Winning global confidence

Just nine days after the US announced a plan to cut defence spending by $US400 billion over 10 years, China put its first aircraft carrier to sea.

One week after Standard & Poor's downgraded the creditworthiness of US government bonds, an adviser to China's central bank said his country would continue to lend money to the US and European governments - but only if they "really alter the declining trend" in their deficits.

Hillary Clinton once asked Kevin Rudd, in talking about dealing with China: "How do you get tough with your banker?" according to documents released by WikiLeaks. Now, it seems, America's banker is getting tough with it.

Most American states have been cutting their public services; in China, two-thirds of provinces are increasing welfare payments to the poor.

These contrasts capture a mood of decline on one hand, while the other is a picture of thrusting ambition. Australia exists in the space between these forces. The US stock market sank on Thursday, Sydney time, while China's rose. Australia's was in-between, finishing flat. Australia sells a quarter of its exports to China and only 4 per cent to the US. But it has its deepest security alliance with America and China is its greatest reason for wariness, says the Defence White Paper.

It's not just that the creeping shift of power from West to East has become a rush. We've known about that for years. There is something else going on, too. You can see it in the price of gold. An ounce of gold traded for about $300 a decade ago. This week it hit an all-time high of $US1800. Why?

Some investors have lost faith in the US dollar. It was the official global reserve currency for the first 25 years after the Second World War and the de facto reserve currency after that. Even the governments of the G-20 nations are actively discussing the idea of spreading the risk, creating a new reserve system comprising the currencies of multiple countries. This was unthinkable just a couple of years ago.

But while confidence in the US might be sinking, there is no corresponding rise in confidence in China. "You can see it in the price of gold," observes one of Australia's leading investors, Kerr Neilson, the head of Platinum Asset Management. "There is a system change under way."

But while the old system is faltering, there is not yet a new system. Where Standard & Poor's has cut America's debt rating from AAA to AA , it rates China's three notches lower. In the category of "things we never thought we'd live to see", the US has a lower credit rating than Australia, in the Standard & Poor's universe, at least. And the superpower shares the same credit rating as New Zealand.

It doesn't matter how much money China has. It's inherently risky. Why? Because China has no independent institutions. It does not even have the institutions of a normal nation-state because they are inseparable from the ruling party. Chinese reformers have long talked about the need to change this, but the Chinese Communist Party's need for absolute power has always trumped the national need for systemic stability. In China, everything turns on the whim of a small group of elites, who are as unaccountable as they are invisible. It is a country without foundation.

The former Commonwealth Bank chief and chairman of the federal Future Fund, David Murray, gave investors a general warning this week that in buying any investment instrument in any country, they are "buying politics".

He's quite right. This is exactly the reason Standard & Poor's gave for downgrading US government debt: "The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges."

The political system is how a country solves its problems. If the problem-solving mechanism is broken, then a country is stuck. Markets don't have terribly high expectations of politicians. Note, for instance, that Standard & Poor's has given tiny Belgium the same credit rating as the US. This is a powerful commentary. Belgium hasn't had a government for more than a year and shows no sign of being able to form one soon.

It's right that China's sovereign debt rating should be several notches lower. Because although China has managed to solve some of its most pressing problems, notably poverty, its politics are impenetrable and unaccountable and its systems are inherently unpredictable.

Even many of its outward signs of strength are actually, on deeper scrutiny, dubious. The aircraft carrier that it launched on its sea trials this week is not a sleek new piece of Chinese craftsmanship but an ancient Soviet ship that China has refitted. At the same time it launched the carrier, it has suspended the expansion of its vaunted new high-speed rail network after the recent crash of two trains, killing 40, raised questions about safety standards and corruption.

China has an extraordinary $US3.2 trillion in foreign exchange reserves, but how much debt does it carry? Its official figures are reassuringly small, yet few trust the official figures and some experts suspect that, if provincial and other government debts are included, it could be as high as the equivalent of 80 per cent of GDP, which is approaching a dangerous level. Chinese sharemarkets rose on Thursday not because of improving prospects but because government funds were being used to prop up share prices, according to Chinese media.

This is a discredited approach - Japan did this for years, and not only did it fail to overcome market forces, it lost a lot of public money in the process.

China is far from being able to assume the rights and responsibilities of the new global reserve currency. Quite apart from anything else, the value of its currency is fixed by officials, not markets, and capital flows are controlled. In other words, it is simply unworkable for investors to put large sums in and out of the country.

If Beijing were to float its currency, the yuan, it would probably surge as speculative foreign money rushed in. On the other side of the ledger, many rich Chinese would take the opportunity to get their funds out, and for the same reason that China's rich all carry a second passport - because of political risk.

Yet a floating exchange rate alone would not qualify China, no matter how big and powerful, as the new global standard-bearer. It would take a lot more, including security of private property rights and an independent court system, before big investors could contemplate using the yuan as the global reserve. The case of the Australian businessman Matthew Ng, on trial in China's sham courts, shows anew the political risk to foreign investors in China.

So as power and weight moves from West to East, and as the existing global reserve system falters before a new one is ready, the risk of a new global recession comes as a moment of great vulnerability for many countries, Australia included.

Some global investors are putting big sums into Australia, buying Australian bonds and putting money into Australian banks, but also, to use David Murray's phrase, they are buying Australia's politics. In part they are expressing confidence in Australia's prospects and policies and institutions, and they are buying into the credibility that Australia established over the past two decades of economic reform and economic outperformance. This is a new recognition.

Three years ago, investors shunned Australia when fear struck the markets. The Australian dollar was slammed and Australian banks couldn't raise money on the world wholesale market. Today, it's the reverse. Other countries' governments have been buying Australian bonds and the big Australian banks are so awash in foreign cash that they have started to turn away big wholesale deposits by offering unattractive interest rates.

If another global recession hits Australia in the months ahead, these are two of the features that would differentiate 2011 from 2008. Australia's credibility is better, and its banks are in a much stronger position.

Australia's situation today is better for a third reason - the massive slate of planned investments, worth more than $400 billion, mainly in mining and construction, would support activity. Some would fall over, but many would remain.

In three important ways, however, Australia's situation is weaker. In 2008, the federal government had no debt, only assets. Today, its debts are modest by world standards, yet they are real and would pose a constraint on stimulus spending.

This is why the Gillard government should not see a global downturn as an opportunity to relax its stance and justify deficit - although in a serious downturn that would be inevitable - but why it needs to redouble its efforts to pare spending.

Congratulations on your forthcoming parenthood, Penny Wong, and Julia Gillard might have told you to take time off, but this is precisely the time a finance minister should be putting new rigour into scrutiny of spending.

Second, consumer confidence in Australia is much weaker than it was in 2008-09. Confidence was an invisible but invaluable support last time; this time, shaken by teetering house prices, jittery stock markets and Opposition scaremongering, it would be no help.

Third, the inflows of foreign money into Australia may be a nice compliment to Australia's new status as a safe haven, but it's having the effect of holding the Australian dollar at a relatively high level.

In a recession, you want your currency to lose value because it improves your export competitiveness. This shock absorber seems set to be weaker next time around, if we are, indeed, heading into a next time. We have to hope for the best, but, in a world that has lost its old moorings, prepare for the worst.

Peter Hartcher is the political editor.