Why the Australian Economy’s Bet on China Will Fail

Yesterday we left you with the thoughts of Reserve Bank of Australia (RBA) governor, Glenn Stevens.

To recap, here’s what he told the House of Representatives economics committee last week:

‘After that the rate of resource investment is likely to decline, while the export shipments of the resources themselves will pick up. By then we might expect that some other sectors that have been weak of late, like residential and non-residential construction, might be starting to pick up.’

An issue we’ve railed at even more than the China collapse is the collapse of the Australian economy and the Australian housing market.

Well, now things are really hotting up. And to us it looks like the next 12 months could be the time when the Australian economy finally cracks. We’ll explain why below…

You can tell when an empire or political system is about to end. Those in power become desperate to stay in power.

You can learn that from history. As Suetonius wrote of Nero in The Twelve Caesars:

‘But, above all things, he most eagerly coveted popularity, being the rival of every man who obtained the applause of the people for any thing he did…

‘Because he was thought to equal Apollo in music, and the sun in chariot-driving, he resolved also to imitate the achievements of Hercules. And they say that a lion was got ready for him to kill, either with a club, or with a close hug, in view of the people in the amphitheatre; which he was to perform naked…

‘He had an insatiable desire to immortalize his name, and acquire a reputation which should last through all succeeding ages…’

Before the 2007 federal election, PM John Howard threw billions of taxpayer dollars to vested interests and those he hoped would vote for him.

2007 saw the end of the Howard Empire.

Not long after, the Fairy Ruddfather threw taxpayer dollars at his favoured vested interests as he tried to hold onto power.

The Rudd Empire ended in 2010.

And in the same sign of fear, the current government plans to spend billions of taxpayer dollars it doesn’t yet have to make sure it stays in power. As today’s Australian Financial Review (AFR) notes:

‘Even as China’s economic boom shows signs of cooling, potentially torpedoing the federal government’s revenue projections, political parties continue to raise expectations about costly future policies.

‘These include the National Disability Insurance Scheme, which is expected to require an extra $10.5 billion a year within six years, a $4 billion dental care scheme, announced yesterday, as well as $5 billion a year for education recommended by the Gonski schools review.’

Even the mainstream analysts who usually cheer for more spending admit the government has already wrung taxpayers dry. Chris Richardson, partner at Deloitte Access Economics told the AFR:

‘The politicians just don’t get it yet. Both sides are operating on a rule of thumb that worked for a decade, which is that China paid for all sorts of things, and that’s just not true anymore.’

That’s because, like Nero, politicians covet popularity. And the only way they can stay or become popular is to make promises paid for using other peoples’ money.

The Australian Economy’s Luck to Run Out

Mr Richardson is right. China can’t pay for Aussies’ luxuries anymore. Of course, we’ve said that for years…and we were criticised for it. But now all we’ve said is coming true.

Our old pal, Greg Canavan has written a report detailing how the collapse will happen and how you can profit from it and protect your investments.

But the warnings on China don’t end there. Today’s Age newspaper highlights another independent report that points to the death of the Australian economy. The Age quotes from the report, titled Australia: The Unlucky Country:

‘The mining sector has crowded out almost all other sectors of the economy and also funnelled credit and liquidity into a housing bubble in the real estate sector…

‘It will be almost impossible to move mining capacity to other sectors in Australia. This is a classic problem for economies who suffer from Dutch Disease. When the hangover arrives, writing off production capacity is often done at a considerable discount to cost.

‘In addition, the manufacturing sector is under-developed and will not be able to take up the slack for the loss of momentum in construction and mining.’

But don’t panic. The RBA says residential building will pick up where the mining boom left off. Seriously, that has to be the dumbest piece of economic analysis we’ve ever heard.

Australian Housing is Consumption, Not Production

But it’s the way most Aussies think. They think housing is an economic driver.

But it’s not. Housing is consumption.

Housing, along with other consumption (such as food, fuel, clothing, etc.) is the reward for productive labour.

Put it this way; you can only afford to buy a house, food, and clothing after you’ve produced something that someone else needs.

So for the central bank to claim that residential building will fill the void left by the end of the resources boom is just barmy.

It’s the worst kind of lazy thinking. It’s a lack of knowledge about how an economy works. The fact is the resources boom has a much bigger impact on the Australian economy than most people think.

Put simply, when companies like BHP Billiton [ASX: BHP], Rio Tinto [ASX: RIO], and Fortescue Metals [ASX: FMG] export raw materials, they receive payment for it.

These big miners use the money to buy labour, goods and services to support their mining activities. The money flows from these service providers to other areas of the Aussie economy: housing, car industry, retailers, etc.

But that’s only part of it. Before the money flows to other sectors it goes into the banking system first. And this is where the important stuff happens. This is where you get the leverage effect.

Thanks to the fractional reserve banking system, banks can use $10 of deposits to lend $90 to borrowers. It’s this newly created money that has the biggest effect when it spreads through the economy.

Because it’s not the $10 deposited in the bank that filters through the economy, it’s the $90 created by the banks from thin air that filters through the economy.

Or put another way, the $60 billion of exports to China doesn’t mean a $60 billion benefit to the Australian economy…it means there’s a $600 billion benefit to the Australian economy.

The money flows in from China, it goes into bank accounts, and then the banks leverage this to create new loans. It explains why the Australian housing market was strong despite crashes elsewhere in the world.

Australian Economy to Take $100 Billion Hit

But as anyone who knows about leverage will tell you, leverage is a double-edged sword. It magnifies returns when the market goes your way, but it magnifies losses when the market goes against you.

In this case, even if exports to China only fell to $50 billion, it wouldn’t mean a $10 billion hit to the Australian economy. Because of the leverage used by the banks to drive up credit, it would actually be a $100 billion hit to the economy.

That’s simply because there’s less money flowing into the economy for the banks to use as capital for new loans.

That should be a warning for you. And that’s why even a small drop in China’s resources spending will have a big impact on the Australian economy.

So for anyone to think that housing will boom once the resources boom ends, they’re in for a rude awakening.

The fact is, contrary to what the brains trust at the RBA may think, far from leading the Australian economy to recovery, housing will be the worst investment to own when the resources boom finally ends.


PS. Our old buddy Greg Canavan recently told his readers to prepare for an Aussie dollar crash. In his latest newsletter he revealed the best way to protect the value of your Aussie dollar assets when the Aussie’s dream run comes to an end. Find out more details here

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Kris Sayce

Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the editor of Microcap Trader — where he reveals the best opportunities he’s discovered in the markets. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays.

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