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Why a crash in China is about to devastate our economy

ANALYSIS

I RECENTLY watched the federal Treasurer Scott Morrison proudly proclaim that Australia was in "surprisingly good shape". Indeed, Australia has just snatched the world record from the Netherlands, achieving its 104th quarter of growth without a recession, making this achievement the longest streak for any OECD country since 1970.

I was pretty shocked at the complacency, because after 26 years of economic expansion, the country has very little to show for it.

For over a quarter of a century our economy mostly grew because of dumb luck. Luck because our country is relatively large and abundant in natural resources, resources that have been in huge demand from a close neighbour - China.

Out of all OECD nations, Australia is the most dependent on China by a huge margin, according to the IMF. Over one-third of all merchandise exports from this country go to China including all physical products and things we dig out of the ground.

Outside of the OECD, Australia ranks just after the Democratic Republic of the Congo, Gambia and the Lao People's Democratic Republic and just before the Central African Republic, Iran and Liberia. Does anything sound a bit funny about that?

Australia's economy is a house of cards, ready to collapse.
Australia's economy is a house of cards, ready to collapse.

 

As a whole, the Australian economy has grown through a property bubble inflating on top of a mining bubble, built on top of a commodities bubble, driven by a China bubble.

Unfortunately for Australia, that "lucky" free ride is just about to end.

Societe Generale's China economist Wei Yao recently said: "Chinese banks are looking down the barrel of a staggering $1.7 trillion worth of losses". Hyaman Capital's Kyle Bass calls China a "$34 trillion experiment" which is "exploding", where Chinese bank losses "could exceed 400 per cent of the US banking losses incurred during the subprime crisis".

A hard landing for China is a catastrophic landing for Australia, with horrific consequences to this country's delusions of economic grandeur.

 

NOBODY NEEDS THAT MUCH STEEL

The initial rally in commodities at the beginning of 2016 was caused by a bet that more economic stimulus and industrial reform in China would lead to a spike in demand for commodities used in construction. That bet rapidly turned into full-blown mania as Chinese investors, starved of opportunity and restricted by government clamp downs in equities, piled into commodities markets.

This saw, in April of 2016, enough cotton trading in a single day to make a pair of jeans for everyone on the planet, and enough soybeans for 56 billion servings of tofu, according to Bloomberg.

Market turnover on the three Chinese exchanges jumped from a daily average of about $78 billion in February to a peak of $261 billion on April 22, 2016 - exceeding the GDP of Ireland. By comparison, Nasdaq's daily turnover peaked in early 2000 at $150 billion.
 

 

China is one of Australia's largest buyers of steel-making coal.
China is one of Australia's largest buyers of steel-making coal. Emily Smith


 

While volume exploded, open interest didn't. New contracts were not being created, volume instead was churning as the hot potato passed between speculators, most commonly in the night session, as consumers traded after work. So much so that sometimes analysts wondered whether the price of iron ore is set by the market tensions between iron ore miners and steel producers, or by Chinese taxi drivers trading on apps.

In April 2016, the average holding period for steel rebar and iron ore contracts was less than three hours. The Chief Executive of the London Metal Exchange, said "Why should steel rebar be one of the world's most actively-traded futures contracts? I don't think most people who trade it know what it is".

Steel, of course, is made from iron ore, Australia's biggest export, and frequently the country's main driver of a trade surplus and GDP growth.

Australia is the largest exporter of iron ore in the world, with a 29 per cent global share in 2015-16 and 786Mt exported, and at $48 billion we're responsible for over half of all global iron ore exports by value. Around 81 per cent of our iron ore exports go to China.

Unfortunately, in 2017, China isn't as desperate anymore for iron ore, where close to 50 per cent of Chinese steel demand comes from property development, which is under stress as house prices temper and credit tightens.

In May 2017, stockpiles at Chinese ports were at an all time high, with enough to build 13,000 Eiffel Towers. Last January, China pledged "supply-side reforms" for its steel and coal sectors to reduce excessive production capacity. In 2016, capacity was cut by six per cent for steel and eight per cent for coal.

In the first half of 2017 alone, a further 120 million tonnes of low-grade steel capacity was ordered to close because of pollution. This represents 11 per cent of the country's steel capacity and 15 per cent of annual output. While this will more heavily impact Chinese-mined ore than generally higher-grade Australian ore, Chinese demand for iron ore is nevertheless waning.

Over the last six years, the price of iron ore has fallen 60 per cent.

 

SHOULD WE STOP MINING BLACK GOLD?

Australia's second biggest export is coal, being the largest exporter in the world supplying about 38 per cent of the world's demand. Production has been on a tear, with exports increasing from 261Mt in 2008 to 388Mt in 2016.

While exports increased by 49 per cent over that time period, the value of those exports has collapsed 38 per cent, from $54.7 billion to $34 billion.

The only bright side for Australian coal in 2017 was that, unexpectedly, Cyclone Debbie wiped out several railroads and forced the closure of ports and mining operations, which has caused a temporary spike in coal prices.

 

Australia's Treasurer Scott Morrison looks at a piece of coal during House of Representatives Question Time at Parliament House in Canberra, Thursday, Feb. 9, 2017. (AAP Image/Lukas Coch) NO ARCHIVING
Australia's Treasurer Scott Morrison looks at a piece of coal during House of Representatives Question Time at Parliament House in Canberra, Thursday, Feb. 9, 2017. (AAP Image/Lukas Coch) NO ARCHIVING LUKAS COCH

Australia's main export markets for coal are Japan and China, two markets in which the use of coal is forecast to decline through 2040.

Australia's top export market for coal is Japan, and the unfortunate news is that the ramp up in coal exports here is a short lived adaptation after power companies idled their nuclear reactors in the wake of the Fukushima disaster. Between a zombie economy and fertility levels far below the replacement rate, Japan's population is shrinking and thus naturally net electricity generation has also been declining in Japan since 2010.

Coal consumption in China has dropped three years in a row, and in January 2017, 100 coal fired power plants were cancelled. China has announced that it is spending a whopping $360 billion on renewables through 2020, and this year is implementing the world's biggest cap-and-trade carbon market to curb emissions.

Blind to the reality of this situation, Australia is ramping up coal production while China commits to ending coal imports in the very near future in what can only be described as a last-ditch "dig it up now, or never" situation.

 

WE'VE WASTED OUR GRAVY TRAIN

What is more shocking is that despite the gargantuan amount of money that China has been pumping into the system since 2014, Australia's entire mining industry - which is completely dependent on China - has struggled to make any money at all.

Across the entire industry, revenue has dropped significantly while costs have continued to rise.

According to the Australian Bureau of Statistics, in 2015-16 the entire Australian mining industry which includes coal, oil and gas, iron ore, the mining of metallic and non-metallic minerals and exploration and support services made a grand total of $179 billion in revenue.

It had $171 billion of costs and generated an operating profit before tax of $7 billion which representing a wafer thin 3.9 per cent margin on an operating basis.

In the year before it made a 8.4 per cent margin.

Collectively, the entire Australian mining industry (ex-services) would be loss making in 2016-17 if revenue continued to drop and costs stayed the same.

Our "economic miracle" of 104 quarters of GDP growth without a recession today doesn't come from digging rocks out of the ground, shipping the by-products of dead fossils and selling stuff we grow any more. Mining, which used to be 19 per cent of GDP, is now 6.8 per cent and falling. Mining has fallen to the sixth largest industry in the country. Even combined with agriculture the total is now only 10 per cent of GDP.

 

ARE WE BUYING HOUSES WITH FLAT WHITES?

With an economy that is 68 per cent services, as I believe John Hewson put it, the entire country is basically sitting around serving each other cups of coffee or, as the Chief Scientist of Australia would prefer, smashed avocado.

Successive Australian governments have achieved economic growth by blowing a property bubble on a scale like no other.

A bubble that has lasted for 55 years and seen prices increase 6556 per cent since 1961, making this the longest running property bubble in the world (on average, "upswings" last 13 years).

In 2016, 67 per cent of Australia's GDP growth came from the cities of Sydney and Melbourne where both state and federal governments have done everything they can to fuel a runaway housing market. The small area from the Sydney CBD to Macquarie Park is in the middle of an apartment building frenzy, alone contributing 24 per cent of the country's entire GDP growth for 2016, according to SGS Economics & Planning.

According to the Rider Levett Bucknall Crane Index, in the fourth quarter of 2017 between Sydney, Melbourne and Brisbane, there were now 586 cranes in operation, with a total of 685 across all capital cities, 80 per cent of which are focused on building apartments. There are 350 cranes in Sydney alone.

 

By comparison, there are currently 28 cranes in New York, 24 in San Francisco and 40 in Los Angeles.

According to UBS, around one third of these cranes in Australian cities are in postcodes with 'restricted lending', because the inhabitants have bad credit ratings.

This can only be described as completely "insane".

That was the exact word used by Jonathan Tepper, one of the world's top experts in housing bubbles, to describe "one of the biggest housing bubbles in history". "Australia", he added, "is the only country we know of where middle-class houses are auctioned like paintings".

Our Federal Government has worked really hard to get us to this point.

Many other parts of the world can thank the Global Financial Crisis for popping their real estate bubbles. From 2000 to 2008, driven in part by the First Home Buyer Grant, Australian house prices had already doubled. Rather than let the GFC take the heat out of the market, the Australian Government doubled the bonus. Treasury notes recorded at the time say that it wasn't launched to make housing more affordable, but to prevent the collapse of the housing market.

 

BUBBLE BUILT ON 'FAKE' CHINESE INCOME

Already at the time of the GFC, Australian households were at 190 per cent debt to net disposable income, 50 per cent more indebted than American households, but then things really went crazy.

The government decided to further fuel the fire by "streamlining" the administrative requirements for the Foreign Investment Review Board so that temporary residents could purchase real estate in Australia without having to report or gain approval.

It may be a stretch, but one could possibly argue that this move was cunningly calculated, as what could possibly be wrong in selling overpriced Australian houses to the Chinese?

I am not sure who is getting the last laugh here, because as we subsequently found out, many of those Chinese borrowed the money to buy these houses from Australian banks, using fake statements of foreign income. Indeed, according to the AFR, this was not sophisticated documentation - Australian banks were being tricked with photoshopped bank statements that can be bought online for as little as $20.

UBS estimates that $500 billion worth of "not completely factually accurate" mortgages now sit on major bank balance sheets. How much of that will go sour is anyone's guess.

 

WE CAN'T AFFORD TO LIVE HERE

Foreign buying driving up housing prices has been a major factor in Australian housing affordability, or rather unaffordability.

Urban planners say that a median house price to household income ratio of 3.0 or under is "affordable", 3.1 to 4.0 is "moderately unaffordable", 4.1 to 5.0 is "seriously unaffordable" and 5.1 or over "severely unaffordable".

At the end of July 2017, according to Domain Group, the median house price in Sydney was $1,178,417 and the Australian Bureau of Statistics has the latest average pre-tax wage at $80,277.60 and average household income of $91,000 for this city. This makes the median house price to household income ratio for Sydney 13x, or over 2.6 times the threshold of "severely unaffordable". Melbourne is 9.6x.

This is before tax, and before any basic expenses. The average person takes home $61,034.60 per annum, and so to buy the average house they would have to save for 19.3 years - but only if they decided to forgo the basics such as, eating. This is neglecting any interest costs if one were to borrow the money, which at current rates would approximately double the total purchase cost and blow out the time to repay to around 40 years.

Unsurprisingly, the CEOs of the Big Four banks in Australia think that these prices are "justified by the fundamentals". More likely because the Big Four, who issue over 80 per cent of residential mortgages in the country, are more exposed as a percentage of loans than any other banks in the world, over double that of the US and triple that of the UK, and remarkably quadruple that of Hong Kong, which is the least affordable place in the world for real estate. Today, over 60 per cent of the Australian bank loan books are residential mortgages. Houston, we have a problem.

 

 

 

WE'VE BEEN HERE BEFORE, LONG BEFORE

Australia is not alone, Chinese "hot money" is blowing gigantic property bubbles in many other safe havens around the world.

But combined with our lack of future proof industries and exports, our economy is completely stuffed. And it's only going to get worse unless we make a major transformation of the Australian economy.

We can't rely on property to provide for our future. In 1880, Melbourne was the richest city in the world, until it had a property crash in 1891 when house prices halved causing Australia's real GDP to crash by 10 per cent in 1892 and seven per cent the year after.

The depression caused by this crash was substantially deeper and more prolonged than the Great Depression of the 1930s. Macro Business points out that if you bought a house at the top of the market in 1890s, it took 70 years for you to break even again.

Instead of relying on a property bubble as pretence that our economy is strong, we need serious structural change to the composition of GDP that's substantially more sophisticated in terms of the industries that contribute to it.

Australia's GDP of $1.6 trillion is 69 per cent services. Our "economic miracle" of GDP growth comes from digging rocks out of the ground, shipping the by-products of dead fossils, and stuff we grow. Mining, which used to be 19 per cent, is now seven per cent and falling.

Combined, the three industries now contribute just 12 per cent of GDP thanks to the global collapse in commodities prices.

If you look at businesses as a whole, Company tax hasn't moved from $68 billion in the last three years - our companies are not making more profits. This country is sick.

 

CAN WE FIX IT?

We have serious problems in this country. And I think they are about to become very serious. We are on the wrong trajectory.

I'll leave you now with one final thought.

Harvard University created something called the Economic Complexity Index. This measure ranks countries based upon their economic diversity - how many different products a country can produce - and economic ubiquity - how many countries are able to make those products.

Where does Australia rank on the global scale?

Worse than Mauritius, Macedonia, Oman, Moldova, Vietnam, Egypt and Botswana. Worse than Georgia, Kuwait, Colombia, Saudi Arabia, Lebanon and El Salvador.

Sitting embarrassingly and awkwardly between Kazakhstan and Jamaica, and worse than the Dominican Republic at 74 and Guatemala at 75, Australia ranks off the deep end of the scale at 77th place.

77th and falling. After Tajikistan, Australia had the fourth highest loss in Economic Complexity over the last decade, falling 18 places.

Thirty years ago, a time when our Economic Complexity ranked substantially higher, these words rocked the nation: "We took the view in the 1970s - it's the old cargo cult mentality of Australia that she'll be right.

"This is the lucky country, we can dig up another mound of rock and someone will buy it from us, or we can sell a bit of wheat and bit of wool and we will just sort of muddle through.

"In the 1970s … we became a third world economy selling raw materials and food and we let the sophisticated industrial side fall apart … If in the final analysis Australia is so undisciplined, so disinterested in its salvation and its economic well being, that it doesn't deal with these fundamental problems … Then you are gone. You are a banana republic."

Looks like Paul Keating was right.

The national conversation needs to change, now.

 

This is an edited version of Matt's original article, which appeared on LinkedIn.

 

Matt Barrie is an award winning technology entrepreneur. He is Chief Executive of Freelancer.com, the world's largest freelancing marketplace.

Topics:  china economy housing international


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