It is time we intervened to hold back the dollar

OUR problem is the dollar. You can pontificate until you're blue in the face about productivity, or business taxes, or the carbon tax or cautious consumers and they're all important. But what is putting otherwise viable Australian businesses at risk now is the fact that our dollar is too high for them to compete.

On the broadest measure, the Australian dollar is now 72 per cent higher than it was a decade ago. Against the US dollar, it has almost doubled. At $US1.05 or more, it is 50 per cent higher than its long-term average of US70?, between 1985 and 2005, before the mining boom drove it up.

A high dollar makes Australian exports more expensive in the rest of the world. It makes imports cheaper here. It makes it cheaper for us to spend our money abroad as tourists or consumers and more expensive for the world to spend its money here.

If you lower the dollar, the other problems become second order issues. If you can't lower it, and it keeps going higher, then business and government may have to move hard and fast to find ways to save enterprises and the workers they employ.

That is the reality the Reserve Bank highlighted in its quarterly statement on monetary policy last week. It is the reality that has made its former board members Warwick McKibbin and Adrian Pagan urge it to try new ways to stop foreign demand for Australian dollars driving up its price.

In March, I wrote on this page that we need to talk about the high dollar, suggesting the Reserve should drop its hands-off policy, and intervene to cap its value, as the Bank of Switzerland has capped the value of the Swiss franc. That conversation has now begun, and about time.

The stakes are high: not only for our trade-exposed enterprises and their workers, but for both sides of politics. On July 1, we began living with the carbon tax that Tony Abbott has told us over and over will be "like a wrecking ball through our economy". It has become the defining issue of our politics, the prime mover for Abbott's rise in the polls and Julia Gillard's fall. Now the rhetoric of both will be put to the test.

In July, the wrecking ball failed to wreck anything. Last week the Bureau of Statistics estimated that seasonally adjusted employment grew by 14,000, and private analysts TD Securities and the Melbourne Institute estimated that inflation rose by just 0.2 per cent.

Of course, these are early days, and survey data can be wrong. But it was a preview of the potential damage to Abbott's credibility if the carbon does not wreck the economy. The polls show he himself is unpopular; if his campaign against the carbon tax turns out to be hollow, the political balance could swing sharply against him.

But the argument cuts both ways. If the economy goes badly in 2012-13 and I mean the economy of south-eastern Australia, where Labor has 60 of its 72 seats in the House of Representatives then Labor and its carbon tax will be blamed, regardless of whether or not it really caused the slump.

The Age economic survey last month found an overwhelming consensus among private forecasters that Australia would do well in 2012-13. Virtually none think the carbon tax to be a wrecking ball through the economy.

But the economic tides now are very uncertain. Even the Reserve Bank, with its well-documented tendency to be over-optimistic, now concedes the big risk is that the economy in 2012-13 will go worse than expected, not better.

Part of the reason for that, as the Reserve sees it, is Europe's inability to solve its problems. It is sanguine about China, although the anecdotes from there point to a more alarming slump than the statistics admit to. But it is also worried that the rising dollar is doing more damage than its models have forecast and in Australia too, the anecdotes point to deeper problems than the statistics so far show.

Most observers expect the Reserve to do nothing more than voice concern. It has never intervened in the markets to keep the dollar down, only to push it up. Deputy governor Philip Lowe said last month it was hard to make a case that the dollar was overvalued. But then, the International Monetary Fund disagrees, estimating that in June, when the $A was roughly at parity with the $US, it was already overvalued by 5 to 15 per cent.

What could we do? Two options stand out:

The Swiss solution: impose a cap on the Australian/US exchange rate, maybe at parity, and print dollars to sell whenever the cap is threatened. There is no limit on the Reserve's ability to create Australian dollars only the risk that they will end up back here adding to inflation, and the risk that it will become a huge holder of US dollars and other currencies.

The McKibbin solution: since the main surge in demand for Australian dollars is from other central banks buying them as safe investments, the Reserve should sell them directly to its cousins, printing dollars to meet their needs, and so taking pressure off the dollar in the markets.

I'll say it again: we need to talk about this. We should not let fear of trying something new cost us good enterprises and good jobs.

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Plain Packs: Dominican Republic v Australia

THE international legal campaign against Australia's controversial plain cigarette packaging laws is spreading, with a third country joining in a formal challenge at the World Trade Organisation.

The WTO announced overnight that the Dominican Republic, a leading cigar exporter, had joined Honduras and Ukraine in claiming that the plain packaging legislation breached Australia's commitments under global trade rules.

The case is shaping up to become the biggest trade dispute Australia has ever faced as a defendant. And while anti-smoking campaigners see it as driven by the big tobacco companies - Ukraine has not exported tobacco to Australia for years - it has the potential to overturn the anti-smoking law.

The WTO was set up to spread free trade, and defendants rarely win cases before its disputes panels. In recent times WTO panels have ordered Australia to end export subsidies (the Howe Leather case), and scrap state laws or quarantine rules to open our markets to Canadian salmon and New Zealand apples.

But the plain-packaging case is an unusual one. Observers say part of the interest in it is because it has significant implications for interpreting the Agreement on Trade Related Aspects of Intellectual Property Rights (known to its friends as TRIPS), signed in 1995 as part of the Uruguay Round.

The Department of Foreign Affairs and Trade has taken the unprecedented step of setting up a special branch-level taskforce to handle the WTO case and a second challenge, brought by Philip Morris Asia, which claims the laws breach Australia's investment treaty with Hong Kong. That case is now well advanced. A three-member disputes panel was set up in May under United Nations rules, to arbitrate on the cigarette company's claim that the plain-packaging law expropriates its intellectual property by forbidding it to use its own packaging.

Australia in reply pointed out that Philip Morris transferred ownership of its Australian arm to a Hong Kong-based subsidiary some 10 months after the legislation was announced. Critics say the move was a blatant example of ''forum shopping''.

The case before the WTO is still in the preliminary stage of consultations. Australia has refused to give ground, so the original complainants now have the option of requesting a disputes panel. That can take up to a year, and the loser then appeals, which can take another few months before there is a final ruling. Compliance with the ruling can take longer still.

The 12 countries that have joined the WTO consultations have a range of motives: three are neighbours of Honduras. Some, such as Indonesia, are significant tobacco producers; Indonesia's biggest tobacco maker Sampoerna, now part of the Philip Morris empire, withdrew its clove-flavoured Kretek cigarettes from Australia in 2009 rather than display the ghoulish warnings required by existing packaging laws.

But New Zealand has joined the case because it is considering similar legislation to Australia, and the European Union, which has interests on both sides, also signed up to the case as a neutral observer.

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Opening night at the economic forum

JULIA Gillard has renewed her push to cut company tax rates and taken aim at the states' stamp duties on home purchases, at the launch of the government's economic forum in Brisbane last night.

Opening the forum, the Prime Minister asked delegates to focus on how the nation could improve its competitiveness and increase labour mobility to ensure that Australian workers filled more of the jobs created by the resources boom.

She made it clear that despite scrapping her promise to lower company taxes, Labor would revive it if it had support from other parties. The tax cut was abandoned after the Liberals refused to support it and the Greens insisted it be restricted to small business.

"I've got no doubt the company tax rate should be lower and no doubt the revenue base has to be maintained as well," Ms Gillard said.

She linked the issue of labour shortages in the mining sector to stamp duties on real estate transactions, saying: "We've got to talk about labour mobility . . . We've got to crack this nut.

"We've worked on national licensing of professions and trades and on incentives for welfare to work, and now we're turning attention to more improvements to jobs services, and to issues like state transaction taxes on property as well."

Abolishing stamp duties on conveyancing would be popular with home buyers, who fork out $23,500 in tax to buy an average $500,000 Melbourne home. But in most of Australia, it is the third biggest source of state revenue. Victoria relies on it to fund $3.5 billion a year of spending.

The ACT government last week began a 20-year phasing out of stamp duties, which it will replace with higher property rates. The states' choices would be to increase the GST which the Gillard government has ruled out or raise land taxes, as the Henry tax review urged.

Critics point out, however, that the mining boom has had to be manned by fly-in, fly-out workers because Australians prefer to stay with their friends and families.

At the opening dinner, Treasurer Wayne Swan called on the 150 delegates from business, unions, governments and community groups to focus on improving productivity in service industries, so that they become the suppliers of choice for Asia's rapidly-growing middle class.

He urged Australians to put down partisan views and start "a mature debate about productivity" with the aim of lifting Australia into the world's top 10.

The opening session of the forum focused on the importance of Asia to Australia's economic future but also on the reforms needed if Australia is to maximise its gains from Asia's phenomenal growth.

Five sessions today, mostly behind closed doors, will debate the problems of the patchwork economy and the high dollar; innovation and collaboration in industry; investing in infrastructure; building skills and education; and deregulation and reform of competition policy.

Mr Swan announced that he would lead a business delegation to China and Hong Kong next month, to celebrate the 40th anniversary of diplomatic relations between China and Australia, and give Australia's business leaders "an opportunity to develop business links with major Chinese companies and authorities".

Mr Swan said he welcomed debate on productivity, but some claims being made "were not grounded in facts". He struck a John Howard stance, telling business leaders: "The challenges and opportunities of the Asian century are bigger than the day- to-day cut and thrust of our political debate. They're bigger than any partisan divide."

But his appeal for bipartisanship fell on deaf ears. Ted Baillieu is the only Liberal premier to attend the event, and Opposition Leader Tony Abbott dismissed it as "a carefully-scripted, choreographed event".

"She [Ms Gillard] is not interested in changing policies. She's just interested in stifling criticism," Mr Abbott said.

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High dollar. We're the second-most expensive place to do business

THE high dollar is ravaging the competitiveness of Australian business. Global consulting firm KPMG reports that Australia has become the second most expensive place to do business among the major economies, behind Japan.

In its survey of global business costs, Competitive Alternatives, KPMG finds that since 2010, costs have risen more in Australia than in any other country. Most of that is due to the sharp rise of the Australian dollar against the US dollar, which has pushed up costs in every area.

Of the 113 cities surveyed, Melbourne is now the ninth most expensive place to do business, across areas ranging from manufacturing to back office services and research and development.

Sydney is now the fifth most expensive place to do business, more expensive than New York. Among the 54 big cities in the survey, only Tokyo and Osaka put more strain on corporate profitability.

In the most extraordinary finding, Australia's electricity prices have become the most expensive of any major economy, by a long way. Electricity charges to firms surveyed were more than double those in the US and Canada, and more than 40 per cent higher than in Japan.

The Bureau of Statistics reports that in the five years to December, electricity prices shot up 79 per cent in Sydney and 74 per cent in Melbourne.

The original KPMG survey in 2010 found Australia was the third cheapest location for business of the nine Western economies surveyed.

''The Australian dollar's strength is the key driver behind the changed index results,'' KPMG Australia said. ''Australia is experiencing a once-in-a-generation resources boom that ? has boosted national income and turned around the balance of trade. A corollary has been the strong appreciation of the $A that has affected local firms' competitiveness.''

The report's authors note that ''if the currency were to decline to [the level] in the previous report [March 2010], the rankings for Australia would improve by at least 50 per cent''.

The report surveyed the US, Japan, Germany, Britain, France, Italy, Canada, Australia and the Netherlands, along with China, India, Russia, Brazil and Mexico.

Overall, China was the cheapest location for global manufacturing, and India the cheapest for global service industries. Of Western countries, Britain is now the cheapest location for manufacturing and services, and Manchester the cheapest city. Canada was the best for IT and the Netherlands the best for research and development.

In virtually every sector surveyed, Australia was the the most expensive location outside Japan. The only exceptions were in manufacturing green energy products, in which Australia was the most expensive, and digital entertainment, in which it was the fourth most expensive.

In the car industry, the higher dollar has made Australia's wages the third highest behind Japan and Germany.

One limitation of the report is that it assumes that raw materials cost the same the world over. For example, it also ranks Australia the second worst location for food processing, due to the same mix of high wages, transport and utility costs. In the real world, access to cheap farm-gate produce offsets that.

Against comparable US cities, Sydney was uncompetitive as a location in every sector surveyed. Sydney was the most expensive of any of the 113 cities for biomedical research and development, clinical trials and software design.

Australia had many strengths, including the top rating for ''overall wellbeing'', and high ratings for government, transparency and the rule of law. But often the strengths were not turned to our advantage. For example, Australia ranked second for access to university, but 11th in local graduates. It had the fourth highest public research and development spending, but ranked 10th for commercial innovation.

All four Australian cities surveyed were in the world's 10 most expensive locations. Adelaide (10th) came in marginally cheaper than Melbourne (9) and Brisbane (8), with Sydney (5) bringing up the rear. Chengdu in south-western China was the cheapest location, followed by Chennai, Shanghai and Mumbai.

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It'd be a brave PM who pulled the plug on Holden

YOU can have a car industry with taxpayer subsidies. Or you can save taxpayers' money and scrap your car industry. There are good arguments for either policy, but you can't have a car industry without subsidies.

That was the choice facing the Gillard government, and its decision was obvious. Holden is an Australian icon. Its Adelaide plant produces two of the four biggest-selling cars in the nation. It would be a very brave Prime Minister who pulled the plug on Holden.

Why do we have to pay to have a car industry? Because the world does. In Germany, Britain and the US, governments subsidise car plants because they bring not only the jobs of their workers, but far more who make their components, or benefit from the flow-on of all that spending through the economy.

Australia has probably the most open, trade-exposed market of any country in which cars are designed and built from scratch. The average tariff on imports is just 3.5 per cent. In a market of a million cars each year, there are twice as many brands competing as in the US and Japan.

The question is: do we want Australian-made cars to be part of this? Yes, the public says whenever the pollsters ask. Yes, John Howard said when he faced the issue in 1997 and 2002. Yes, Kevin Rudd said in 2008, when he set out the $3.4 billion Automotive Transformation Scheme to roll out support to 2020.

No, the economic rationalists say. They argue that if there is no prospect of Australia's car makers being able to survive without government subsidies, we should cut them off now. In effect, the government will pay almost 20 per cent of the cost of Holden's new models: what other industry receives such support?

That depends how you look at it. Former industry minister Kim Carr used to say Australians pay the cost of a footy ticket a year to support the car industry: $17 a head. That is well short of what we pay to support the mining industry: the diesel fuel tax rebate alone now costs us about $2 billion a year, or almost $100 a head, with far less flow-on to the economy.

Gillard had no choice. Manufacturing is being hammered by the high dollar, and Holden would have left town without support. To let go of Holden would be to say goodbye to manufacturing, and send south-east Australia into an economic maelstrom.

The tough choices are what to do about all the other firms whose profits are being torn to shreds by the high dollar. The answers there are less obvious, but even more crucial.

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Nation's growth at crossroads

AUSTRALIA is heading for a fifth consecutive year of below-trend growth in 2012, with weakness in most of the economy offsetting spectacular growth in mining investment, Westpac chief economist Bill Evans predicts.

As the nation's commodity price forecaster told farmers that 2011-12 will be as good as it gets for farm incomes, Mr Evans, the first last year to tip that the Reserve Bank would have to cut interest rates, said the Reserve will deliver two more rate cuts in 2012 as job losses mount.

Speaking at the Outlook conference of the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES), he predicted that Australia would grow just 3 per cent in 2012, with unemployment rising to 5.75 per cent.

Mining investment would be ''spectacular'' but 40 per cent of it would go on imports. Household spending would be held back by the ''very unnerving'' combination of ''world-class'' household debt and falls in the value of the real estate assets supporting it.

''We need lower interest rates to arrest that disturbing trend,'' Mr Evans said. ''That would help with the labour market. I don't think Australia needs the highest rates in the Western world.''

Unveiling ABARES' annual forecasts, executive director Paul Morris said farmers are now enjoying ''the most positive incomes for about 30 years'' and should use their time at the top of the hill to plan for tougher days ahead.

Mr Morris urged farmers to focus production on ''the highest-value markets, the middle-income countries to our north''. They want to eat more meat, fruit and vegetables, he said, which implies that farms should move away from cereals back to sheep and cattle.

The conference heard sharply different short-term forecasts for the world economy, although similar concerns for the medium to long term. Mr Evans predicted China's growth would slow to 7.5 per cent this year, bringing world growth down to 2.8 per cent - apart from 2009, its weakest year since the ''tech wreck'' of 2001.

But chief economist of J.P. Morgan in New York Bruce Kasman said the world economy is lifting already, with the US likely to grow at 2.5 per cent to 3 per cent, and China growing at 9 per cent by mid-year.

But he warned that this was under threat from the ''unsustainable'' budget cuts demanded in Europe and from the political impasse in the US over deficit cuts.

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Recession a risk in slow lane of two-speed economy

TEN years ago, mining investment in Australia began rising sharply. By 2005-06 it had trebled in just five years. Over the next five years it doubled again. On current plans, it will double again in just two years to mid-2013.

It is being driven by what Treasury deputy secretary David Gruen calls ''a once-in-a-lifetime boom'' in commodity prices and Australia's terms of trade: the ratio of the prices of the things we sell overseas to the prices of the things we buy overseas. We all know the story, but even so, the numbers are staggering.

The terms of trade index has almost doubled, from 66.2 in June 2003 to 131.5 in September 2011. In other words, the same volume of exports today buys us twice as many imports as in 2003.

The Reserve Bank's index of commodity prices in $US has shot up from 34.2 in June 2003 to 157.0, last August, before ebbing back to 142.0. That means that a typical tonne of coal or iron ore exports today earns its owners four times as much as in 2003.

And where commodity prices go, the $A follows. Between 1985 and 2005 it averaged 70 US cents. In the past year, it has averaged $US1.05. That's made local production 50 per cent more expensive in $US, and imports 33 per cent cheaper in $A. So firms are shutting down and jobs are going overseas.

The scale of this shift is colossal. And it is a tribute to our policymakers, and the policy framework they inherited, that Australia has kept on the rails. Past resources booms always ended in tears, because inflation got out of control. This time the Reserve has focused on keeping inflation down and, apart from a flare-up in 2007-09, has succeeded.

There has been a price for this. The economy is growing more slowly; Australia's average growth since 2004 has been 2.75 per cent, or just over 1 per cent per capita. We're still stuck in third gear. Unemployment is back over 5 per cent, low in our terms, but well above the 2 and 3 per cent of success stories such as Singapore, Korea and Norway.

But there's been a bigger cost that policymakers are reluctant to admit, or tackle. Australia has fractured into two economies.

The growth is overwhelmingly in minerals development, in Western Australia, Queensland and the Northern Territory. The south-eastern states - Victoria, New South Wales, South Australia, Tasmania and the ACT - are now going backwards on some indicators, growing slowly on others. Australia has been a two-speed economy since 2005, but now the two speeds are 100km/h on one side of the country, and 10km/h on the other.

Treasury anticipated this. In a recent speech, Gruen said its budget forecast of 4 per cent growth in 2011-12 assumed the non-mining economy would grow just 1 per cent. The first forecast was way out. Economic growth is now likely to be between 2.5 and 3 per cent, which implies the non-mining economy is virtually flat.

The pain is being felt where the non-mining economy is concentrated: in the south-east, where two-thirds of Australians live and work. The risk of recession in south-eastern Australia is now real. In the past year, that two-thirds of the country has seen falls in jobs, job vacancies, newspaper job ads, construction activity, home building approvals, retail sales volumes, and now, a sizeable drop in business investment plans. Growth is almost at a standstill. What should the government do? The word from Treasury and the Reserve is: do nothing. High mineral prices are here to stay, maybe for a decade, maybe for many decades.

That implies that the high dollar is also here to stay. It may not stay quite as high as it is now, but their message to business is: if you can't find a way to compete with the dollar at something like parity (with the $US), you'd better find another life.

(To be fair, Treasury secretary Martin Parkinson told a Senate committee last month the best way to help manufacturers is to improve education, workplace relations, management skills and infrastructure. But all of them are things we want to do whether manufacturing is in boom or bust. For manufacturing, Treasury's advice is: do nothing.)

If Treasury and the RBA are right in assuming that mineral prices and the dollar will stay high, then their advice makes sense. Australia's car industry cannot compete globally with the dollar at parity. To try to keep it going would be expensive, and probably futile. Better to cut it off now and retrain its workers for jobs elsewhere.

But there are two problems. First, this advice is based on forecasts, not facts. Treasury and the RBA have not covered themselves in glory in recent forecasting; it's a long time since either has got a call right. They're human like the rest of us.

Chris Richardson of Deloitte Access Economics once called it ''a pure punt that China and India will keep growing faster than the world's miners can keep digging deeper''. It is a gamble that the global supply of minerals will never catch up with the growth in demand. And that's a big gamble.

If it's right, then you save money you might have spent trying to salvage industries that are beyond saving. But if it's wrong, the manufacturing firms you shut down will not come back. We would permanently lose economic capacity that we will need when mineral prices subside.

The second problem is that by doing nothing, you risk sending Melbourne, Sydney and two-thirds of Australia into recession or near-recession, so that the Pilbara and Bowen Basin can be developed at top speed. That is not just bad economics. It is bad politics.

Let me try a forecast: if that's Labor's policy, it will end 2013 back in opposition.

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Car exports slump

AUSTRALIA'S car exports have crashed to their lowest level since 1998, as the high dollar and the loss of foreign export contracts has left car-makers battling to keep a toehold in the global market.
The Bureau of Statistics said exports of built-up cars earned $1.35 billion in 2011, a shuddering 63 per cent fall from the $3.69 billion three years earlier.

Holden has been the biggest victim, after General Motors ended exports of Commodores to the United States to protect jobs at its US plants. From 56,140 cars exported in 2008, Commodore exports shrank to 7811 in 2010.

But last year's victim was Toyota, now the only significant exporter of Australian-made cars. In 2008 it produced record exports of 101,668 Camrys and Aurions, but that dropped to 82,630 in 2010 and then to just under 60,000 last year.

Toyota spokeswoman Vesna Benns said the loss of $A earnings was even bigger, since export contracts are written in $US, and the $US has fallen sharply against the $A in the past year. Toyota's total export earnings, including sales of accessories, slumped from roughly $1.5 billion in 2010 to $1 billion in 2011, she said.

Total exports of Australian-made cars have fallen from a record 162,000 in 2008 to about 70,000 last year.

But total Australian exports grew 10 per cent in 2011 to a record $313 billion, with most of that growth coming from minerals, and the rest from farm exports. Imports grew 9 per cent to $294 billion, and the trade surplus rose from $15 billion to $19 billion.

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Australians taking strong dollar out of the country

THE high dollar is driving Australians out of the country. In April, there was a stunning 20 per cent jump in the number heading overseas, with almost 700,000 flying out.

In breathtaking evidence of how the high dollar is shifting Australians' spending overseas, the Bureau of Statistics reports that three Australians went overseas in April for every two overseas visitors coming here.

Unreported bureau figures this week suggest that even before the April surge, more than a fifth of the growth in consumer spending in the March quarter was spent overseas by Australian tourists.

While the national accounts showed household spending up 3.4 per cent in the year to March, the detailed figures suggest the growth in household spending within Australia was only 2.8 per cent.

In the March quarter, consumer spending locally grew only 0.46 per cent. Yet in a year, net consumer spending overseas almost doubled, rising in real terms from $1.05 billion to $2 billion.

These figures exclude online purchasing from overseas websites, so actual growth in local spending was even lower.

The shift of consumer spending overseas is accelerating. Visitor arrivals in Australia grew only 3 per cent in April, and were down 3 per cent in the April quarter.

But Australians are making the most of the strong exchange rate, taking their dollars overseas, and spending them when they buy more.

A record 78,000 Australians spent April in Indonesia, which is challenging New Zealand (93,000) as our top overseas destination.

But there were also record departures for the United States (71,000), Thailand (46,000), China (33,000), Fiji (29,000) and almost everywhere else - except Australia.

The high dollar discourages foreigners, since their currency buys less in Australian stores, hotels and restaurants. In April, only 462,000 tourists came here but more than 690,000 Australians travelled overseas.

Year on year, tourist arrivals rose by by only 19,000, whereas Australian tourist departures rose by 137,000. The growth in arrivals is mostly from Asia, where soaring airfares have diverted tourists from America or Europe to nearby Australia.

Tourism and Transport Forum chief executive John Lee expressed alarm at the trend and urged the government to give tourist operators transitional help with the carbon tax.

''If international aviation is exempt, but the tax applies to domestic travel, that will encourage more people to head overseas, as travelling locally will be relatively more expensive,'' Mr Lee said.

The strong dollar had already meant that fewer Australians were taking their holidays in Australia, he said.

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Benefits from free-trade pacts are merely 'modest'

THE Productivity Commission has damned the government's focus on regional and bilateral free-trade agreements (FTAs) with the faintest of praise. It finds the gains from past FTAs were exaggerated in rhetoric but modest in reality.

In a draft report, the commission proposes big changes to Australia's and the world's approach to free trade negotiations. It urges a shift away from the Doha Round and bilateral FTAs to more flexible, industry-specific deals.

Between 2003 and 2007, the Howard government negotiated FTAs with the United States, Thailand and Singapore. The Rudd government negotiated FTAs with the 10-member ASEAN group and Chile. And the Gillard government is now negotiating FTAs with China, Japan, Korea, Malaysia, regional FTAs with about 20 other countries, and is considering FTAs with India and Indonesia.

But the commission's draft report suggests the negotiating effort going into all this could be better spent elsewhere. It urges the government to consider "alternative measures that could deliver similar or greater benefits at less cost".

The report, co-written by former World Trade Organisation deputy director-general Andrew Stoler, now at the University of Adelaide, found some evidence of benefits for Australian exporters from past FTAs, but only modest ones.

"The commission has found that expectations of the benefits have been optimistic," said commissioner Patricia Scott.

As always, the commission advocated unilateral tariff cuts and trade liberalisation as the best policy. But the report also proposed a new set of approaches to trade reform:

Without abandoning the Doha Round, consider joint moves with "like-minded countries" to reduce trade barriers in specific sectors once a "critical mass" of countries has signed on as when barriers were removed on IT products in the 1990s.

Negotiate simpler mutual-recognition agreements with other countries to liberalise access to services, bilateral investment treaties, and even a services-only FTA with the European Union.

Simplify future FTAs by scrapping side issues such as government procurement, intellectual property where the US FTA took us backwards by extending copyright to 70 years labour standards and competition policy.

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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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Sands of politics drift over the hard bits

THE Henry report has drawn up a vast agenda of potential reforms to our tax and welfare system. From that, the Rudd government has delivered one big reform, one small one, and a third which Team Henry opposes.

That was predictable. The Government agreed to the tax review under prodding from business and the 2020 summit. But it was never willing to take on a big tax reform agenda as Bob Hawke and Paul Keating did in 1985, or had a political strategy to deliver one.

What we've got instead is classic Rudd: a package to deliver benefits to the many, paid for by taking money from the top end of town, with the rest of Henry's reform plans either shelved or ruled out.

Treasurer Wayne Swan excuses this by describing Henry's work as a 10-year reform agenda. But most governments don't survive that long. If they do, new topics take over the stage, and unfinished business gets pushed aside.

Swan has flagged two more reforms, to reduce tax on income from savings, and to relieve us of the need to fill in a tax return. The risk is that, with these marketable parts of Henry's plans delivered, the more difficult bits will end up buried in the sands of politics.

Labor's big reform extending the resource rent tax to mining is fine in principle. Mining is not like other industries. A factory, a farm, a shop or an office can keep adding value to the economy indefinitely. Mining is one-off. It generates income by depleting the nation's capital our stock of mineral assets.

There's nothing wrong with that. There's no point in leaving assets in the ground. But apart from coal, there is no risk that our minerals will be left in the ground. They will be mined some day, and if that is 20 years away, logic suggests they will be more valuable then than now. There is no benefit in mining them now rather than later.

As Rudd and Swan argue, those assets belong to the Australian people. As they can be mined only once, we are entitled to a good return. You can argue over whether 40 per cent is the right rate, but this is the right tax.

It would be even better if the money was channelled into a long-term infrastructure fund, so that one form of the nation's capital wealth is used to create another. But only a bit of it is going to infrastructure, while the rest will pay for increased superannuation, cuts to the company tax rate, accelerated depreciation for small business and probably for cuts to taxes on savings, yet to be unveiled.

The government says the cut in company tax from 30 to 28 per cent of profits will make non-mining business better off. Not by the time their superannuation guarantee payments are lifted from 9 per cent of wages to 12 per cent, it won't.

Back in 1995 Paul Keating's plan was that workers themselves should pay that extra 3 per cent, with the government chipping in another 3 per cent. In other countries, employers and workers share the cost of providing for the workers' retirement income.

And so they should. Why make Australian business globally uncompetitive by making it pay the workers' share?

The next steps for Swan are the savings and simplification reforms. Team Henry came up with an ingenious plan to improve the tax treatment of bank savings (highly taxed), capital gains (lightly taxed), negative gearing and margin trading (both highly subsidised) by a 40 per discount on income and losses alike, across the board.

This would reduce the tax paid by savers, and reduce the tax rorts for those using debt to reduce their tax. But Team Henry's clever plan was blocked by Team Rudd.

Reforms work by using handouts to sweeten the tough reforms. Swan appears to be gearing up to give us the handouts without the medicine.

A once-in-a-generation opportunity for tax reform looks like being buried in the sands.

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What's the us free trade agreement worth to us? Take your pick

There are three economic studies of the Australia-US free trade agreement. One estimates it will raise Australian incomes by $52.5 billion over the next 20 years. A second says it will make us $47 billion worse off. And a third estimates that, at best, it will generate a tiny gain of $53 million a year.

The first, of course, is the report commissioned by the Australian Government. Carried out by Canberra's Centre for International Economics, it stunningly argued that most of the agreement's benefits would come from removing the need for most US investments in Australia to be approved by the Foreign Investment Review Board.

The CIE report estimated that while removing trade barriers would give Australians $16.5 billion more to spend over 20 years, the minor change to investment rules - except for real estate investments, FIRB is a rubber-stamp authority that on average rejects one proposal a year - would generate gains of more than $50 billion over the next 20 years.

The report's reception was summed up by Professor Ross Garnaut's devastating putdown that it fails the "laugh test". In the real world, you don't get new greenfield investment of $3 billion a year from a minor change to investment rules.

The second report, by contrast, was commissioned by Australian Manufacturing Workers Union. Carried out by Melbourne's National Institute of Economic and Industry Research, under its director Peter Brain, it too took an unexpected tack, but one based on one of the most useful concepts in economics: opportunity cost.

The opportunity cost of doing something is the loss of the benefit you would gain from doing something else instead. Instead of spending $10,000 on an overseas holiday, for instance, you could repay $10,000 from the mortgage and have that benefit plus the savings in interest. And it's a concept that applies equally well to everything you do in life.

To Brain, the opportunity cost of the free trade agreement is that it will prevent Australia developing into a knowledge economy. He focuses on an area ignored in public debate: the restrictions the FTA imposes to prevent future Australian governments operating an industry policy.

Future governments will be forbidden to give preference to Australian firms in contracts, forbidden to require local content (or "offsets") in contracts with US firms, and of course, unable to prevent up-and-coming Australian firms being taken over by US rivals.

In Australia, the conventional wisdom assumes for ideological reasons that government intervention must worsen economic outcomes. Hence the FTA's restrictions on industry policy have passed virtually unnoticed; even Labor has made little of them.

But Brain points out that, in the real world, in all the success stories from Japan and Taiwan to Ireland and China, governments took a leading role to drive economic development. They negotiated the transfer of technology, created leading edge high-tech companies, got finance, resources and export support to growth firms, and protected home-grown intellectual property.

Despite the huge difference in their bottom lines, Brain and the CIE do agree on two things. Both believe the tariff reductions will work to Australia's benefit, mostly in agriculture. And both expect the agreement to create a small but noticeable "dynamic effect" in which increased competition lifts productivity.

There are two problems with Brain's modelling. He sees the killer cost coming from a new review body making pharmaceutical benefits far more expensive, as US drug companies get expensive drugs listed and keep out generics.

But the Australian Government insists that the review body will be outside the decision-making stream, and all decisions not to list drugs for benefits will be made, as now, by the Pharmaceutical Benefits Advisory Committee.

OK, the US Government has presented a very different spin, saying the new deal will raise prices (and hence US profits). And our Government has yet to explain who will be on the review body, and how it will work. But unless the Government has lied to us, it is hard to see how the changes as outlined could make more than a marginal difference to the cost of the scheme.

The second problem is that Brain's approach assumes that some future Australian government would want to follow the kind of policies he and I support. He's a more optimistic bloke than I am.

The third report was released last week by the Labor-led Senate committee on the deal, and produced by former Productivity Commission economist Philippa Dee, now of the Australian National University.

Labor is basically sitting on the fence deciding which way to jump, and appropriately Dee produced a neutral bottom line, picking apart the CIE's analysis and cutting the annual gains to "a mere $53 million a year . . . a tiny harvest from a major political and bureaucratic endeavour".

The Howard Government in turn will produce a reply picking apart Dee's analysis. Labor is still likely to support the FTA. But the intriguing question is what would happen if an election is called first, Labor wins, and then John Kerry unseats George Bush.

This free trade agreement might never become reality.

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