A sharp downturn in the Chinese economy would have only a modest effect on Australia, provided it did not turn into a broader financial crisis, an International Monetary Fund modelling exercise has found.
Australia’s other trading partners in Asia and the US would pick up much of the slack left by a collapse of exports to China, helped by a depreciation of the Australian dollar.
The IMF’s new study of the links between the Chinese and Australian economies comes amid a fresh bout of concern about China’s ability to manage its high level of corporate and local government debt as the economy slows.
The IMF’s annual review of the Chinese economy, to be released this week, is expected to focus on the financial and trade risks to its growth, calling for greater commitment to reining in the growth of debt and reforming state-owned enterprises.
Reserve Bank governor Philip Lowe last week highlighted the build-up of financial risks in China and the historical experience in other countries, showing a financial crisis or a collapse of growth nearly always followed.
Lowe emphasised that this was not inevitable, and that Chinese authorities were serious about tackling the vulnerabilities, but said it was too early to tell whether they would be successful.
The IMF study’s starting point is the intensity of the bilateral relationship, with Australia more dependent on exports to China than any other advanced economy, with the exception of Taiwan.
Although Australia’s exports to China are dominated by resources, the rapid growth of services exports — principally education and tourism — benefits from the efforts of the Chinese authorities to reduce the role of heavy industry as the driver of economic growth in favour of household consumption.
The IMF sees the lift in China’s services imports as a reflection of its transformation towards becoming an advanced economy.
As well as modelling a downturn, the study explores the potential for better than expected outcomes in the Chinese economy, including a faster build-up of domestic consumption. It also canvasses the spin-offs for Australia if China accelerates the rationalisation of its domestic iron ore, coal and steel industries.
These two “upside” scenarios are consistent with developments over the past year that are generating a lift in the Australian economy, with commodity prices strengthening and support for consumption coming from more than a million Chinese students and tourists.
The IMF’s first upside scenario envisages China’s private savings falling by 1 per cent of GDP in favour of greater consumption, while productivity growth accelerates in response to a faster restructuring of the economy.
China’s services imports rise by 7 per cent, accounting for half the lift in Chinese consumption. Australia’s services exports are 2 per cent higher over the first five years and 1 per cent higher in the long term, with real exchange rate shifts reducing the impact. There is a small lift in Australia’s GDP (less than 0.1 per cent) that is eventually reversed.
The second upside scenario is based on China tackling overcapacity and inefficiencies in its steel and commodities industries, with a cut to steel capacity of 10 per cent and a 5 per cent cut to its domestic coal and iron ore industries.
Over the past year, China has been moving in this direction, partly motivated by a goal of reducing air pollution.
The IMF estimates global prices for iron ore and coal are raised by 3 per cent permanently, with larger short-term increases.
The restructuring causes a 0.6 per cent fall in China’s GDP associated with a fall in investment and labour income, which results in a 1 per cent fall in consumption. China’s real exchange rate falls.
China’s demand for education and tourism services would drop, cutting Australia’s services exports by 1.3 per cent. However, the real exchange rate would appreciate because of the increase in the value of commodity exports.
The IMF calculates that Australia’s real GDP would be about 0.15 per cent lower over the long term, as a result of the exchange rate shift, but consumption would be 0.6 per cent higher, thanks to the greater commodity wealth and cheaper imports of consumer goods.
The downside scenario is drawn from the IMF’s last review of the Chinese economy and contemplates the failure of a number of large state-owned enterprises amid an unsuccessful restructuring of the steel industry. Productivity growth falls while there is a permanent 1 per cent increase in the corporate risk premium for state-owned enterprises, because the state can no longer be relied upon to bail them out.
Real GDP drops by 4 percentage points immediately and is 10 per cent lower over the long term, mainly due to the fall in productivity. Consumption also falls by 10 per cent because of reduced incomes and household wealth. Demand for services falls by 7 per cent, with a similar fall in imports.
This is as serious a downturn as anyone contemplates, short of a full-blown financial crisis. Of course it has a material affect on Australia, but it is not the “China sneezes, Australia catches pneumonia” dynamic that many fear.
The IMF estimates that Australia’s GDP is 0.4 per cent weaker than otherwise for about two years, before a sharp devaluation in the real exchange rate lifts growth by a similar amount over the medium term.
Because of the fall in commodity prices and the contraction of Chinese demand, the share of GDP made up by commodity exports falls by 1 per cent, while services exports to China drop by 3 per cent.
Reduced wealth and more expensive imports means consumption is almost 3 per cent lower, but the depreciation in the Australian dollar against both the yuan and other trading partner currencies boosts exports to other markets, which are between 3 per cent and 4 per cent higher.
Services industries gain more from exports to the US and other nations in Asia than they lose from China.
This is similar to the dynamic that prevailed during the Asian financial crisis in the late 1990s, which did not generate the widely anticipated recession in Australia.
Although Australia’s other Asian trading partners are also affected by the downturn in China, the fall in commodity prices raises GDP in commodity importing countries.
“Australia’s diversified economy is also reliant on strongly established trading relationships with the rest of Asia, both advanced and emerging countries, not just China alone, which mitigate the effects from widespread shocks to China,” the report says.
It concludes with the caveat that there is no financial contagion from China into the broader regional and world economy, and that China’s real exchange rate is allowed to adjust.
“A scenario with substantial financial turmoil would dampen an otherwise optimistic outcome for Australia,” it says.