, yet our GDP is only 2.7 times the size it was then.

On the IMF's figures, China has gone in just 30 years from being one of the world's poorest countries to being its biggest middle-income country. For 30 years it has averaged growth of 10 per cent a year. Not even Japan or South Korea have matched that.

Nonetheless, China has got there with an economic model that owes far more to its Asian neighbours than to standard Western economics. In Western economics, the consumer is king, and the goal of economic policy is to maximise consumer welfare. In Chinese economics, the producer is king, and the goal of economic policy is to make Chinese producers the most competitive in the world.

Its policy mix is quite different from that used by Japan and Korea in their rise. They relied essentially on protecting their domestic market by shutting out foreign investment and imports alike, and developing a highly effective culture of innovation by imitation and kaizen (continuous improvement) to develop world-class industries behind their protective walls. The walls came down only when they were already globally competitive.

By contrast, in the 1990s, the West forced China to lower its protection dramatically as its entry fee for joining the World Trade Organisation. That forced China to rely on weapons the WTO could not control: a heavily undervalued currency that makes its exports more competitive, and imports into China less competitive; a host of behind-the-border controls; and a culture of ruthless piracy of Western innovations.

Many argue that this cannot last. To keep its exchange rate low despite its explosive growth, for instance, China acquired more than $1 trillion of US Treasury bonds exposing itself to the risk of huge losses if its de facto currency peg collapses. But as the US dollar has slid since 2009, the People's Bank has managed to juggle its conflicting goals: at first going down with the US, then allowing the yuan to creep up by 5 per cent against the $US, but continuing to slide against other currencies.

It is gradually moving out of US Treasuries, instead using its huge current account surpluses to buy up companies and resources in direct investments around the globe. Federal Reserve data suggests China bought just $51 billion of Treasury bonds in 2010, and has been a net seller this year.

The fears of investors are not shared by the international financial authorities. The IMF's latest Outlook last month projected that China's growth would slow only marginally, from an average of 10 per cent a year since 1980 to 9.5 per cent over the coming decade. Here in Australia, Treasury's forecasts are broadly similar.

If it is wrong, the consequences for Australia could be dramatic although more for individual companies than for the economy overall. Australia's currency has soared largely because of the high commodity prices created by China's booming demand for iron ore and coal. If China stumbles, the first casualties here would be high commodity prices and the high dollar.

The effects of that could be complex. Mining companies gain from high prices, but lose from the high dollar. The new mines opening up are cost efficient and a lower dollar could see them offset lost sales in China by gaining new markets elsewhere. But the dislocation would be severe.

Mining investment would slow sharply. But other globally exposed industries such as manufacturing, tourism and agriculture would benefit if the high dollar disappeared.

The Reserve Bank too would face conflicting pressures. The high dollar has helped it by lowering import prices and slowing the rest of the economy: the transition to a low dollar would imply higher import prices, pushing up inflation. But the Reserve's prime fear is that the resources boom could lead to a wage-price spiral. If China stumbled, that boom would deflate, and the fear with it.

But will China stumble? Before you join the bears, remember: China is a country that lives well within its means. The IMF estimates its savings rate at an astonishing 54.3 per cent of GDP. And its current account is running a surplus of 5.7 per cent of GDP. Just as Australia is bound by its low savings rate and current account deficit, China's high savings rate and surplus gives it the freedom to flick the switch to consuming whenever it needs to.

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China to lead world economy

CHINA is about to overtake the United States as the world's biggest economy, creating profound changes in the balance of global power.

In forecasts inserted quietly on its website in recent days, the International Monetary Fund has projected that, by 2016, China will overtake the US in real economic output - the first time in the modern era that any country has done so.

Economic historian Angus Maddison estimated that the Soviet Union at its peak produced only a third as many goods and services as the US; Japan's economy at its peak was still less than half the size of the US economy.

China's ascension has been startlingly different, in speed and size. If it grows at anything like the 10 per cent rate it has averaged since 1980, its economy will be far bigger than that of the US within a generation.

Australian National University professor of strategic studies Hugh White said the looming end of US economic dominance marked a turning point for the world, and had serious implications for Australia.

''For us, it is the end of a very long cycle in which both our great allies, first Britain, then the United States, have been the strongest economy in the world and the greatest military power,'' Professor White said.

''For the first time, the greatest economic power in the world will not be our close ally.

''One issue is whether we will have to accommodate an ambitious, growing China that behaves reasonably well, or face an aggressive China that operates without such constraints. Another is how the US responds to China's growing military strength.''

Professor White said that while the US had confronted more-hostile enemies before - Nazi Germany and the Soviet Union - it had never had to contend with a rival that matched it in economic strength.

He said this would pose a ''very tough strategic choice'' for Australia as to whether or not to back the US in a conflict.

China's growth has been unprecedented. In 1980, when its economic reforms were just starting, the IMF estimates the US produced more than 10 times as many goods and services. Even 10 years ago, when China overtook Japan to become the world's second-biggest economy, the US still produced three times as much.

But since then China's share of global output has doubled, while that of the US has shrunk rapidly. From 25 per cent of global output in 1986, the US share has shrunk to less than 20 per cent and a projected 17.8 per cent by 2016.

China produced just 2.2 per cent of the world's output in 1980, but this rose to 7 per cent by 2000, 14 per cent now, and is projected to top 18 per cent by 2016.

By 2016, the IMF estimates, China will be producing more in a fortnight than it did in a year when the reforms began. Over that period, its output would have risen to 30 times its starting level; US output would have risen to 2.7 times its 1980 level.

The US would still be the world's biggest market. If China keeps its currency heavily undervalued, as it is now, the IMF projects that, in nominal terms, by 2016 the US economy will still be two-thirds larger than China's.

But this gap would simply reflect currency values. Factor in relative prices, and China's real output of goods and services would be the world's biggest.

The IMF assumes that China will grow at 9.5 per cent a year over the coming decade, a tad slower than previously, while US

growth would accelerate from an average of 2.1 per cent over the noughties to 2.75 per cent in the new decade.

Australia is assumed to average growth of 3.25 per cent, and more or less maintain its place in the world economy, which has changed remarkably little over the past century.

On Professor Maddison's estimates, Australia in 1913 produced 1.02 per cent of the world's output. On the IMF's figures, this edged up to 1.34 per cent in 1981, is 1.19 per cent now, and will shrink further to 1.11 per cent by 2016.

This reflects the rapid growth not only of China, but developing countries as a whole. In 1990 they produced just 31 per cent of the world's output, but by 2010 this had risen to almost 48 per cent, and by 2013 most of the globe's output would come from low- and middle-income countries.

India's growth is projected to continue at more than 8 per cent a year. It is on track to overtake Japan next year to become the world's third-biggest economy in real output.

The relative weight of Japan and the European Union is declining rapidly. On IMF projections, by 2016 Japan would account for just 5 per cent of global output, down from 10 per cent a generation earlier, while China and the US would have overtaken the EU's output.

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Peoples' Republic will lack workers: Garnaut

CHINA is entering a future where it will run out of workers. Its workforce will peak within five years, says eminent economist and China-watcher Ross Garnaut and the consequences for Australia and the world could be profound.

In a forward look to China in 2030, Professor Garnaut told a Melbourne Institute/Australia-China Business Council forum the next 20 years would be dominated by China's transition from population growth to population decline with its labour force declining first.

The consequences would include a fall in China's savings, a decline in its lending to the world, and hence rising interest rates impinging most on heavy borrowers such as the US and Australia.

Professor Garnaut, a former ambassador to China and now at the Melbourne Institute, said China's population would peak in about 2030 with 1.45 billion people, of whom 400 million would be over 60. But the labour force would turn around first. After growing by 7 million a year over the past five years, it would shrink by 1 million a year from 2016, and by 5 million a year from 2021.

Professor Garnaut said worker shortages had already emerged, pushing up real wages. "Real hourly wages rose 90 per cent between 2001 and 2009, and non-wage benefits rose even faster. That crunch is going to increase."

While savings rates of more than 50 per cent of gross domestic product had driven China's extraordinary growth which the late economics historian Angus Maddison predicted would see it overtake the US in real GDP by 2015 savings would decline as wage share of income rose and that of profits fell.

"Household savings rates in China are 35 per cent, very impressive compared to others," Professor Garnaut said.

"But corporations save almost 100 per cent of their profits and reinvest them. In future, savings and investment rates will be closer, and the current account surplus will decline.

"That will make it more difficult to fund the savings deficits in the world including Australia's large deficit in private-sector savings.

"As China's savings fall, global interest rates will rise and debt will become more expensive to finance.

"The rest of the world will be sorry if it gets what it asked for."

But Professor Garnaut said a shrinking workforce would not necessarily shrink China's growth.

Productivity growth could accelerate as its skilled workforce moved into "more technologically sophisticated and capital-intensive" sectors spreading its competitive pressures to a wider range of industries in the West.

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Could this be the end? Mood and data mixed, nellies nervous

JUST months after the world entered a recovery, some analysts are worrying that we might be about to exit it.

As we open a new financial year that we expected to bed down the recovery, nervous investors are now speculating that the world will sink back into a double-dip recession.

That's not unusual. Keep this firmly in mind: nervous investors tend to see a lot of recessions coming that never arrive. The consensus view, here and overseas, is that this is another of those times.

But the consensus too can be wrong. And if the mood and data grow darker, it will hurt the Gillard government in its bid for re-election as the government that kept Australia out of the global financial crisis.

In 2008, Kevin Rudd had the money to spend his way out of trouble. Julia Gillard doesn't have that option.

Yesterday the sharemarket sank for the seventh day in a row, in the wake of Wall Street falling to its lowest point for eight months. The benchmark S&P/ASX200 Index, which topped 5000 in mid-April, ended the financial year at 4301.5, falling almost 15 per cent in the past 11 weeks.

For those who prefer pessimism, there are clouds almost everywhere: some of Europe's governments have borrowed more than they can readily repay; the potential for China to be blown off course as its real estate bubble bursts; the data showing very weak growth in Europe and unsteady growth in the US.

In Australia, the data is mixed, with growing signs that the Reserve Bank might have moved too fast in raising interest rates.

Yesterday the Bureau of Statistics reported that job vacancies shrank 3 per cent in the past three months, even in seasonally adjusted terms. New home sales tumbled in May, while building approvals are doing zigzags rather than rising as predicted. Business and consumer confidence have plummeted since March. And the trend of retail sales has been virtually flat so far in 2010.

And yet there has been no letup in the pace of jobs growth, which is still charging along. Business investment plans as of April/May were still strong, especially among mining companies. China has kept growing at breakneck pace, pushing demand and prices for our minerals to records.

Our fortunes depend more on China, Japan, India and Korea than on Europe and the US. Some analysts warn that China's local governments are so heavily in debt that even Beijing will not be able to bail them out without serious damage.

In those idyllic times two months ago, when the market downturn was just beginning, the Reserve forecast growth of 3.5 per cent over the new financial year, and Treasury forecast 3.25 per cent. The way things look now, they might be too optimistic, but probably not by much.

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Trading places - Beijing and Taiwan make surprisingly good partners

FOR almost 60 years, their rivalry matched the Cold War enmity between the US and Russia. Each coveted the others' territory, claiming it as their own.

Twice they brought the world to the brink of war. In 1995, China fired missiles across the Taiwan Strait landing just short of Taiwan, to warn there would be war if its island neighbour declared independence.

But yesterday in the Chinese city of Chongqing, these bitter enemies signed a path-breaking free-trade agreement. It's an outbreak of peace fiercely opposed by many Taiwanese, who fear China is pursuing free trade to try to bring the island back under its control.

Almost unnoticed by the rest of the world, China's President Hu Jintao and Taiwan's President Ma Ying-jeou have set aside their nations' long enmity to accept a political status quo and work to make the most of their formidable economic partnership.

China has many free-trade agreements on its plate. It has been negotiating one with Australia since 2004. A free-trade agreement with the 10 ASEAN nations took effect this year. But an FTA between China and Taiwan is something different.

In Taiwan, the government hopes it will open the way for trade agreements with the rest of the world. Foreign Minister Timothy Chin-tien Yang told The Age he hopes Australia will now start negotiating its own free-trade agreement with the island our seventh largest export market.

In China, the government hopes this agreement and those that will follow as the two sides pursue their relationship will, over time open the door for Taiwan to submit peacefully to Beijing's authority. But that goal is vehemently opposed by most Taiwanese, led by the opposition Democratic Progressive Party (DPP).

Their goal is full independence from China. In office from 2000 to 2008, the DPP was held back from declaring independence only by pressure from Washington, Taiwan's military protector.

The agreement signed yesterday is not dramatic, and for political reasons, is heavily lopsided in Taiwan's favour. It is the early harvest of what is planned to be a cascading series of agreements to open trade and investment across the Strait.

China will remove tariffs on 539 export lines from Taiwan, while Taiwan ends tariffs on 267 export lines from China. Both sides will open up some service sectors. China will stop its companies copying patented designs, products and processes from Taiwanese companies.

But to opponents, the agreement goes to the heart of Taiwan's identity crisis: is it part of China, the land of its ancestors, yet which has ruled it for just four of the past 115 years? Or is it an independent country, which the world and China should accept as free? To supporters, the agreement, known as the Economic Co-operation Framework Agreement or ECFA, is a pragmatic acceptance that the status quo will not be changed any time soon. Close relations with China are the best guarantee of peace, prosperity, and acceptance of Taiwan by the rest of the world.

Opinion polls suggest its supporters are in the majority. But on Saturday, nearly 100,000 people marched through Taipei in opposition to the treaty, which DPP leaders say will lock Taiwan into dependence on China.

"ECFA will open the door to unification", Hsiao Bi-khim, adviser to DPP leader Tsai Ing-wen, told The Age. "We would lose other options.

"They have expansionist ambitions over Taiwan. ECFA would give the Chinese greater leverage over Taiwan. Many people made sacrifices to try to bring about the kind of democracy we have today. We feel very strongly about defending that."

FOREIGN Minister Yang rejects that. "We are not talking about unification", he says. "We will leave these issues for future generations. We are engaged in confidence-building measures, step by step."

Taiwan's chief negotiator, Chiang Pin-kung, says opinion polls show that rather than opt for independence or unification, most Taiwanese want to keep the status quo, and the free-trade agreement will not alter that.

"Our export markets are concentrated in Asia, but we have no free trade agreement with any country in Asia," he says. "Mainland China is a huge market, and since it signed a free-trade agreement with ASEAN, we have lost competitiveness. And ECFA will make it easier for us to sign other FTAs."

It is ironic. President Ma is the head of the Kuomintang, the party that ruled China before being overthrown by the communists in 1949. Former Chinese leader Chiang Kai-shek fled to Taiwan with China's gold stocks and a million or more followers, and set up a rival government under US military protection.

Taiwan evolved into a rich country and a vibrant democracy. It is formally recognised only by about 20 developing countries dependent on its aid, yet its 23 million people now make up an economic powerhouse that is one of the world's 20-largest economies, with a GDP per head that this year will overtake Japan.

It is a giant in IT and electronics. It produces many of the world's flat screens and silicon chips. All the world's notebooks, whatever the brand, are made by Taiwanese companies in factories in China.

China still views Taiwan as a rebel province, but recognises that it cannot invade without risking war with the US. Most Taiwanese see their country as independent, but their government cannot declare it as such without risking war with China.

So, under the table, they have formed one of the world's strangest but strongest economic partnerships. It began in 1992, when in Singapore, they signed four agreements to pave the way for Taiwanese firms to invest in China an agreement that has become instrumental in making China the workshop of the world.

In the past two decades, even as China installed 1300 missiles facing Taiwan and threatened to invade, Taiwanese companies were invading the mainland. They organised millions of cheap Chinese workers to assemble Taiwanese components into the world's computers, TVs and mobile phones.

China became the world's biggest manufacturing base. Taiwan became its biggest foreign investor. Taiwanese companies now export close to $100 billion of goods a year from their factories in China.

Yet until President Ma was elected in 2008, their governments were fiercely hostile. Taiwan is only 120 kilometres from China, but there were no flights or ships between then, so all travel had to be via Hong Kong. Taiwanese companies invested more than $100 billion setting up plants in China, with uncertain security. And almost 1 million Taiwanese managers, technicians and their families have settled in China to run this vast empire.

A classic example is the iPad. It is made in China, for a US company, Apple. But Apple contracts production to Taiwanese electronics giant Hon Hai, known in the West as Foxconn. The components largely come from Taiwan but are assembled in Hon Hai's plants in China.

To business, economists and strategic thinkers in Taipei, these investments and the government's embrace of China, are the right way for Taiwan to go. "The logic is very clear", says Academia Sinica economist Chu Wan-wen, co-author of a study on Taiwan's economic growth, Beyond Late Development . "It's normal to have anxiety about China's growth, but we have to enter some kind of agreement to avoid being totally marginalised."

Strategic analyst and former minister Lin Chong-pin sees the agreement as a Chinese initiative. "In the summer of 2002, Beijing made two crucial decisions on hard choices," he says. "First, in relations with Washington, co-operation would take priority over conflict. And second, economic development was more important than unification with Taiwan.

"These decisions were not made easily. But Beijing has learnt, through trial and error, that to buy Taiwan would be cheaper than to attack it. And related to that, to pressure Washington to constrain Taipei is better than to pressure Taipei directly."

Foreign Minister Yang, who spent five years in Canberra as head of Taiwan's de facto embassy, sees the warming of relations across the Taiwan Strait as positive for Asia and the world. "They used to threaten us, and stage military exercises across the strait," he says. "They're not doing that any more. Both sides are showing goodwill to each other."

He hopes it will also end Taiwan's diplomatic isolation illustrated last year at the Copenhagen climate conference when its environment minister was admitted only as the representative of an NGO.

"My message to our Australian friends is, 'Please, take Taiwan seriously'," he says. "We need moral support from the world, so that we have the confidence to go forward with this policy."

Mr Yang wants Australia to resume ministerial visits to the island, ended by the Howard government after Chinese pressure, to consider negotiating its own FTA with Taiwan, and to back its bids to join international bodies such as the UN climate change negotiations.

Australian sources are sceptical about the idea of negotiating an FTA with Taiwan. They point out that Australia's exports to Taiwan are mostly coal, iron ore, and other minerals, which face virtually no tariff barriers while Taiwan would never agree to end tariffs on Australian farm exports.

But for the world, the real test of President Ma's embrace of China is whether it becomes accepted across the divide of Taiwanese politics.

OPINION polls show only 19 per cent of Taiwanese want ultimate reunification with China, whereas 45 per cent want long-term independence, and the rest hope to preserve the status quo indefinitely. The argument is not likely to end soon.

But back at the Australian National University in Canberra, Taiwan analyst and former head of the Department of Foreign Affairs and Trade, Stuart Harris, cites a very different poll: fewer than 30 per cent of Americans are prepared

to go to war with China to defend Taiwan.

"People in Taiwan privately concede that Taiwan has to make a deal with China," he says. "They've got 99 per cent of what you need to be an independent country. Does the other 1 per cent really matter enough to risk a war?"

Tim Colebatch, economics editor, visited Taiwan as a guest of the Taiwanese government.

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Eastern economies will decelerate

THIS is the Asian century. Since 2007, the continent with most of the world's people has generated most of its growth. And despite the question marks over China, the odds are that it will keep doing so.

We knew that. On the International Monetary Fund's figures, the 2000-01 tech wreck saw the world's engine of growth shift from the G7 countries to the developing economies of Asia, mainly China and India. In the past decade, gross domestic product (GDP) in the G7 increased by 16 per cent. But developing Asia — China, India, Indonesia and so on — more than doubled its GDP, up 116 per cent.

In the past five years, say the IMF figures, developing Asia generated half the growth in the world's output. The rich countries generated 18 per cent, and the G7 just 9 per cent.

The baton was passed long ago. Why does the IMF proclaim it as something new?

It reflects a confusion between two ways of measuring countries' output. The easy way — widely used because it's so easy — is to translate each country's output into US dollars using today's exchange rate. But on that measure, output rises and falls whenever markets or governments change the exchange rates.

A more realistic measure comes from comparing prices in each country to calculate its purchasing power parity (PPP). In 2006-07, a World Bank team led by former Australian Statistician Dennis Trewin carried out rigorous worldwide price comparisons to do that. The IMF figures quoted here are based on its work.

A simple example: suppose it costs $20 to see a film in Japan but $1 to see it in India. On the exchange rate measure, the value produced in Japan is 20 times as much as in India. On the PPP measure, the value is the same whichever country you see it in.

The differences are huge. On the exchange rate measure, India and Australia have roughly similar levels of GDP. But on a PPP basis, India produces more than four times as many goods and services as we do.

But the exchange rate measure does allow us to measure the size of countries' markets in a common currency. That matters for exporters. And reducing the disparity between the two measures matters if we want to rebalance the world's economy and reduce the risks raised by large sustained current account imbalances — especially in the US.

But you can only predict future GDP levels on the exchange rate measure if you can predict exchange rates. Even the IMF can't do that, which makes yesterday's forecasts by its Asia director, Anoop Singh, pointless.

One of the odd things in his paper is a graph predicting that Asia's share of the world economy will shrink between 2000 and 2030. That's probably an error, but it reminds us that demographics will be working against east Asia, not for it.

The population of Japan is falling already. By 2030, the populations of China, Korea and Taiwan will all start shrinking. As the century goes on, these proud economic powerhouses will have to accept migrants or shrink relative to the rest of the world.

Africa, the Middle East and Latin America have begun to apply the secrets of growth. That, and their growing populations, means they will grow faster in the long term, as Asia slows.

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