I've uploaded an excellent paper by Edward Chancellor which highlights concerns that I and a lot of others are having about China. Given the close ties China has to the Australian economy and how dependent we are on Chinese demand for our natural resources, a downturn in China would spell disaster for our "lucky country."

In Australia, interest rates are still almost as low as they have ever been historically and the next move is going to be up. Even if we drop into crisis mode and Stevens the Keynesian in charge of the RBA slashes rates again, we may just get a US/Japan style situation where banks keep loans "performing" by lowering the borrower's rate to almost nothing and just require interest-only payments (still making a small profit on the spread) to stay in business (no hit to capital). That's all hunky dory but they certainly won't be making loans to businesses or any other private parties so the economy will just stagnate. We will end up excessive government debt and our mighty four-pillar banks reduced to zombies.

Back to the article, I especially like the Mills quote from 1867, "Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works," which is exactly why bailouts do nothing to help the poor taxpayer or 'economy' but merely transfer wealth from them to the politicians buddies (large campaign contributors, former colleagues, etc).

Malinvestment is certainly rife in China as it always is under central planning. Resources are allocated sub-optimally and often arbitrarily by planners which may make for a great GDP figure but can hardly be called wealth creation when individuals don't actually want it. They have papered over the cracks with massive monetary inflation over the past few years which makes these (mal)investments look better than they actually are, but as Hayek said that can only be maintained with an ever-increasing rate of inflation. Thus, the income bonuses Australia has received over the past decade from the unsustainable natural resource demand in China are exactly that, unsustainable. They are being driven by monetary inflation and bank credit expansion. Malinvestment is rife and, as the article states, there are red flags everywhere.

As is always the case with bubbles, the hardest thing to predict is the timing. Take for instance the data: recall the Soviets boasting about their excellent 'free' healthcare system. Each hospital was allowed a certain number of deaths per annum and doctors were rewarded based not on profit or how well they treated their customers but on death statistics. So doctors did what they had to to avoid punishment: they would either fudge the statistics; refuse to treat people near death; and sometimes would simply wheel existing patients out the doors if they looked like dying. While the context and severity is different, a Chinese banker would be faced with a similar situation: choose between recording a 'death' in a loan or manipulate the data for as long as possible. The whole process can take a very long time to unravel and reveal the true state of the country and how much malinvestment really exists.

Unfortunately, Australia is tethered to the ship that is China and if she goes down we're going down with her, unless of course something else doesn't sink us before then (as the article mentions, when you have a state-run economy you can delay the inevitable for an unbelievably long time). When this happens government and businesses that have been relying on high commodity prices and demand from China will suffer. Governments find it very very very difficult to cut spending when revenue falls and thus this will result in an expansion in the unproductive government sector relative to the whole economy. We might be in deficit for some time to come.

Click here to download China's Red Flags, a March 2010 GMO White Paper by Edward Chancellor.