Is the China boom an illusion? Gottliebsen

In just over two months, the government will set out its budgets for 2010-11 and subsequent years. Companies all around Australia are now completing similar tasks. Australian households who have borrowed large sums will have their own budgets.

 Almost every one of those budgets – and particularly the federal government and corporate budgets – has behind it the same simple assumption: that the China boom will continue for the foreseeable future.

That’s why I was shocked when I read the work of respected Fairfax China correspondent John Garnaut, showing that Australia’s economic research to back this country-wide assumption is flimsy.

Garnaut says that while some Australian companies that depend on China are improving their analytical capability, most are yet to acknowledge they have a problem. Last year, Stephen Joske, previously the Australian government’s top China economist, claimed: “There’s no one in Treasury who can tell up from down on China, beyond what they read in the newspapers.”

According to Garnaut, the RBA doesn’t yet have a permanent representative in China and even Treasury, The Office of National Assessments and Defence Intelligence Organisation all have insufficient staffs of China experts.

Garnaut admits that the four China-based journalists with Australian media houses, including himself, are just too few to cover the huge range and complexity of events and trends.

So, with almost no one on the ground, we base the entire Australian economic strategy on an assumption that almost everyone in Australia says is right, so it must be right. But in and around China not everyone agrees.

John Garnaut himself last year highlighted the alarming views of Professor Yu Yongding, the recently retired director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

The problem, according to Yu, is that China’s demand just cannot keep up with the supply being created by over-investment. The government’s response is to invest more government money in projects that will only create even more oversupply. That, reports Garnaut, has seen investment double as a proportion of GDP since 2001 – now representing around half of economic activity.

Yu told Garnaut this was an “unsustainable process” that had been “concealed by ever-increasing net exports” and again obscured by last year’s stimulus-investment binge – which only worsened the situation of an economy producing too many things that the population is not demanding.

Very similar views were expressed last year by Pars Mellstrom and Carl George at Pivot Capital.

China’s latest budget documents confirm these basic trends. Last year China was driven by a 21.2% increase in government spending plus borrowing from an even faster government-directed increase in bank lending.

The budget shows China has started to build or upgrade 380,000 kilometres of roads, 266,000 kilometres of electric power lines and 35 civil airports and to produce 13.6 million vehicles. But this enormous level of construction will not be repeated in the coming year.

Barry Naughton, who ‘wrote the book’ on the Chinese economy, shows in the latest China Leadership Monitor that the costs of the Chinese state’s successful response to the financial crisis could be deeper than many had feared.

The problem is not just that money flowed to inefficient state-backed projects. Rather, the sudden expansion of administrative power ”profoundly disrupted” China’s steady evolution towards a more market-oriented incentive system.

”Once the scope of the state sector is indeterminate, and administrative interventions are repeatedly redrawing the boundary between state and private, then individuals must devote a great deal of their attention to anticipating and manipulating those administrative acts,” writes Naughton.

In short, it became rational for state and non-state actors to spend much more effort on politics and much less effort calculating market risks and rewards. The most obvious damage was to the integrity of China’s banking system, Naughton warns.

As I see it, Australia has no way of independently assessing the validity of these warnings. Some pundits have even suggested the figures are wrong in the other direction.

We have a simple blind faith in the China growth story. So far we have ignored most China warnings and we have been right – and both Peter Costello and Wayne Swan have basked in the glory. May it continue, because we are totally unprepared for the disaster that will befall Australia if the Chinese doubters turn out to be half right.

This article first appeared on Business Spectator.