Top Secret: The Chinese envoy's briefing paper on the Great Southern Province's economic prospects

ECONO-LEAKS (a new service involved in the exclusive gathering of economic intelligence) has intercepted the following secret cable transmissions from the Chinese envoy to the leaders in Beijing on the prospects for Australia. The first cable covers Australia's vulnerability to China and the European debt crisis.

Your Excellency, I am pleased to present the requested report on the economic outlook for the Great Southern Province of China, currently referred to by the local population as ''Australia''. For convenience I will refer to the country by this older name. Deep dependence on our great nation means Australia's future is inextricably linked to China. Given that the white European colonisers historically feared the ''yellow peril'', the irony of the situation will be not lost on the Politburo. Despite recent engagement with us and the rest of Asia, Australia's focus seems confused. The country's head of state remains an octogenarian British Queen. Australia also believes its security is guaranteed by the United States of America, with whom it has extensive defence links. The locals continue to believe in both its sovereignty and also its bright economic prospects.

Escaping AcronymsThe popular narrative is that Australia escaped the GFC (global financial crisis - the locals are acronymic) through their own planning. The country was certainly in a better position to cope with the problems.

The federal government did not have much debt. But some state governments have significant borrowing. Governments also systematically shifted some of their debt into public private partnerships (PPP). Because of the strategic nature of this infrastructure, these projects de facto enjoy the indirect support of governments. Private household debt is also high.

At the start of the crisis, Australian interest rates were relatively high, providing greater flexibility. But Australia did not escape the crisis unscathed. One major bank lost nearly a billion Aussies (colloquial term for the Australian dollar, the local version of the renminbi). Investors, including a number of charities and local councils, suffered significant losses from investments in various financial products. A number of highly leveraged infrastructure and commercial real estate investors failed.

Local banks escaped the problems of their overseas counterparts. The near-death experiences in the recession of the early 1990s encouraged them to stay home eschewing overseas adventures and complex financial structures. That said, another year or so, they would not have been so lucky.

The local banking regulator, APRA (Australian Prudential Regulation Authority), and politicians take credit for the banks being relatively unaffected. This is curious, given that banking regulations are largely uniform around the world. One can only assume that Australia has superior regulators and politicians to the rest of the world - an example of ''Australian exceptionalism''.

In reality, its swift recovery was driven by large cuts in interest rates, government guarantees for banks, government stimulus and a commodity boom.

This is not a new phenomenon in Australian history. It can be traced back to the famous gold rush of the 19th century, when many of our countrymen travelled to Australia in search of their fortunes.

BoomFormer prime minister of Australia Paul Keating, a prominent Sinophile, recently remarked that Australians were luckier than most races, having been given an entire continent. He might have added that it was also remarkably rich in mineral wealth.

Australia has benefited from a substantial increase in demand for and prices for its mineral products.

The country is enjoying its best terms of trade (measured as price of exports divided by price of imports, showing the quantity of imports that can be purchased theoretically from the sale of a fixed amount of exports) in 140 years. Australia's terms of trade have improved by 42 per cent, just since 2004.

The commodity boom is driven by a sharp increase in demand, supply constraints because of under-investment in mineral production and associated infrastructure and some unexpected effects of the GFC.

The GFC also boosted investment in commodities. As traditional investments fared poorly (stocks, interest rates and property prices all fell), investors switched to hard assets, like commodities.

The underlying logic was that these were real assets with genuine underlying uses rather than the fictions created through financial engineering.

Low interest rates also helped demand and prices, as it cost less than before to buy and hold commodities, which paid no return. As central banks started printing money to restart growth, investment in commodities increased further as investors sought a hedge against the risk of inflation. As Your Excellency knows, one of China's priorities is to preserve the value of its foreign exchange reserves, currently around $US3.2 trillion. The bulk of these funds are invested in US dollar, euro and yen-denominated securities.

To reduce the risk of losses as these securities lose value due to the actions of governments to devalue the currency against the renminbi, we have executed your instruction to purchase and stockpile large amounts of strategic commodities.

Boomier The economists, who failed to forecast the rise in commodity prices or the GFC, now speak of a ''super'' boom lasting decades. The boom is more fragile than now understood.

As growth in China and other emerging countries decelerates, demand for commodities is likely to slow.

High prices have encouraged investment in expanding existing mines, building new mines and additional infrastructure, as well as exploration. As new capacity and supply comes on stream, there will be pressure on prices.

At Your Excellency's suggestion, we have extensively studied the commodity purchasing strategies of Japan in the 1980s. Based on this analysis, we have actively cultivated new sources of supply of essential commodities.

This will enable us to play suppliers off against each other to achieve more favourable prices in the long term.

Westerners place great store in contracts, such as long-term agreements to purchase minerals at agreed prices. In the Chinese way, these are, at best, statements of intention based on conditions existing at the time of agreement. If conditions change, then we will, like the Japanese, renegotiate the arrangements in our favour.

SinophiliaAround 23 per cent of Australian exports now go to China. The real quantum is higher as some Australian exports to Asia are then re-exported to China. China currently faces significant challenges.

Our two major trading partners - Europe and America - face serious problems, which will lead to a slowdown in our own exports. Recent statistics, such as the volatile Purchasing Managers Index that measures manufacturing activity, suggest a sharp slowdown. In turn, this will affect our suppliers, such as Australia, by way of lower demand and also lower prices for commodities.

Unlike 2008, our capacity to respond to any slowdown is reduced. Then, we increased lending through our policy banks to boost demand. In 2009 and 2010, we were able to grow loans by around 30-40 per cent of our GDP to drive growth. Unfortunately, party cadres have not used the money wisely in all cases, resulting in some unproductive investment and bad debts for the banks.

As Your Excellency is also aware, around $US800 billion, or 25 per cent of our $US3.2 trillion, in foreign exchange reserves is invested in ''risk free'' European government bonds. Continued losses in these investments and on investments in US government bonds also further restrict our flexibility. Our economic growth will be slower than widely anticipated.

European TsunamisAustralians believe that physical distance from Europe and proximity to China and Asia affords protection from European debt problems. Despite record terms of trade and high export volumes, Australia continues to run a current account deficit with the rest of the world of around 2-3 per cent of GDP, around $US30-40 billion a year. This must be financed overseas. Sovereign debt problems and the resultant problems in the banking system will affect international money markets for some time to come. Australian borrowers will face reduced availability of funding and increased borrowing cost.

Before the crisis, Australian bank deposits totalled 50-60 per cent of loans made. The difference was funded in wholesale markets, generally from institutional investors. In 2007, deposits made up around 20 per cent of bank borrowing down from 34 per cent a decade earlier. Domestic wholesale borrowing and foreign wholesale borrowing were 53 per cent and 27 per cent of bank balance sheets.

Following the GFC, increases in the cost of overseas funding and regulatory pressure, Australian banks significantly reduced their loan-to-deposit ratios, with deposits now around 70 per cent of loans. They also reduced their dependence on international borrowings.

Nevertheless, Australian banks face significant international refinancing pressures, needing about $A80 billion in 2012. Around $A35 billion are AAA-rated government-guaranteed bonds, which will need to be financed without government support unless the policy changes. In addition, the banks have a further $A28 billion worth of bonds that mature in the domestic markets

Money Too Tight To MentionFacing reduced availability and higher cost of funding, Australian banks may reduce loan volumes and increase rates to customers.

The problems of international banks, especially European banks, previously active in financing local businesses, will compound the problem. Before the GFC, European banks provided around 35 per cent of loans to Australian corporations. This has fallen to around 16 per cent in 2011 and is likely to decline further.

The reduced participation reflects losses on sovereign bond holdings, pressures on bank capital and increases in $US funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures.

They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe. Given that Australian companies will need to refinance around $A80 billion of maturing loans in 2012, these pressures are not welcome.

The European crisis has affected Australian public finances. Falls in income and capital gains have reduced tax revenue. The government is cutting expenditure and tightening taxes to offset the reduction in revenue. Falls in income on retirement savings, reduced business investment and general loss of confidence is likely to adversely affect the domestic economy. Australia may not escape the possible European tsunami.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). His report concludes tomorrow.