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Economic Research

Global Data WatchSeptember 10, 2010

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JPMorgan Australia Ltd., Sydney

Helen Kevans (61-2) 9220-3250helen.e.kevans@jpmorgan.com

Australia to benefit from Chinaties for some time yet The rise in Aussie exports during the GFC owed

much to the Chinese governments stimulus spending

Australia will continue to benefit from Chinas

strength via higher income, exports, and investment

Our base case is for only a modest slowing in China,

with 2010 GDP growth forecast at 9.8%

The Australian economy exited the global financial crisis

(GFC) with fewer scars than most. Thanks to its close ties

with Asia (and to China in particular), the economyavoided the worst effects of the global downturn. Though

global trade was in freefall, Australia emerged as the only

developed country not to record a drop in export volumes.

This owed primarily to Chinas seemingly insatiable appe-

tite for raw materials. Indeed, much of the fiscal stimulus

delivered by the Chinese government in 2009 was directed

at fixed asset and infrastructure development, leading to a

spike in Chinese demand for commodities. This, of course,

helped resource-rich Australia escape the great recession.

Going forward, Australias economic fortunes remain bright

due largely to these ties. While we acknowledge the risk that

the policy measures put in place by Chinese authorities couldresult in a larger-than-intended slowing in growth, it is not

our base case. We forecast that monetary normalization and

policy curbs targeting the property market and local govern-

ment investment will slow Chinas GDP growth to a still-

solid 7.5%-8.1%q/q saar pace in 2H10. After recording an-

nual GDP growth of 9.1% in 2009, we expect growth in

China of 9.8% in 2010 and 8.6% in 2011.

China increasingly important to Australia

The role of the US in determining the fate of the Australian

economy has diminished. Australia was closely tied to the

performance of the US during the 1990s. When the US fellinto recession, so did Australia; hence, the old truism about

Australia (and the rest of the world) catching a cold when

the US sneezed. From 1990-99, the correlation coefficient

between annual real GDP growth in Australia and the US

was a significant 0.92. It since has slid to 0.65.

In contrast, China has become increasingly important to the

continued prosperity of the Australian economy. Only re-

cently, though, has a close cyclical relationship between the

two economies evolved. Between 1990-99, when this rela-

Economic Research Note

tionship was in its infancy, the correlation coefficient be-

tween annual real GDP growth in Australia and China was

just 0.25. It nearly doubled to 0.47 between 2000-09, al-

though since 2004, it shot up to 0.74, and since 2007, it has

spiked to 0.98.

It follows, therefore, that a significant slowdown in China

would increase the risk of sub-trend growth in Australia.

As a rule of thumb, on our estimates, the direct result of a

moderation in Chinas GDP growth of 1%oya over any one

quarter (which is roughly in line with our forecasts in

2H10) would result in a 0.5% slowing in %oya terms in

Australias GDP growth.

Exports, income, investment to hold up

The efforts of Chinese policymakers to shift growth onto a

more sustainable path should be healthier for long-termtrade between the two countries. Nonetheless, the modest

slowing we forecast in Chinas rate of economic growth

will affect Australia via the primary channels of exports,

income, and investment.

China now receives one-quarter of Australias exports, hav-

ing overtaken Japan as the nations largest trading partner in

early 2009. Chinas higher infrastructure spending bolstered

demand for Australias key commodity exportsiron ore to

fuel the production of steel and coal to produce electricity.

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1

2

3

4

5

6

6

8

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12

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16

%oya, GDP

Australian economic growth to moderate, but remain solid

04 05 06 07 08 09 10 11

China

Australia

J.P. Morgan forecast

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0

2

4

6

5

10

15

%oya, GDP, both scales

Australian story i ncreasingly linked to China's since 2000

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US China

Australia

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Economic Research

Australia to benefit from China ties for sometime yetSeptember 10, 2010

JPMorgan Australia Ltd., Sydney

Helen Kevans (61-2) 9220-3250helen.e.kevans@jpmorgan.com

In the June quarter of this year, Australia posted a trade sur-

plus of A$6.6 billion, an A$11 billion turnaround from the

deficit in 1Q, owing mainly to increased trade with China.

With China now Australias most significant trading part-

ner, the recent drop in coal and iron ore exports to China in

July generated concerns that Australia was facing an abrupt

slowdown. These concerns, in our view, are overdone.

First, the inventory correction in China during the second

quarter largely explained the drop in Chinas imports of

commodities. That correction now is past. Second, Chinese

steelmakers probably held back on buying when commod-

ity prices were high, and instead ramped up domestic pro-

duction of these materials. As prices fall, Chinas commod-

ity imports should increase. And, third, routine mainte-

nance at Chinese steel mills in July prompted a temporaryslump in iron ore imports.

Terms of trade nearing historic heights

Boosted by Chinas resource-intensive growth, a massive

upswing in commodity prices already is washing through

the Aussie economy. The 1.2%q/q spike in 2Q GDP largely

reflected higher incomereal gross domestic income raced

up 4%, the largest rise since 1Q73. With prices of mineral

resources surging, and import price growth subdued, the

terms of trade has returned to historic highs. Moreover, the

resulting boost to national income is having positive multi-

plier effects throughout the economy, boosting real GDP,

generating jobs, and lifting domestic demand.

The fact that commodity prices still are elevated despite the

severity of the global recession suggests that demand-sup-

ply imbalances are at play. This means that, even with a

moderation in economic growth in China (and the rest of

world), iron ore and coal prices will be slow to fall as

world supply catches up with demand. Prices probably will

settle well above their long-term average levels, leaving the

terms of trade to rise 19% this year, in our view.

Higher prices, higher investment

These sharp price rises have generated huge profits in themining sectorprofits spiked 63%q/q in 2Qand a huge

rise in mining investment. Owing to a wave of new mining

projects, business spending on investment soon will reach

its highest share of GDP in half a century. The miners con-

tinue to upgrade capital spending plans to meet strong de-

mand for resources from China, in particular. There cur-

rently are A$725 billion (nearly 60% of GDP) of projects

sitting in the investment pipeline, most of which involve a

large expansion of iron ore and coal industries. While not

all will be completedmany are in the early stages of plan-

ning and are being inhibited by capacity constraintsthe

filling pipeline paves the way for a further gain in the in-

vestment share.

Chinas urbanization far from complete

Even if China slows, further sizeable increases in Chinese

demand for commodities seem likely. With China still in an

early stage of development, strong demand for Australian

commodities should continue to underpin economic

growth. The process of Chinas economic convergence

with more developed countries is far from complete.

According to the IMF, the consumption of commodities

typically grows with income until real GDP per capita

reaches US$15,000US$20,000, as countries go through a

period of industrialization and infrastructure construction.

In 2009, Chinas GDP per capita was just US$3,700, well

below that of other recently industrialized economies. Also,

the percentage of the population in urban areas was less

than 50%; this means that Chinas consumption of com-

modities will rise for a long while yet as it feeds its re-

source-intensive expansion. If we make the simple assump-

tion that Chinas GDP per capita continues to grow at the

average rate of the past decade, Chinas level of income

will not reach US$15,000 until 2020. Thus, the growth po-

tential of China suggests that the expansion in resource de-

mand has much further to run.

0

1000

2000

3000

4000

0

10000

20000

30000

40000

50000

GDP per capita US$, both scales

China's urbanization and industrialization far from over

80 85 90 95 00 05

China

Japan

Korea

40

60

80

100

120

12

14

16

18

20

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2426

Index

Surging terms of trade to drive further investment

% of GDP

80 85 90 95 00 05 10

Investment

Terms of trade