Peter Redward details how China's economic hard landing is already hitting Australian iron ore and coal receipts and why it may last into next year

By Bernard Hickey

Emerging Asia economist and strategist Peter Redward of Redward Associates has warned Chinese economic growth has slowed rapidly to around 6.5% and is unlikely to stabilise until early next year.

Redwood pointed out in this monthly Emerging Asia Report video interview above that a sharp slide in iron ore and coal prices in recent weeks was an early indicator a hard landing in China would quickly weaken Australia's trade balance with every 1% fall in iron ore prices cutting receipts for the lucky country by A$63 million. Australia is the largest buyer of New Zealand's exports, while China is the largest buyer of Australian exports. China is also the second largest buyer of New Zealand exports.

"The landing is definitely becoming harder," Redwood said pointing out that Chinese growth of 6.5% disguised a serious slowdown in private sector investment in China. Government investment and a likely improvement in China's trade balance because of weaker imports made that growth look better than it actually was, he said.

"The 6.5% number is actually pretty bad. What it suggests is the manufacturing sector, the industrial engine of China, is very, very weak," he said.

"That in turn is leading to very weak electricity production, which is in turn leading to the accumulation of coal both in the production facilities and then all the way back to Newcastle and Gladstone in Australia, which is pushing coal and iron ore prices down. That in turn is weakening Australia's balance of payments and increasing the fragility of the Australian dollar."

Redward pointed out 60% of Australia's merchandise exports were now basic materials such as iron ore, coal, oil, gas and minerals, up from 35-40% a decade ago.

"The country is becoming increasingly reliant on that commodity engine. As the commodity intensity rises, the sensitivity of the balance of payments to commodity prices is increasing," he said of the Australian balance of payments deficit, which he said had the capacity to blow out in the second half of this year as coal prices fell significantly.

Redward said the Reserve Bank of Australia may be underestimating this slowdown, given it relied on commodity price figures showing overlapping contracts, which introduced inertia into its estimates.

"That's giving them a bit more comfort than they should take away right now," he said.

"We've seen in the last week or two significant falls in the price of iron ore," he said in the interview last week, pointing out Australia's iron ore exports were worth A$63 billion in the last year.

Why is China slowing?

Redward said China's economy was maturing and its demographic profile was shifting.

"The need for rapid infrastructure build-outs is beginning to drop away. Secondly, we've been through a period of very easy credit for many years in China and very rapid monetary growth. Money and credit growth was curtailed last year. We're seeing it pick up now, but that effect (from last year) is still flowing through," he said.

Redward pointed to the latest estimate of China's new factory orders in MNI's Purchasing Managers Index, which collects data from smaller, more private enterprises than from state owned operations. It showed output heading back to the lows seen in late 2008 after the collapse in global trade in the wake of the Lehman crisis.

Redward said China may try to loosen monetary policy through ordering its banks to lend, but it may not be as effective as it was in 2008 given a reduction in the money multiplier in the economy and the reluctance of many private companies, SOEs and local governments to invest.

"While the government can force banks to lend through their window guidance policy -- they can tell a bank to lend to an enterprise -- there are risks. The bank might lend the money, but the State Owned Enterprise or local government might recycle that into government bonds or back onto the central bank's balance sheet and they may not spend it all," he said.

Redward said his reading of the financial market leading indicators for the spread between two and 10 year bond yields in China suggested the slide had been arrested.

"Right now it's saying we're probably reaching a trough, but it doesn't tell you anything about the nature of the recovery," he said, adding that a recent flattening of that yield curve suggested financial market pricing was becoming more pessimistic

"The availability of credit to small businesses is actually tightening again," he said.

"It would suggest the slowdown in the industrial sector is going to continue right through the second half of this year. Barring some sort of shift in policy, we're not going to see some sort of stabilisation until sometime early next year and then the recovery could be quite mild."

Why won't China stimulate hard like in 2008?

"I don't think the Chinese want to stimulate strongly because they're concerned about longer term impairments and potential balance sheet damage, and the political implications of doing that. There's also a perception that it may not be particularly effective, and this is a problem they have to ride out. They are also concerned that if they inject too much liquidity into the system, all they would do is inflate the property market even further."

Redward said financial markets had already priced in the impact of expected quantitative easings in America and Europe, which meant the recent strength of the Australian and New Zealand dollars (despite lower commodity prices) may be overdone.

"That's a significant risk," he said of the chances the Australasian currencies would fall.

See more here about Redward Associates here, which produces Emerging Asia Today, a daily subscription newsletter.