Pacific Money

China and Australia’s Coming Economic ‘Divorce’

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Pacific Money

China and Australia’s Coming Economic ‘Divorce’

Why “decoupling” may be the new buzzword as both nations rebalance their economies.

In an interconnected world, “decoupling” is the idea that it’s possible for one country to avoid the transmission of economic pain from another. It holds that, although an emergent economy may have depended on its more mature neighbors as export markets and sources of investment, eventually it will strengthen to a point where it breaks free from that dependence, such that a crisis or shock in the latter will not affect it adversely.

The most recent debate about decoupling occurred as Western economies faltered in the wake of the 2008 financial crisis. Many analysts believed that economies – especially those in emerging Asia and Latin America – would be able to avoid the severe pain and disruption in the so called “advanced economies”. The jury is still out on whether this was worked. The collapse of demand in the United States and European Union produced serious economic pain for those nations reliant on exports or those in the international manufacturing and supply chains that serve developed markets.

The main success story, looking only at GDP growth rates alone, was China. After a brush with growth collapse in late 2008 and early 2009, Beijing introduced a massive investment-fuelled stimulus program, along with 3 years of monetary easing. Chinese GDP quickly recovered and only started to slow in 2011.

History will judge whether or not China truly “decoupled”. While growth picked up, many economists and leaders both in and outside China remain concerned that the stimulus was basically a “shot of adrenalin” that did nothing to address underlying structural imbalances. Indeed, it may have exacerbated the problem. (For the record the writer is in this camp)

Whether China’s current slowdown is a cyclical dip, or whether it’s the beginning of a long, gradual, Japanese-style slump, is one of the most pressing questions for today’s economists.

And now a new question has arise: will the economies that have been relying on China be able to decouple if its GDP growth continues to weaken?    

Australia is a good example. Unlike the U.S., which runs significant trade deficits with China, Australia has enjoyed Chinese demand for commodities and raw materials, in particular iron ore. Mining magnates took advantage of China’s soaring property, infrastructure and manufacturing demand for iron and steel; the process has also boosted the government budget. Firms such as BHP Billiton and Rio Tinto rode the “resources boom” and made record profits for years. Then, as China’s investment-heavy stimulus kicked in, Australia began to run net trade surpluses. Now, with China’s slowdown lengthening and its steel industry in trouble, these firms have been left facing excess capacity, overinvestment and a collapse in prices. 

The Australian economy has become so bound up with China’s fortunes that many investors use Australia as a proxy-play on China’s economy. Investors bet on China’s strength by speculating on the Australian dollar, since its value is closely linked to the China’s demand for Australia’s exports. With China’s recent slowdown likely to continue into a seventh consecutive quarter, things are getting a little bit tough for Australia’s federal government. As China has slowed, Australia’s trade account has fallen further and further into deficit – now at a 3.5-year high.

Yet Australia has a “natural hedge”: a fall in Chinese demand will weaken the Australian dollar, giving a competitive boost to firms exporting non-resource products and services, and who have been suffering under the high interest rates that accompanied the resource boom. Further interest rate cuts will also give a boost to certain sectors of the Australian economy, such as housing.

While China definitely needs to rebalance its economy, it seems that Australia may be on the verge of doing the same. Decoupling needn’t be tumultuous if policymakers act in time, rather than having their hands forced.