Rates may favour Rudd but China is the key to Australia's economy

Interest rates have been kind to Kevin Rudd the campaigner. They were going up when he first ran for PM in 2007. That year, the Reserve Bank took the controversial decision to lift rates during the election campaign, delivering an electoral blow to Rudd's opponent, John Howard.

Now, there is a good chance that rates will be cut in the prelude to Rudd's 2013 campaign to levels not seen in 50 years.

There is a strong case for the Reserve to reduce rates when it next meets on August 6. Business confidence is frail, unemployment is creeping higher and there are fresh concerns over China's economic outlook.

The latest inflation figures, released on Wednesday, left the door open for another cut. The underlying rate of inflation in the year to June was 2.4 per cent - in the middle of the Reserve Bank's target range of between 2 and 3 per cent.

"Things are a bit soft at the moment," says HSBC chief economist and former Reserve Bank official Paul Bloxham. "With inflation low, I think we will see the RBA deliver another rate cut as soon as they can."

If Bloxham is right, it will be the eighth cut in interest rates in 21 months.

An August rate cut would hand Rudd a useful economic narrative on the cusp of a tight election campaign. It would be especially valuable in the key electoral battleground of western Sydney, where levels of household debt are high.

Economist Stephen Koukoulas, an economic adviser to Julia Gillard in 2010 and 2011, says Labor has not made enough of the very low level of interest rates. "They didn't take ownership of low interest rates even though we know it's such a sensitive issue and the household sector is still carrying a fair amount of debt. They didn't thump the table about it the way John Howard and Peter Costello did."

Rudd and new Treasurer Chris Bowen are likely to campaign much more aggressively on low interest rates.

"My hunch is they will milk it for all it's worth," Koukoulas says.

But super-low interest rates are a sign of the difficult economic transition under way in Australia as the effects of the mining boom fade. Ideally, other economic drivers such as housing investment and consumer spending will emerge to sustain growth. But there are well-placed fears those alternative growth boosters will not be nearly strong enough to compensate for the minerals boom.

Rudd has already signalled managing this transition will be a key theme of the election campaign. He told the National Press Club earlier this month: "Australian Labor governments know how to manage the great transitions in our economy."

It is likely that economic figures released during the next few months, including gross domestic product and jobs data, will be weak and this could influence debate during the election campaign. They are also likely to underscore the economic challenges awaiting the incoming government.

Economic growth has been below par for more than 18 months, and the jobs market has been slowly deteriorating. Last month, the unemployment rate reached a four-year high of 5.7 per cent, and a survey that tracks consumer expectations of rising unemployment has reached the highest mark since the global financial crisis.

A report on Australia's business outlook by consultancy Deloitte Access Economics this week said "pretty much every sector" of the economy, from mining to governments, are in cost-cutting mode.

"This isn't a recession," the report said. "Coal and iron ore prices would need to fall a lot more for that to happen. Yet it hurts anyway: Australia's annual national income growth peaked at $115 billion in early 2011, but fell to a bare $49 billion in the past year."

Academic economist Ross Garnaut says the "accumulated decline" in Australia's potential economic output is quite large and "will continue to grow on current policy settings".

The Australian dollar's recent fall below parity with the US dollar is good news for export-oriented sectors, including manufacturing, farming, tourism and international education. But Professor Garnaut says the dollar needs to fall much further if a recession is to be avoided.

"If the real depreciation is too little too late, recession and possibly deep recession becomes inevitable, but we are not there yet," he says.

Meanwhile, there is lingering uncertainty about the economic health of Australia's most important trading partner, China. On Wednesday, China reported the slowest pace of manufacturing growth in nearly a year, while other recent economic indicators have been weaker than expected.

Chief economist of the Asian Development Bank Changyong Rhee said last week the whole region would feel the effects of slower Chinese growth.

"The drop in trade and scaling back of investment are part of a more balanced growth path for [China] and the knock-on effect of its slower pace is definitely a concern for the region," he said. "We are also seeing more subdued activity across much of developing Asia."

This followed an International Monetary Fund warning that the slowdown in emerging markets such as China could last longer than expected.

Nobel prize-winning economist Paul Krugman went much further this week when he pronounced: "China is in big trouble.

"We're not talking about some minor setback along the way, but something more fundamental," he wrote in The New York Times. "The country's whole way of doing business, the economic system that has driven three decades of incredible growth, has reached its limits. You could say that the Chinese model is about to hit its Great Wall, and the only question now is just how bad the crash will be."

Garnaut says the inevitable slowing and rebalancing of the Chinese economy will be a major challenge for whoever wins this year's election. He says the incoming government will need to involve the whole Australian community in a national effort "to raise productivity, keep government expenditure within sustainable limits and share sacrifices in an equitable way.

"It will test the cohesion of Australian society and it will test to the limit Australia's political leadership."