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JPMorgan Australia Ltd., Sydney Helen Kevans (61-2) 9220-3250 helen.e.kevans@jpmorgan.


Economic Research Global Data Watch September 10, 2010

Economic Research Note

Australian story increasingly linked to China's since 2000

%oya, GDP, both scales 6 4 2 0 -2 US China 5 10 Australia 15

Australia to benefit from China ties 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 economy avoided 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 appetite 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 could result 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 government investment will slow Chinas GDP growth to a stillsolid 7.5%-8.1%q/q saar pace in 2H10. After recording annual GDP growth of 9.1% in 2009, we expect growth in China of 9.8% in 2010 and 8.6% in 2011.






Australian economic growth to moderate, but remain solid

%oya, GDP 6 5 4 3 2 1 0 04 Australia 05 06 07 08 09 10 11 10 8 6 J.P. Morgan forecast China 16 14 12

tionship was in its infancy, the correlation coefficient between annual real GDP growth in Australia and China was just 0.25. It nearly doubled to 0.47 between 2000-09, although 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.

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 fell into 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 recently, though, has a close cyclical relationship between the two economies evolved. Between 1990-99, when this rela-

Exports, income, investment to hold up

The efforts of Chinese policymakers to shift growth onto a more sustainable path should be healthier for long-term trade 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, having 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.

JPMorgan Australia Ltd., Sydney Helen Kevans (61-2) 9220-3250

Economic Research Australia to benefit from China ties for some time yet September 10, 2010

In the June quarter of this year, Australia posted a trade surplus 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 partner, 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 commodity prices were high, and instead ramped up domestic production of these materials. As prices fall, Chinas commodity imports should increase. And, third, routine maintenance at Chinese steel mills in July prompted a temporary slump in iron ore imports.

Surging terms of trade to drive further investment

Index 120 100 80 60 40 Investment Terms of trade % of GDP 26 24 22 20 18 16 14 80 85 90 95 00 05 10 12

China's urbanization and industrialization far from over

GDP per capita US$, both scales 4000 3000 2000 1000 0 China Korea 80 85 90 95 00 05 Japan 50000 40000 30000 20000 10000 0

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 multiplier 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-supply 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.

ning and are being inhibited by capacity constraintsthe filling pipeline paves the way for a further gain in the investment 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 commodities will rise for a long while yet as it feeds its resource-intensive expansion. If we make the simple assumption 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 potential of China suggests that the expansion in resource demand has much further to run.

Higher prices, higher investment

These sharp price rises have generated huge profits in the mining 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 continue to upgrade capital spending plans to meet strong demand for resources from China, in particular. There currently 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 plan2