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Eslake, Saul --- "Catch me if you can" [2006] MonashBusRw 3; (2006) 2(1) Monash Business Review 16

Catch me if you can

Saul Eslake

Australia is one of the few countries whose principal exports won’t be priced out of global markets by China and India. Meanwhile, our program of unilateral trade liberalisation leaves us safe from their growing dominance in other markets, writes Saul Eslake.

The emergence of China and India in the world economy and in the world markets for tradeable goods and services, commodities, labor and financial assets is, arguably, the most significant change in global macro-economics since the breakdown of the Bretton Woods currency system in the early 1970s. It is at least as important as Japan’s sustained and rapid growth in the decades following the end of the Second World War, which from 1966 to 1992 put Japan as the world’s second largest economy.

Over the past decade, China’s economy has expanded at an average annual rate of 8.4 per cent while India’s economy has grown over the same period by 6.0 per cent. The OECD average is 2.7 per cent. Although these rates are rapid, they are not unprecedented for economies at China’s and India’s stage of development. For example Japan’s economy grew at an average of 8.8 per cent in the 1950s and 10.5 per cent in the 1960s; West Germany 8.2 per cent in the 50s; South Korea 8.7 per cent, 9.6 per cent and 9.1 per cent in the 60s, 70s and 80s, respectively; and Singapore at annual rates of 9.2 per cent, 9.0 per cent, 7.1 per cent and 7.7 per cent in the decades from the 50s through the 90s.

If the long-term consensus projections by Consensus Economics are vindicated, then as Table 1 indicates, by the year 2015 China will have (just) overtaken the US as the world’s largest economy, while India will have moved past Japan into third place.

Even though they are expected to rank first and third in terms of absolute size in 10 to 15 years, China and India will still be relatively poor countries. China’s per capita GDP will be one-fifth of the US and slightly less than one-third of Japan’s; while India’s will be about one-tenth that of the US and one-seventh of Japan’s. From a long-term perspective, the prospect of China and India becoming the world’s largest and third-largest economies within the next 10 to 15 years represents not an ‘emergence’ – something new as it is usually portrayed – but a return to the order which has prevailed throughout most of human history.

According to calculations by Angus Maddison (2001), from at least the beginning of the common era until the early 19th century China or India were the world’s largest economies: for much of this period China and India were intact political entities, had the world’s largest populations and were technological leaders, while in Western Europe, independent thought and entrepreneurial activity were stifled by superstition and mediaeval Christianity.

However, between the early 18th and late 20th centuries Renaissance, Reformation and then industrial revolution in Western Europe and the formation and rapid expansion of the US occurred while China retreated from engagement with the global economy during the Ming Dynasty which continued right up to the quarter-century of chaos and misrule under Mao Zedong during which an estimated 40 million people died from other than natural causes.

In India, the attainment of independence from Britain in 1948 was followed by 40 years of growth-stultifying socialism, as the Nehru dynasty pursued a utopian ideal of self-sufficiency in everything under the ‘licence Raj’.

The adoption by China in 1979 and India in 1991 of more stability-oriented and ‘growth-friendly’ macro-economic policies and ‘micro-economic reforms’ spurred rapid economic growth and allowed both countries to lift more people out of poverty than at any other time.

But in most respects China has done significantly better than India. Indeed, in 1950, three years after India gained independence from Britain and the Communists gained complete control of China, India’s per capita GDP was some 40 per cent higher than China’s. Not until 1978 did China’s per capita GDP surpass India’s. By 2002, however, China’s per capita GDP was more than double India’s (see Table 2).

China’s stronger GDP performance compared to India can be attributed to:

• Greater success in lifting labour force participation and in sustaining faster rates of productivity growth

• Saving and investing upwards of 35 per cent of GDP, compared with 22 per cent in India

• Manufacturing, where productivity gains are typically fastest, has accounted for 50 per cent of China’s GDP over the past decade, as against 25 per cent of India’s

• China has higher literacy rates and doing business there is easier compared with India

• China has more effective tax collection, has made more progress in cutting tariffs, attracted more foreign direct investment and integrated better into the global economy.

However, that does not necessarily mean the hare will outpace the tortoise in the long term as China has been much less efficient than India in its use of capital for investment and energy, particularly coal. And India is much better placed to handle the inevitability of its population being able to satisfy its basic physical needs like education, good health and good job prospects. Also, China confronts a much more serious demographic challenge than India, largely as a result of its ‘one-child’ policy.

Tradeable goods

One of the most important ways in which China, and to a lesser extent India, is reshaping the global economy is via its impact on the prices of tradeable goods. China’s merchandise exports have grown at an average annual rate of 13 per cent since 1981 (in US$ at market exchange rates), and by 18 per cent since 1991. China is now the world’s third largest exporter, after Germany and the US. If the growth rates of the past decade are sustained, China will overtake the US in 2007 and Germany in 2009.

China’s merchandise imports have grown rapidly at 15 per cent per annum since 1981. With 6.1 per cent of the world total, China is also now the world’s third-largest importer. India’s exports have risen at 12 per cent pa since 1991, though from a much lower base, and globally ranks 24th, with just under 1 per cent of the global total (see figure 3, over page).

China is now large enough, relative to the markets in which it trades, to affect the prices of the goods it trades. As a generalisation, it is pushing up the prices of the goods it imports, mainly commodities; and pushing down the prices of the goods which it exports, mainly manufactured goods. India is doing the same, though to a much smaller extent, and in relation to services rather than goods.

China’s oil consumption has risen by 2.2mn barrels per day over the past five years (a growth rate of 8.6 per cent per annum), accounting for 38.4 per cent of the increase in global oil consumption and absorbing 28.6 per cent of the increase in world oil production over this period. India is now the world’s sixth largest oil consumer and has accounted for 7 per cent of the increase in global demand over the past four years. China’s impact on the global coal trade has been even more striking and today it is the world’s largest coal user by a wide margin rising 14.2 per cent pa over the past five years, accounting for 70 per cent of the increase in global consumption over this period. It seems almost unarguable that the demand for energy to fuel China’s rapid industrialisation and growth (and to a lesser extent that of India) has been an important, if not the most important, contributor to the sharp rise in energy prices over the past few years, and that this effect will continue to be felt for many years to come.

China’s rapid industrialisation has also had a significant impact on the markets for a range of other metals and minerals. For example, it is now producing close to 300Mt of steel annually, double the amount in 2001, and nearly three times as much as Japan, making it a major source of iron ore and metallurgical (coking) coal. Over the past five years China’s imports of iron ore have risen at an average of 30 per cent each year, accounting for more than 85 per cent of the increase in global iron ore trade; its consumption of nickel has trebled and demand for copper has risen 75 per cent.

However, where China is, or has become, a significant net exporter of commodities the impact on prices has been rather different. For example, it has been a net exporter of aluminum since 2002 and a more significant producer of refined zinc, causing prices for both to rise by much less than other metals. China’s emergence towards the end of last year as a net exporter of steel products such as coil and wire has likewise exerted a significant downward effect on the prices in 2005.

One of the most striking aspects of the current phase of rising commodity prices is that higher commodity prices have not led to rising prices for finished goods, and therefore higher inflation. In fact, a study by Dresdner Kleinwort Wasserstein in The Economist (30 July 2005) suggests China has lowered the US inflation rate by almost a full percentage point in recent years.

How Australia benefits

In short, what China is doing is changing relative prices in a way that is particularly beneficial to Australia. In simple terms, China is a net importer of (non-agricultural) commodities and a net exporter of manufactured goods. Australia, on the other hand, is the opposite: a net exporter of commodities, and a net importer of manufactured goods.

Indeed, Australia is one of the few countries in the world whose principal exports are not at risk of being priced out of global markets by China – since China cannot conjure up reserves of coal, iron ore, nickel, natural gas etc. it does not have. And Australia is also one of the few countries in the world which has little to lose from China’s growing dominance of markets for the products which it can now, or will, eventually produce – since we have exited those industries through our own program of unilateral trade liberalisation. It is thus no co-incidence that China’s emergence as a significant influence on the global economy has been paralleled by a dramatic reversal in Australia’s terms of trade.

Vendor financing

China’s impact on the Australian dollar is, of course, just one very small aspect of its growing influence on global financial markets. Until 2003 China’s current account surpluses were typically quite small, averaging less than 2 per cent of GDP between 1990 and 2002 and exceeding 3 per cent of GDP (at market exchange rates) in only four years. Over the past two years however China’s current account surplus has mushroomed, reaching US$70bn (4.2 per cent of GDP) in 2004 and on track to exceed US$100bn (5 per cent of GDP) this year. On top of this China has attracted a large and growing volume of foreign direct investment – exceeding US$50bn per annum in recent years – and, more recently a rising tide of portfolio and other capital inflows, which topped US$56bn in 2004.

In effect the People’s Bank of China (PBoC), in company with other East Asian central banks, has been running what could be described as the greatest vendor financing scheme the world has ever known: lending to US consumers via the US budget the money they need to keep borrowing so that they can keep buying the products east Asian economies need to keep selling them so that they, in turn, can keep growing at the rates to which they have become accustomed.

China’s move at the end of July 2005 from a rigid peg to the US dollar to a ‘managed’ peg to a basket of currencies (and the other developments which have been announced since) is an important change along the road to a more flexible exchange rate regime, but it does not amount to a retreat from China’s strong preference for exchange rate stability.

Were China to move immediately – or even over an interval of a few years – to a freely floating exchange rate with free cross-border capital flows it is just as likely that the renminbi (Rmb) would fall as rise, as Chinese savers sought to withdraw their savings from domestic banks of (currently) dubious solvency in favour of overseas investments. More than anything else, this reality explains why the Chinese authorities regard reform and recapitalisation of the banking system as more important than, and a pre-requisite for, the adoption of a more flexible exchange rate system.

Any subsequent decision by the PBoC to discontinue its policy of doing ‘whatever it takes’ to prevent a rise in the Rmb against the US$ (a decision which would likely be mirrored by other Asian central banks) would undoubtedly have significant consequences for the financing of the US budget and current account deficits, and hence for US long-term interest rates and asset prices. All of which illustrates the point that the world has rarely responded rationally to the rise of a new economic power. As Robert Kagan observes in a Washington Post article (15 April 2005) “rarely have rising powers risen without sparking a major war that reshaped the international system to reflect new realities of power … There is no reason to believe that we are any smarter today than the policymakers who mismanaged the rise of Germany and Japan.”

There are, however, plenty of reasons to hope that we are smarter than those policy makers – the benefits to Australia being not least among them. While China’s rapid economic growth and industrialisation is unequivocally beneficial to Australia, in the same way as Japan’s was 30 years ago, it raises political and strategic questions that Australia never confronted in the context of its relationship with Japan or other east Asian countries.

Australia in the middle

China is not, and probably never will be, a strong ally of the US. On some issues – international terrorism and the North Korea nuclear weapons challenge – their interests coincide; but mostly they diverge. Despite this China is increasingly seeking a role in regional and global affairs commensurate with its population and growing economic weight. Almost inevitably, this means there will be issues and areas of conflict. But it is also likely Australia may have to choose between our commercial and economic interests on the one hand and our strategic interests on the other – in a way that has never arisen with Japan.

Meanwhile, the pattern of growth and development being followed by India is less complementary to Australia’s economy. India’s pursuit of global dominance in services industries – such as IT and business process outsourcing – has little impact on the demand for Australia’s principal commodity exports; but does potentially put at risk jobs in our services industries, which accounts for more than 70 per cent of total employment.

Nonetheless, a more prosperous and wealthier India will undoubtedly be a positive influence in the region and for the world. Partly because it is a democracy, India’s interests are less likely to conflict with those of the US than China’s – a point which has already not escaped the attention of leading US policymakers. India’s rapid growth serves to remind Australians that, even as we become more economically dependent on China, and its seemingly insatiable thirst for our resources, we will need to continue to deepen and strengthen our economic, political and cultural ties with other Asian nations, including India, as well as our other long-standing friends and trading partners in east Asia.

Cite this article as

Eslake, Saul. 'Catch me if you can'. Monash Business Review. 2006.; Monash University ePress: Victoria, Australia. http://www.epress.monash.edu.au/. : 16–22. DOI:10.2104/mbr06003

About the author

Saul Eslake

eslakes@anz.com

Saul Eslake is Chief Economist of the Australia & New Zealand Banking Group Ltd (ANZ). He was previously with National Mutual Funds Management and McIntosh Securities Ltd and is a member of the Australian Government’s Foreign Affairs and Trade Policy Advisory Councils.

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