China's Pain Is Not Australia's Gain

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Double-digit growth rates for the world's second largest economy are, more or less, over. During the second quarter, China's economy expanded 7.5% over a year earlier. Most countries would kill for a performance like that. But, for a global economic powerhouse like China that delivered real annual GDP growth of nearly 10% through 2012, it's a bitter pill to swallow.

So, what went wrong? And more importantly, what's the upshot for Australia, one of the Asian giant's closest trade partners?

China's success story

China's emergence as an economic superpower was mainly driven by large-scale capital investments (financed by mountainous domestic savings and foreign direct investments), cheap labor force coupled with an undervalued currency that skyrocketed its exports, and blistering productivity growth – the result of deep economic reforms and a genuine ability to soak up foreign technology and know-how.

Even the 2008 fiasco that wreaked havoc on major economies around the globe didn't quench the Red Dragon's flames. Its crucial export sector hit a wall as global demand crumbled and many Chinese workers were left high and dry, but after a massive $586 billion stimulus package and a looser monetary policy, China returned to double-digit growth rates in 2010.

What went wrong?

Yet, the country's economic model hid a multitude of sins. China's investment-obsessed, credit-fueled system on top of its incomplete transition to a market economy, gave government-favored corporations the upper hand. Subsidized state-owned enterprises gobbled up credit while carrying on strategies that served government interests and often made light of returns on investment.

Moreover, despite the whopping growth rates, disposable income relative to GDP tailed off and so did private consumption. Inadequate social safety nets forced households to save more and spend less. Meanwhile, rock-bottom interest rates kept returns on banking deposits low.  Not to mention, accelerating average real wages and an alarmingly aging population erode its biggest competitive advantage, its cheap labor.

More importantly, since 2009, out-of-control credit growth has been fueling inflation and asset bubbles, driving China's leaders to put a lid on several forms of traditional borrowing, including bank-issued mortgages. Shadow banks unconventional nonbank lenders subject to limited oversight jumped at the chance and offered loans to small and medium-sized companies that are cold-shouldered by large state-run banks. And, often, these loans are packaged and sold to investors looking to make a killing.

Recently, interbank and money market rates reached nosebleed highs as Chinese leaders decided to take a hard line with speculators and keep tabs on behind-the-curtain lending. But the government's attempts blew up in its face. Banks remained reluctant to lend to each other and fears of a cash squeeze put a dark cloud over the economy. 

The side effects

China's thorny shift toward a more balanced economy that's less dependent on fixed investments on top of last month's soft trade data have left its trading partners sort of up the creek. Australia is sitting on pins and needles as it is China's No 1 source of iron ore and coal.

So far this year, iShares MSCI Australia Index (NYSEMKT: EWA), which provides broad exposure to Australian equities, has been going down quite a rocky road. Over the past decade, China's immense infrastructure spending propelled this fund's mining holdings to record highs. But, choppy economic data from China, sinking commodities prices and sluggish demand have taken a toll on Australian stocksLooking ahead, heavy capital spending is no longer an option for China and mining companies, as well as the Australian economy, need to roll with the punches. China's trade surplus took a 14% nosedive in June compared to last year while its iron ore imports dropped to 62.30 million tons – the lowest in four months.

Yet, during the fiscal year through June 2013, BHP Billiton (NYSE: BHP) , a world-class mining company, ramped up its iron ore output by 7%. Not just that, but also it's really keen on expanding its operations in its Jimblebar mine and in this way swell its annual iron ore production capacity to a record 220 million tons. Does BHP know something that we don't? Apparently, the bellwether miner is doing its best to keep a firm grip on the market and maximize economies of scale while smaller industry players are about to bite the dust.

What about the Aussie dollar?

On the Forex front, things are not looking that good for the Australian dollar. Earlier this year, the Reserve Bank of Australia (RBA) chopped the benchmark cash-rate target to an all-time low of 2.75% as continuing pressure from a strong currency weighed on the nation's manufacturers and exportersMeanwhile, “tapering,” the latest buzzword, pushed the USD higher against the Aussie dollar. But, more importantly, given the trade ties between China and Australia, the Australian currency is highly sensitive to China's economic performance. Thus, it's no wonder it hit the skids this year.

On the plus side, Australia's export sector, including BHP, could eventually benefit from a weakening currency. EWA is also well-positioned to cash in on this trend as the mining giant is one of its major components. On the other hand, placing a bet on CurrencyShares AUD Trust (NYSEMKT:FXA), which tracks the price of the Australian dollar, is probably not the wisest thing to do, at least, for now.

At a July 2 meeting, the RBA eased fears of an additional cut, which would make the currency less attractive to investors. Nevertheless, it all depends on how the domestic economy performs. Traders are pricing in an around 60% chance for another interest rate cut next month, when the board meets again. And if, going forward, China's performance does not meet expectations, FXA could go downhill.

Looking ahead

Barclays Capital says that China's quarterly growth could drop to 3% at some point over the next few years. So, the million dollar question is whether China's freshly established government will be tempted enough to boost the economy using stimulus packages. Given the fact that credit expansion has gotten out of hand and inflationary pressures fueling asset bubbles is the last thing China needs right now, this scenario is highly unlikely.

The Asian giant has too much on its plate right now trying to move away from fixed investments and focus more on consumer demand. This might translate into slack GDP rates over the medium term. But, over the long run, a more balanced Chinese economy will get us all out of harm's way. The rest of the world, and particularly Australia, will have to come to terms with a less dynamic but more stable Chinese economy. 


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