Australia's New China Boom

If China's economy is so strong, why is capital fleeing...?

The AUSSIE market kicked off the week on a positive note, says Greg Canavan in The Daily Reckoning Australia.

The afterglow from Trump's election victory one month ago is still strong. Global equity markets are bullish. No one wants to sell. It's a 'buy the dip' mentality.

The US Federal Reserve, which has gone to ground over the past month, meets this week to (in all likelihood) raise interest rates. Remember when that prospect put the fear of God into markets? Now it's nothing more than a formality.

Oh how expectations and beliefs change!

Meanwhile, back in Australia, have you noticed how bank shares are again on the rise?

On the surface, this is surprising, given that, just last week, the Australian Bureau of Statistics (ABS) reported that the Aussie economy contracted by 0.5% in the three months to 30 September.

If the economy is shrinking, that should be bad for banks, right?

Well, it's not quite as simple as that. The headline measure of economic growth is a little misleading. It measures economic output, and doesn't take into account price changes in our exports and imports.

If you've been paying attention, you'll have noticed that iron ore prices, and a range of other commodities, have rallied strongly this year. That, in turn, boosts Australia's 'terms of trade'. When the terms of trade rises, it translates into increased national income.

The ABS factors the terms of trade into a measure of economic growth it calls 'real net national disposable income'. It's actually a broader measure of growth than the one you see quoted in the business pages.

On this measure, economic growth actually expanded 0.8% in the September quarter and 3.2% over the past year.

That's a decent rate of growth. Collectively, the economy isn't as bad as the contracting headline rate suggests. But it does mean that growth is skewed towards the export sector.

As iron ore is Australia's largest export, its rising price translates into increased national wealth. It also boosts the government's coffers through increased taxes.

But what the economic growth figures don't take into account is the ownership of the profits from increased iron ore production.

For example, Rio Tinto (ASX:RIO) and BHP Billiton (ASX:BHP) are the two largest producers of iron ore in the world. However, the shares of these companies are not fully owned by Australians.

In fact, they are dual-listed shares – with a secondary listing in London – meaning that foreign ownership levels are quite high. This, in turn, means much of the profits earned from higher iron ore prices flow offshore.

This is partly reflected in our current account deficit, which measures the balance of trade as well as net financial flows.

Thanks to rising commodity prices, the current account deficit for the September quarter was 'only' $11.4 billion – the best result in seven quarters. But that's still well below where the bulls thought it would be a few years ago. After all, the commodity investment boom was meant to lead to greater production (which it did), which was then meant to improve our trade deficit (which it didn't).

But the world doesn't really care about trade or current account deficits any more. I'm not sure what it cares about actually. More debt growth?

But I do know that, if bank share prices are on the rise again, the economy can't be doing that badly. At least not the debt-dependent, asset-shuffling part of the economy, anyway.

Last Friday, a whole bunch of bank share prices closed at multi-month highs – Commonwealth Bank (ASX:CBA), ANZ Bank (ASX:ANZ), National Australia Bank (ASX:NAB), Westpac (ASX:WBC), Bendigo and Adelaide Bank (ASX:BEN), Macquarie Group (ASX:MQG), and Suncorp Group (ASX:SUN).

In other words, capital is flowing back into the banking sector. It tells me that official interest rates are not about to rise, and that the housing market isn't about to collapse.

In fact, because the headline rate of economic growth contracted, there is probably an expectation that the RBA may even cut rates again.

It also confirms the pricing power of the banks. In recent weeks, most banks have adjusted their fixed and variable rates for investor loans. In the absence of an official interest rate increase, this helps to maintain margins.

As Business Day reports:

"The latest round of interest rate hikes from banks are taking effect about twice as quickly as the time it took lenders to cut home loan rates four months ago, another way in which lenders are seeking to protect their profit margins."

The wildcard, not surprisingly, is China. The resurgence of China this year is a major reason behind the rise in commodity prices, particularly the iron ore price.

One consequence of China's rebound is that it has been accompanied by increasing capital flight. That is, more and more capital is trying to get out of the country, and officials are losing the battle in trying to control these capital flows.

This puts pressure on the Yuan, which is now at its lowest point against the US Dollar in eight years. The Financial Times reports that the Yuan is on track for its worst fall on record this year.

To defend the Yuan, the People's Bank of China (PBoC) must sell its US Dollar reserves. In November, the value of China's reserves fell by nearly US$70 billion; although, up to half of this was the result of currency depreciation.

Still, the PBoC has sold off more than US$500 billion in reserves this year to defend the Yuan. If the Chinese economy is really on the rebound, it doesn't make sense that so much capital is trying to escape the country.

This has major implications for Australia.