Australia's twin fates

Guy Debelle yesterday painted a very convincing picture of a bipolar global economy, with the sombre outlook for the US and Europe contrasting with the buoyant Asian economies.

The senior Reserve Bank official pointed out that US and European banks had yet to feel the full effects of sharp falls in the commercial real estate values.

While he was confident the big US banks would prove resilient, he raised concerns about the smaller, more regional banks.

These second-tier banks are typically concentrated in one geographic region, and their lending is skewed towards commercial property.

If these banks get into trouble with their commercial property exposures, they could choke off credit to US companies. And the big losers will be smaller- and medium-sized companies that can't raise funding in capital markets.

Asia, in comparison, is much more fortunate. Its banks have strong balance and are continuing to lend.

As a result, Debelle said, that while short-term risks "may be on the downside in the US and Europe, they would appear to be on the upside in Asia”.

Debelle's comments are undoubtedly right.

Last Friday, on the eve of the Chinese Lunar New Year holiday, Beijing increased the reserve ratio for Chinese banks, the second time in a month the ratio has been lifted.

A fortnight earlier, Beijing ordered banks to cut back on lending because of worries that excessive growth in China, the powerhouse of the Asian region.

But there is a chorus of voices warning that the China high cannot last. Hedge fund manager Jim Chanos claims there is a massive property and fixed asset bubble brewing in China. He describes China as Dubai times 1,000.

It's not hard to understand why many believe there's a property bubble building up (The five threats to China, January 12; Top Chinese developer warns of property bubble, December 22, 2009).

Chinese banks increased their lending to more than $US200 billion, more than the total amount lent in the final three months of 2009.

A lot of this lending poured into property. As a result, property prices in 70 Chinese cities surged at their fastest pace in almost two years, to stand at almost 10 per cent higher than their level a year before.

And, as every central banker knows, it's not easy to deflate this bubble gently without plunging the economy into a recession.

There are also mounting concerns about the deep-seated imbalances in the Chinese economy.

Chinese gross domestic product jumped 10.7 per cent in the December quarter 2009 from a year earlier, its fastest clip in three years.

Investment – including building new factories, and building new office blocks – was responsible for a staggering 92 per cent of this increase, resulting in a glut of factories and office blocks. Chinese consumption managed only a slight increase.

Undoubtedly, however, the biggest short-term risk to Asian growth is the possibility of increased protectionism in the US and Europe.

Faced with stubbornly high US unemployment and a patchy economic recovery, US President Barack Obama has set the goal of doubling US exports in five years.

The problem is that the US has only limited scope to increase its international competitiveness by devaluing its currency.

In fact, the greenback has been strengthening against the euro, because the eurozone is under intense pressure due to Greece's burgeoning deficit problems.

As a result, the US will take a much harder look at what China's deliberate policy of maintaining an undervalued currency.

The United States and the European Union have already introduced some special duties on what they claim are unfairly subsidised Chinese imports, and they're likely to do more of this in 2010.

At the same time, China will come under huge pressure from both the US and Europe to allow its currency to appreciate, and to rely more on domestic consumption, rather than exports, to fuel its economic growth.

If not, it runs the risk of sparking a trade war, which will be highly damaging to its economy.

As Debelle noted yesterday the interplay between the contrasting fortunes of the US and Europe, on the one hand, and Asia on the other "is likely to be the critical factor in determining the evolution of the global economy.”

It's an evolution that we'll all be watching closely, given how closely Australia's fate is now tied to that of Asia.