China clouds the federal budget

Australia's key trading partner looks set for trouble and our budget is heavily based on China remaining stable.

Summary: The fortunes of China are key to the 2016 federal budget, because estimates contained in the budget papers are predicated on continued strength of the Chinese economy – we must keep in mind that our fortunes are intertwined closely with China not only in terms of mining but also food, agriculture and property.

Key take out: Soros Fund Management’s George Soros is predicting a hard landing in China as debt piles up – and this, more than superannuation or negative gearing, is likely to have a bigger impact on the budget.

Key beneficiaries: General investors. Category: Australian economy.

Normally I don’t comment on the budget in the week prior to its introduction. However, given the amount of leaks and pre-budget announcements, let me look at a few alternative strategies that are emerging and then we’ll line them up in my budget coverage in the special Wednesday edition after the Canberra lock-up next week.

Apart from specific measures, the budget outcome is closely linked to the fortunes of China. My view has always been that China will get through but I have long been an admirer of George Soros’s ability to pinpoint national weakness so I want to alert you to his China warnings. 

What the leaks indicate on super 

In its pre-budget announcements and leaks, what the government appears to be telling us is that they are going to make it tough to get money into superannuation but if you have money in superannuation and this is in pension mode, it will be tax free. 

This is a particularly stupid way of handling superannuation because the majority of people wanting to live off superannuation in retirement make most of their contributions after the children have been educated and the house mortgage reduced or eliminated. That’s what I did. 

We will be watching the budget, but it would seem that is the way the Liberals are headed. And if that is what Treasurer Scott Morrison implements, it will make housing the main avenue of tax advantage savings in Australia. 

On the other hand, the ALP, which is running neck and neck with the government in the opinion polls, has a different strategy. 

The ALP says it will tax superannuation in pension mode and doesn’t appear to want to change the restrictions on contributions to superannuation. However, unlike the government, they are substantially reducing the attraction of residential investment. They will do that by confining new negative gearing proposals to new housing and none will be allowed in the future on existing housing stock – and they will also halve the capital gains concession. Housing will become far less attractive as an investment.

CGT and the investment focus of Australians

I think that more important than Labor's proposed negative gearing change is the capital gains change, because without the current capital gains concession housing prices would be a lot lower than they are today. So we are facing a situation where the result of the election will substantially change the investment strategies of Australians. This is not a pleasant situation because at least in the past we have had a degree of consensus on investment planning rules.

When it comes to budget time, the Treasurer might do things slightly differently to what we expect, but normally the leaks that are made the week before the budget are fairly accurate. 

China's "hard landing" could hurt us

Important for the budget will be what happens to the iron ore price and the Chinese economy. This week I was reminded by George Soros that sometimes you see a trend developing and it can take many years before the dangers inherent in that trend become an actuality. 

So Soros points out Paul Volker isolated the dangers in the US economy many years before the global financial crisis, but his warnings were almost forgotten when the crisis hit the fan. 

Soros equates the dangers he sees in the Chinese economy with the Volker warnings about the US. 

Arguably George Soros is one if the best judges of currency and country risk in the world. In 2013 his Quantum Fund made $US5.5 billion, making it again the most successful hedge fund in history. Since its inception in 1973, the fund has generated $40bn in profits. 

Who can forget September 1992 in the UK when Soros's fund short sold more than $US10bn in pounds sterling?

Soros's profit on the bet was estimated at over $US1bn and he was dubbed "the man who broke the Bank of England". Then, in 1997 he short sold the Thai baht and the Malaysian ringgit and made another killing, which led to the Asian financial crisis. In each case he could smell weakness. Now he senses deep weakness in China. 

The “parabolic” rise in credit in China reminds him of what took place in the US around 2007-2008. Soros says that most of the money the local banks are supplying to the Chinese economy is needed to keep bad debts down and keep afloat loss making enterprises — the so called zombie enterprises. He says it’s “a great red Ponzi scheme”.

Soros says each time the Chinese undergo an extra stimulation, they have to borrow more money and it becomes more and more expensive. Last year when the Chinese economy was slipping away and unemployment was beginning to rise, the Chinese concluded they had to undertake another round of conventional stimulation. And in China, according to Soros, such stimulation means “lighting the furnaces” and so that is what they did. Iron ore stocks had run down and so when China began lighting its blast furnaces it boosted demand for iron ore. Of course they also need to use the steel somewhere, so a whole raft of infrastructure building projects would be started to use up the steel. 

Most of those projects will be of marginal value. 

Soros believes that “it is practically unavoidable that there will be a hard landing in China”. He believes in the current round of stimulation, via lighting the furnaces, means that China is attempting to inflate its economy by reviving some zombie companies that have already died twice. 

He believes that this can only end badly. Of course George Soros can be wrong and the Chinese have so far been very skilled at keeping their economy running, but the sharp rise in the iron ore price which was linked to this new stimulation strategy (the price has softened in recent days) was disturbing.

Clearly traders were involved and the Chinese are trying to clamp on such activities. It was interesting that BHP, close to the peak, made it clear that they didn’t think the recent iron ore price was sustainable. 

All of us in Australia need to understand that we are now more dependent on China than we have been on any country expect for the days when we were in the British Empire. Not only is our mining industry intertwined with China but so is our food, agriculture and property development. 

All the budget estimates that we will read about next week are all predicated on the fact that China doesn’t run into serious problems. Nevertheless, we must take George Soros seriously because he has a formidable record of making long-term predictions that eventually come true.