Thanks for China, Gough

Whitlam's visit to China ushered in closer ties that were largely responsible for Australia's 23 years of uninterrupted growth. But China's engine is starting to falter.

When Gough Whitlam visited China in 1971, its GDP was little more than a tenth of America’s and double Australia’s.

This week, according to the IMF, and after three decades of nearly 10 per cent compound growth, China’s economy is larger than America’s (using an exchange rate based on purchasing power parity). And it’s more than 10 times the size of Australia’s output.

Thanks in part to Whitlam’s historic visit, China has been almost entirely responsible for Australia’s 23 years of consecutive growth -- not far off the Netherlands' world record.

But now China has hit the wall. Growth for the September quarter, out yesterday, was 7.3 per cent, the lowest growth rate since early 2009 and largely due to exports.

China’s growth rate seems inexorably headed for sub-7 per cent, which will send as many shockwaves around the world as US interest rates going up.

And this slowdown does not seem to be the intentional act of central planners in the Communist Party trying to engineer a soft landing, as commonly believed.

In fact, it’s the result of a structural decline in private investment: the sort of vicious cycle that capitalist economies get into when businesses start to fear the future.

The private sector in China can see that growth is slowing and are cutting back on investment plans. That’s not surprising: the potential return on investment has shrunk dramatically because China’s central bank is holding interest rates where they are as growth slows, to control the booming housing market. (Sound familiar?)

It’s true that China’s state-owned enterprises still represent about a third of the economy, more than the typical 5 per cent in most developed countries following the 1990s wave of privatisations around the world.

But that leaves two-thirds of the economy in private hands -- more than enough to bring the economy down if they pull in their horns.

What’s more, the state-owned sector is crippled with debt. According to private research house, Gavekal Dragonomics, the average debt-to-equity ratio of state-owned firms is now 87 per cent.

Gearing in the private sector is less than 60 per cent, down from 77 per cent in 2006, so they could borrow to invest … if they wanted to.

But with the property market looking increasingly unstable and GDP growth slowing more than the government had forecast, they are more inclined to wait.

Fear of a property crash and banking crisis is not only weighing on the Chinese economy by keeping interest rates up and undermining investment, it’s also causing concern around the world. For example, Moody’s recently warned that a “housing downturn in China could derail the global recovery”.

China’s GDP growth peaked in 2007 at close to 15 per cent, crashed in 2008 to 6.5 per cent, was boosted by the world’s greatest fiscal stimulus back to 12 per cent, and has sagged back to the mid 7’s has more or less stayed there ever since.

Of course China’s economy is much bigger now: 7 per cent growth in 1971 (which is what it was) was worth an extra US$6.9 billion in output; today it’s $728bn extra.

Moreover, unless there is a catastrophic banking crisis (not impossible), economic growth is unlikely to crash given the strength of domestic consumption and exports.

But the microeconomic reforms needed to free up the private sector and boost investment are not happening, partly because President Xi Jinping’s administration is so focused on stamping out corruption.

The astounding success of the e-commerce firm, Alibaba, makes it seem like there’s a wave of entrepreneurial success going on, and there has apparently been a surge in the number of new companies being registered in China, but that’s not yet showing up in the private investment data.

China’s economic growth is not about to recover in a hurry and is likely to be below 7 per cent next year.

That means commodity prices will also stay low for some time and Australia’s terms of trade will continue to fall.

Gough Whitlam’s visit in 1971 opened up diplomatic relations with China and began 40 years of rewarding trade for Australian businesses with almost uninterrupted national income growth. In many ways, it was his most significant economic act.

This year -- the year of Whitlam’s death -- is the first in which the relationship he helped set up is proving to be more challenge than opportunity.