Look east, then west

All eyes are on Europe – yet it’s not the only worry. For some years now China has been more important to Australian prospects than the United States ever was.

But China has a few wobbles of its own. Its construction sector grew too fast for too long and for over a year now the authorities have been applying the brakes, trying to slow an inflation surge and to take steam out of a construction sector that had overheated, taking property prices along for the ride.

The good news is that inflation has been brought to heel and that the authorities are boosting the economy once more. Banks are being encouraged to lend, while the government has approved plans for a slew of new work in everything from steel mills to railways.

The even better news is that there’s a lot of firepower if needed: were the slowdown that’s already under way to accelerate, the authorities have room to boost credit growth and use taxpayers’ money to spend up a storm.

Yet there’s more bad news already unleashed than many Australians have yet recognised. There is an enormous underlying demand for new urban housing as people flock from the country to the city to live. However, even so, the pace of apartment building in China in recent years outpaced the enormous need for it, leaving tens of millions of apartments empty: the only argument is whether the overhang of empty apartments measures “just” 10 million or is as high as 60 million new homes.

Developers have responded to that by speeding up rather than slowing down: they want to get new homes to an already flooded market before other developers, thus generating the familiar-but-dangerous dynamic of a soon to be sharply slowing construction cycle.

To date the negatives from that haven’t fully played out in the Chinese data. Moreover, the latter are already showing signs of strain. House prices are falling – spooking the punters who have been banking on further capital gains – while sales of new homes have slumped. At the same time, industrial production and electricity production are ticking down, with factory output recording its weakest growth in nearly three years.

The first chart shows the close link between electricity production and the pace of growth in the wider Chinese economy. The latest electricity data suggest that the current slowdown will get worse before it gets better.

But wait, there’s more: China’s export growth has slowed compared with a year ago and there are anecdotal reports of defaults on commodity imports as steel mills knock back deliveries.

As the second chart shows, iron ore and coal prices have fallen in response, with the hit to thermal coal prices further boosted by declining demand from the US as the latter shifts to gas.

It is coal and iron ore prices that have done so much to generate the rivers of gold that have powered Australia’s economy in the decade since China began its galloping growth. In turn, the drops in these prices spell problems for Australia. Most notably, it will eat into corporate profits, although that is being cushioned by the fall in the Australian dollar that has accompanied China’s slowdown over the past two months.

Also notably, and despite the benefits to the budget of the lower Australian dollar, these falls in commodity prices and the related fall in the sharemarket have once again pulled the rug out from under the government’s hopes of a budget surplus in 2012-13.

That’s why Federal Treasury and the Reserve Bank of Australia have been watching events in China with as much trepidation as they have those of Europe. Of course those two are linked. If Europe can keep its act together, chances are that China will be able to do the same. And, unlike much of the world, China has considerable firepower to bring to bear if its slowdown gathers speed.

But you need to be watching developments in China just as closely as those in Spain and Greece.

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