Newly re-installed Prime Minister Kevin Rudd has declared he wants a free trade agreement with China. Chinese President Xi Jinping seems receptive. While any agreement is unlikely in the life of the current parliament, it will remain an issue for whoever wins this year’s federal election.

There are a number of hurdles to an agreement, but perhaps the chief stumbling block is Australia’s regulation of foreign direct investment. China wants the threshold for screening its investment proposals raised to around $1 billion, on a par with Australia’s agreements with the United States and New Zealand.

Under current arrangements, very little Chinese FDI in Australia escapes scrutiny because of Canberra’s policy of screening all investment by foreign government-related entities, regardless of transaction size.

Canberra maintains that this policy is applied in a non-discriminatory fashion to all foreign government-related investors. But the rules for these entities were only publicly articulated subsequent to the surge in Chinese investment from 2008 onwards. The Chinese can thank the US Embassy in Canberra and Wikileaks for confirming their suspicions that the policy is unofficially directed at them.

The marked deterioration in Australia-China relations during Kevin Rudd’s previous occupancy of the Lodge was in no small part due to the inability of his government to articulate a coherent policy on FDI from China.

Most Chinese FDI proposals are ultimately approved, which in itself is strong evidence that the current level of regulatory scrutiny at the border is costly and unnecessary.

Chinese direct investment in Australia is subject to the same competition, tax, industrial relations, planning, development and environmental laws that apply to other investors.

The additional layer of regulatory scrutiny Australia imposes at the border adds little to these robust regulatory frameworks behind the border. It serves mainly as a vehicle for political interference in commercial transactions the government does not like.

The rejection or modification of foreign investment proposals has often been explicitly protectionist in intent.

Former Treasurer Wayne Swan rejected Singapore Exchange’s bid for the Australian Securities Exchange in part because it would "risk us losing many of our financial sector jobs".

Minmetals’ acquisition of OZ Minerals was made subject to conditions that were, to quote the former treasurer again, "designed to protect around 2000 Australian jobs".

The Australian government has even sought to use the FDI screening process to regulate the level of output and employment in local mining operations.

Such micro-management of FDI trivialises the concept of the ‘national interest’ that is meant to inform the application of the treasurer’s discretion under the Foreign Acquisitions and Takeovers Act.

Some foreign investment proposals could raise genuinely vital national interest concerns. Parliament has already proscribed foreign investment in some sensitive assets.

But it is important that our regulation of FDI does not become an arm of protectionist industry or employment policy or a thinly-disguised proxy for domestic political concerns, harming Australia’s reputation as an investment destination.

What about China’s regulation of Australian outward FDI? It is true that China heavily regulates foreign capital inflows, including FDI. But China is a net importer of FDI and has become home to the world’s second large stock of FDI outside the United States. China is anything but closed to foreign investment.

Canberra no doubt wants significant concessions before lowering the threshold for screening. Yet it is in our interests to lower these barriers, regardless of the level of reciprocity.

The conclusion of a free trade agreement with China will require Canberra to give up some of its discretion over FDI. Yet given the current prime minister’s track record, it is difficult to imagine this occurring on his watch.

For its part, the Coalition has signalled an even tougher approach to regulating FDI, especially in agriculture and agribusiness.

The 2005 Australia-US Free Trade Agreement almost foundered on the issue of FDI. Yet most of the benefit from that agreement for Australia came through the liberalisation of investment screening thresholds.

Australia stands to benefit from being more open to Chinese investment, but only if it chooses to become less like China in its regulation of FDI.

Dr Stephen Kirchner is a research fellow at The Centre for Independent Studies. 

After three weeks of financial market turbulence in China, the good news is the Chinese economy is still here, and the world’s second biggest economy continues to grow strongly – much more so than any other major economy. In view of the deep dependence of the Australian economy on China’s – China alone takes more exports from Australia than the next four trading partners, excluding Japan, combined – this, of course, matters hugely for Australia.

Yesterday’s release of second-quarter and first-half data confirmed that GDP growth is easing, but remains within the Chinese government’s target of around mid-7 per cent year-on-year. For the record, though the attention markets give to a few basis points change in China’s data implies a precision in the data which does not exist, second-quarter GDP was up 7.5 per cent and first-half up 7.6 per cent, year-on-year. Cynics will point out that the second-quarter result was smack on the government’s own target. Too good to be true?

Some analysts prefer proxies for GDP. The most frequently used of these is power consumption. Data just released from the National Energy Administration shows power consumption in the first six months increasing 5.1 per cent, year-on-year. The rule of thumb is that GDP growth is a multiple of 1.5 times growth in power consumption, which would also be exactly in line with reported GDP growth. Some will say this is also too good to be true, and so it may be.

But then the official Purchasing Managers’ Index has also recently been released, which shows continuing but milder expansion at 50.1. However, just as with the GDP numbers, the PMI shows the economy to be slowing from the previous month when the PMI was 50.8.

If we look at successive quarters rather than year-on-year comparisons, we see that Q2 growth was virtually unchanged from the first quarter – down from 7.7 per cent to 7.5 per cent. Whereas, last year, the drop in GDP growth from the first to second quarter was much greater than this year – down from 8.1 per cent to 7.6 per cent. 

It should also be noted that this has been achieved even though growth in China’s exports in June were down 3.1 per cent on a year earlier. For years analysts have fretted about China’s heavy reliance on exports to drive growth but this is now an old story. Fixed asset investment is still the main driver of growth, increasing 20.1 per cent in the first half, almost unchanged from a year earlier. Meanwhile, retail sales were up 12.7 per cent on the first half of 2013.

According to a Xinhua report released on Monday, investment accounted for 53.9 per cent of first-half GDP, consumption (including government consumption as well) 45.2 per cent and net exports just 0.9 per cent. The role of investment has been wound back a long way from the post GFC-period of super charged monetary stimulus.

The conclusion analysts and markets should be drawing then is not that China’s GDP growth is slowing, but rather that it is stabilising around the government’s target rate of growth. It might be too early to conclude that a ‘soft landing’ has been achieved, but the government seems comfortable with current growth rates. Accordingly, as it has said on a number of occasions, struggling sectors can forget about more financial stimulus.

Last weekend the newly appointed Minister for Finance, Lou Jiwei, speaking in Washington, created a frisson among analysts when he was reported to have said 6.5-7 per cent growth would not be “a big problem”. This was widely seen as Lou preparing the ground for a worse than expected figure. The official news agency, Xinhua, was left scrambling as it sought to change his words to say “7.5 per cent”. After the confusion three weeks ago over the spike in inter-bank lending rates, these remarks added to the sense of the new team of economic managers being unsteady.

In recent remarks, Premier Li Keqiang echoed this insouciance saying that as long as key indicators – especially unemployment – do not slip below lower bounds and inflation does not rise too much, macroeconomic settings will remain unchanged. Encouragingly, he said policy in these circumstances would “focus on restructuring and pushing reforms”.

So why the panic in recent weeks when the credit shock hit? Markets have for some time been excessively nervous about China, or excessively speculative. In part this is attributable to the continuing weak international outlook. China has been one of the few bright spots – though not the Chinese stock exchange, which is still at a fraction of its pre-GFC highs.

China also has some real problems in its financial system. Reform and better regulation are urgently needed. The temporary credit shock was said to have been a shot across the banks’ bows to get them to pull back on lending to the informal financial sector, especially Ponzi-like wealth-management funds. If in fact this was true, it was a clumsy move but it did serve to make the point that banks had to be much more prudent in their lending.

The size of the shadow banking sector – a catch-all term for off-balance sheet lending by banks – has increased from about RMB 10 trillion in 2010 to more than RMB 37 trillion. Some RMB 17 trillion is in trouble, split evenly between property investors and municipal governments.

Much attention is paid to the so-called speculative bubble in property, but each year China needs to build a minimum of 10 million housing units just to keep up with normal growth in demand. Unlike in the US individuals are not highly leveraged, although many property development firms, especially in second and third-tier cities, are at risk from the government’s credit tightening. The government is prepared to let some of these go under. For first-tier cities, property prices are still rising at about 20 per cent per year so investors in these areas are not at risk.

Municipal government debt is a bigger risk as borrowings have been used to fund mainly infrastructure projects that yield returns only over the long term.  This investment has been one of the mainstays of China’s GDP growth. We understand that the government plans to issue bonds to fund a continuation of municipal infrastructure development while forcing municipal governments to clean up their balance sheets.

The government is clearly determined to maintain growth around current levels. It seems comfortable with how the economy is tracking and says it is determined to tackle problems in the banking sector. Rebalancing from exports to domestic demand is well advanced and from fixed asset investment to consumption has begun. It was always going to be a slow process so those among the analysts looking for shock therapy will inevitably be disappointed. 

More sustainable GDP growth, such as the current set of data reveal, should be welcomed by Australia.  When people are worrying about China’s growth being a few percentage points below where it was six or seven years ago, remember that the absolute size of the economy is almost twice as big. China is also still a poor country in per capita income terms, which means that growth will continue to be resource intensive for many years to come. Two cheers for China’s latest growth numbers!

Dr Geoff Raby is chairman and chief executive of Beijing-based advisory firm Geoff Raby & Associates, and a former Australian ambassador to China. He is a Vice Chancellor's Professorial Fellow at Monash University and a member of the Board of Directors of Fortescue Mining Group and Yancoal Australia. 

UBS is sticking to its forecast for the iron ore spot price to fall as much as 45 per cent by September 30.

The investment bank’s global commodity research analysts reckon iron ore will drop to US$71 a tonne, cost and freight in China. That’s down from US$129 a tonne yesterday, according to Bloomberg data citing iron ore imported through the northeast Chinese city of Tianjin. The Tianjin iron ore spot price has risen 13 per cent since June 26.

UBS says peak production this year in steel, particularly in China, has already passed. Demand for iron ore is slipping as iron ore supply increases, especially that produced by Rio Tinto and Fortescue Metals as new mines begin operations. Chinese steel mills, conscious that supply is outstripping demand, may go on a buyers' strike sometime in August or September in an effort to lower their raw material costs, causing the price of iron to fall to US$71 a tonne.

“Such a price will be part of a short, sharp correction that will last a few days or as long as a week,” Daniel Morgan, a UBS commodity analyst, told Markets Spectator.

“The iron ore spot market is in its infancy and does not have the liquidity of an oil or gold market. By late August or September there will be a correction."

Those who believe the iron ore price may not fall below US$100 because Chinese iron ore miners will stop their production when iron ore approaches US$100 a tonne are “flawed” in their analysis, says Morgan.

“Producers will produce rather than shut down."

On average iron ore’s spot price in the current quarter to September 30 will be US$100 a tonne, UBS forecasts. By the last quarter this year it will be back up to US$109 a tonne, on average, according to the Swiss investment bank. Longer term, UBS predicts an iron ore spot price of US$72 a tonne, free on board for 62 per cent iron content.

By a staff reporter

Chinese Premier Li Keqiang has moved to allay fears over the country's official growth target, reaffirming it was 7.5 per cent for 2013 not the lower figure flagged by the finance minister last week, according to Xinhua news agency.

His reassurances come after state media outlets corrected comments made by Finance Minister Lou Jiwei on Friday that growth could fall to 6.5 per cent but he thought 7 per cent could be achieved.

At a conference on China's economic situation, Mr Li indicated the government would act to spur growth if it fell to the lower end of the target band and the government should act to "avoid sharp fluctuations and keep economic growth within a reasonable range", Xinhua said. 

"The lower limit is to stabilize economic growth and maintain employment, while the upper limit is to prevent inflation," Li said.

"But when the economy reaches its upper or lower limits, macroeconomic policies should lay more emphasis on seeking growth and controlling inflation," Mr Li said.

He was speaking after data showed China's GDP slowed to 7.5 per cent in the June quarter, from 7.7 per cent in the previous quarter.

"The government should coordinate the efforts of stabilising economic growth, promoting restructuring and advancing reforms," Mr Li said.

China’s economy is flatlining while efforts to crack down on speculative lending and questionable practices are running into powerful Communist Party dynasties who control parts of the economy, say foreign experts on China.

“China is not growing at all,” Anne Stevenson-Yang, the Beijing-based founder of J Capital Research, told a conference organised by The Economist in Sydney.

“There has been a widening gap on statistics and what’s happening on the ground,” she says. “Now it is a gulf.”

China’s government has set a growth target this year of 7.5 per cent. But anecdotal evidence, according to Stevenson-Yang, who has been in several China’s major cities in the past two weeks, suggests growth has hit a wall.

Luxury outlets in Guangzhou, Beijing and Chengdu report to her that their sales are down by a fifth or as much as a third. Geoff Raby, Australia’s former ambassador to Beijing who now runs his own consultancy in the Chinese capital, says restaurants that were all but closed to anyone except Communist Party officials now welcome foreigners. Kerr Neilson, the co-founder of Platinum Asset Management, says prices and volumes of the fiery Chinese liquor Maotai have slumped, indicating the good times, at least for some, are over.

Moreover, says Stevenson-Yang, the spectre of a Chinese financial crisis looms large.

Stevenson-Yang says interviews she has done with executives at China’s smaller banks reveal that such financial institutions devote up to 80 per cent of their lending to rolling over their current loans. Big Chinese banks dedicate 50-60 per cent of their lending in the same way, she says.

And property developers, she says, are content to leave their housing uninhabited because current real estate clearing prices are below the cost of the loan.

A crackdown on the bank lending practices seems unlikely, says Stevenson-Yang as China’s banks are “Teflon banks” are largely immune to pressure because their balance sheets are so poor that any effort to halt their lending practices risks a financial crisis.

Kerry Brown, professor of Chinese studies at the University of Sydney, does not think President Xi Jinping will bring about any fundamental political, economic or financial reform.

The Communist Party of China’s political legitimacy, he says, rests on “its wealth creation machine”. Moreover, state-owned enterprises are “cash flows” for the central government and backed by some of the most powerful families in the country, making them largely above the law. Former premiers Zhu Rongji and Li Peng exert great influence over China’s finance and power industries respectively.

“These tribal political clans… are politically untouchable,” says Brown.

Rio Tinto, the world’s biggest iron ore producer, faces a sharp slowdown in Chinese steel production amid increasing iron ore seaborne trade in the second half of this year, says Morgan Stanley’s Rio analyst Brendan Fitzpatrick.

Geoff Raby, the former Australian ambassador to China and current board member of iron ore miner Fortescue, disagrees.

He says yesterday’s Tianjin iron ore spot price of $US129 a tonne, up 13 per cent since June 26, is a fair indication of rising iron ore demand due to economic growth. 

At 1503 Rio shares were up 77.5 cents, or 1.4 per cent, to $56.295. The stock has fallen 15 per cent this year. Fortescue shares gained 16.5 cents, or 4.7 per cent, to $3.665. The stock has dropped 21 per cent this year.

Raby reckons China’s economic growth is about 7.5 per cent – in line with the official economic data. Steel production, instead of slowing is being “cleared out of the steel yards”. Chinese steel producers aren’t having any trouble selling their steel, he says.

Australian iron ore volumes are set to increase as Rio and Fortescue mine more of the commodity after mine developments in Western Australia’s Pilbara region.

But even if volumes increase, prices will not come down too dramatically, Raby argues.   

Raby made his remarks at a conference in Sydney today.

AAP, with a staff reporter

Chinese investment in Australia soared 93 per cent in the first half of 2013 on the same time last year, outpacing the sharp rise posted in the country's broader overseas investment, to $US45.6 billion ($49.62 billion). 

Data from China's commerce ministry on Wednesday shows overseas investment jumped 29 per cent in the period, with money flowing into the United States almost quadrupling, jumping 290 per cent year-on-year.

Foreign direct investment (FDI) into China rose 4.9 per cent to $US62 billion during the first half of 2013, compared to the previous corresponding period, despite slowing growth in the world's second-largest economy.

Chinese investment into the European Union rose 50 per cent.

However, investment into Japan, with which China is embroiled in a row over disputed islands in the East China Sea, fell 9.1 per cent.

Ministry spokesman Shen Danyang said the fall was mainly a result of a widening choice of investment destinations for cash-rich Chinese companies, as well as "investment barriers" in Japan.

"Whether the Japanese economy and its investment environment is the most ideal among all the countries and regions for (Chinese) companies to go is up to the market and the companies to decide," he said.

In May, China's Shuanghui International announced it would buy US meats giant Smithfield for $US4.7 billion, while Australia is a crucial source of commodities for Beijing.

The most appealing sectors for Chinese investors were construction, which surged 541 per cent in the first half, science and technology (151 per cent), mining (142 per cent) and real estate (110 per cent).

Incoming FDI, which excludes financial sectors, increased to $US62 billion from January through June, the ministry said. For June itself, it rose 20.1 per cent year-on-year to $US14.4 billion.

Japan invested $US4.7 billion in the six-month period, up 14.4 per cent on year, with EU investment 14.7 per cent higher at $US4.0 billion and that from the United States rising 12.3 per cent to $US1.8 billion.

The vast majority of investment into China comes from a group of 10 Asian countries and regions including Hong Kong, Taiwan, Japan and Singapore.

Inflows from those economies gained 5.3 per cent on-year to $US53.8 billion during the first half.

Inward investment fell in 2012 for the first time in three years as clouds gathered over the global economy such as in Europe, while China suffered its own economic slowdown and political tensions soared with Japan.

"It is premature to come to the conclusion FDI has recovered with the single month data in June," Shen said.

"But FDI was relatively stable in the first half and gradually rebounded.

"We expect FDI to maintain steady growth in the second half of the year."

China's economy grew at its slowest pace in 13 years in 2012 as gross domestic product expanded 7.8 per cent.

In the first half of this year growth slipped again to 7.6 per cent, Beijing said this week.

AAP

The International Monetary Fund (IMF) says China's economy is on course to grow 7.75 per cent in 2013 - higher than the government's own 7.5 per cent target and actual growth of 7.6 per cent in the first half of the year.

Prospects for the world's second-largest economy were "clouded by mounting domestic vulnerabilities in the financial, fiscal and real estate sectors", the IMF said in a statement on Wednesday.

But it still expected it to grow at "around 7.75 per cent this year, notwithstanding a moderate slowdown during the first half, with resilient domestic demand offsetting lingering weakness in the external environment".

The optimism comes after private economists expressed alarm following slowing growth the past two quarters, with some doubting the government can achieve its target.

The National Bureau of Statistics announced Monday that China's gross domestic product (GDP) grew 7.5 per cent year-on-year in the April-June period.

That represented a deceleration from the first quarter's 7.7 per cent, which in turn was worse than 7.9 per cent in the final three months of 2012.

China's economy, a key engine of global growth, grew 7.8 per cent last year, its worst performance since 1999.

The IMF's latest assessment of 7.75 per cent growth is unchanged from late May when it downgraded its outlook from the previous 8.0 per cent. The institution also sees Chinese growth barely changing in 2014, at 7.7 per cent.

The Fund's statement comes at the conclusion of regular "Article IV consultations" between the Washington-based IMF and Beijing.

The IMF "welcomed China's continued strong economic growth with subdued inflation" but urged it to "contain risks to financial stability by reining in credit growth and non-traditional forms of lending".

A cash crunch roiled Chinese financial markets late last month before the central People's Bank of China, which had ordered banks to strengthen liquidity management, moved to calm nerves with an offer of support.

The turmoil, though brief, highlighted mounting concerns over excessive lending by banks and other problems in China's financial system, including opaque non-bank forms of lending, often called "shadow finance".

The IMF also warned of continuing "external risks" for China in the form of "potential spillovers from developments in the euro area and major advanced economies".

China's yuan currency "remains moderately undervalued", the Fund said, adding that a "more market-based exchange rate system would facilitate further internal and external rebalancing".

Beijing has faced pressure from the United States, the European Union and others for the yuan to appreciate amid claims its value is artificially low.

The currency has gained about 35 per cent against the US dollar over the past eight years.

The Fund also welcomed China's goal of retooling its economic model to one based more on consumption.

Such a "reform strategy... charts a path toward mitigating risks, rebalancing growth, and addressing income disparities, thus safeguarding China's important contribution to global growth," the Fund said.

The Rudd government is considering an easing of restrictions on Chinese investment in Australia as part of a renewed effort to secure a free trade agreement with Beijing, according to The Australian.

Under Julia Gillard, the federal government had pursued a reduced form of free trade focused on agriculture given that it had refused to ease Chinese investment access.

However, Kevin Rudd has put a comprehensive free trade agreement with Beijing back on the agenda as part of an effort to refortify the Australian economy amid declining revenues and uncertain resources sector outlook.

Newly-installed Trade Minister Richard Marles will soon fly to China to discuss a free trade deal and told The Australian that China is particularly interested in raising the threshold at which non-state investments are referred to the Foreign Investment Review Board.  

Chief executives at some of the world's largest investment banks are warning in their quarterly earning reports that the global economy faces duel threats from the looming withdrawal of United States Federal Reserve stimulus spending and a slowing Chinese economy.

Goldman Sachs chief financial officer Harvey Schwartz noted the impact of talk about the potential tapering of Fed bond buying, while adding that “clients were also concerned with the potential slowdown in China during the quarter”, according to The Australian Financial Review.

“Ultimately our clients are assessing the broader global economy, specifically whether a recovering US will offset potentially slower growth in other economic regions.”

Other executives have suggested a rosy outlook so long as the US and global economies continue to strengthen.

“There's no reason to think that we're not going to have a good trading going forward, because if the economy is strengthening, and our view is that it is, and that capital markets are going to kind of open up again, and people get adjusted to sightly higher new rates,” JPMorgan chief executive Jamie Dimon said in response to a question, according to the AFR.

UBS chairman Axel Weber earlier this month said that the Federal Reserve is doing what is best for the US economy, but that any tapering of its stimulus spending would come “at an awkward point in time” for Europe”.

By a staff reporter

House prices in almost all Chinese cities rose in June, according to data out of the National Bureau of Statistics.

Statistics showed 63 out of 70 cities surveyed recorded an increase in the price of new homes in June, on a monthly basis.

This left five cities positing a fall in prices, while two were unchanged.

In May, 65 out of 70 cities recorded price increases, two were unchanged and three fell.

In terms of existing homes, 55 out of 70 surveyed recorded an increase in price in June on a monthly basis.

This left seven cities positing a fall in prices, while eight were unchanged.

In May, 64 out of 70 cities recorded price increases, three were unchanged and three fell.

Citigroup’s China economist has returned from a trip to Beijing and says the government may put off any talk or action on moving the economy away from heavy state investment in order to achieve its 2013 growth target of 7.5 per cent.

“Premier Li Keqiang’s speech last week, for the first time since taking office, signaled that the government may put growth ahead of reform,” says Minggao Shen. “Many experts we met believed that 7.5 per cent is the likely floor for this year. It’s possible that this target could be reduced to 7 per cent next year.”

Some observers of the Chinese economy believe the world’s second-largest economy will struggle to meet its growth target this year. China’s finance minister Lou Jiwei said earlier this month said the economy could cope with growth of 6.5 per cent.

Still, the spot price for iron ore imported through the northeast Chinese port of Tianjin rose for the seventh consecutive day to $US130.40, perhaps indicating that steel production and industrial sector activity in China remains healthy.

The Tianjin spot iron ore price has gained 15 per cent since June 26, according to Bloomberg data.

At 1428 AEST shares in Rio Tinto, the world’s biggest iron ore miner, were up 54 cents, or 1 per cent, to $56.69. Iron ore miner Fortescue was unchanged at $3.71 while BHP was down 7 cents, or 0.2 per cent, to $34.12.

Chinese telecommunications manufacturer Huawei Technologies poses a significant security threat to Australia and the United States, the former head of the US Central Intelligence Agency (CIA) and National Security Agency (NSA) has told The Australian Financial Review.

The newspaper reported that Michael Hayden said intelligence agencies have evidence that Huawei has spied for the Chinese government, marking the first time that a top Western intelligence official has publicly stated that such evidence exists.

In 2011 Australia's federal government banned Huawei from participating in the building of the National Broadband Network (NBN) over fears that the company posed a security risk. The move prompted concerns in some corners that the move lacked supporting evidence and risked damaging relations with China.

Buy Mr Hayden said intelligence agencies had proof that Huawei was spying and that the company had, at least, “shared with the Chinese state intimate and extensive knowledge of the foreign telecommunications systems it is involved with”.

Since the 2011 ban, Huawei has actively lobbied the Australian government, and governments elsewhere, to see it as a low-cost option independent of China's government.

The company's global cyber security officer, John Suffolk, called Mr Hayden's comments unsubstantiated and defamatory.

“It's time to put up or shut up,” Mr Suffolk said, according to the AFR.

So much for dire predictions for iron ore. The spot price for iron ore imported through the northeast Chinese city of Tianjin has risen for an eighth consecutive day, up $US1.50, or 1.2 per cent, to $US131.90 a tonne. The Tianjin iron ore price is now 19 per cent higher than it was May 31 when it was $US110.40. That’s quite a rise given the volume of dire commentary on the Chinese economy, industrial production and the output of steel mills in particular.

Certainly some investors think so. They have driven shares of BHP and Rio Tinto higher since their lows this year. BHP is up 11 per cent since June 25. Yesterday the stock closed at $34.22, up just 0.1 per cent. Rio’s stock has gained 13 per cent since June 25. Yesterday it closed at $56.70, up 1 per cent. The Tianjin spot iron ore price has risen 16 per cent since June 25.

Ever since Deng Xiaoping reversed the ruinous economic policies of Mao Zedong in December 1978 by effectively decreeing capitalism, many have constantly misread China’s economy. From the sceptics of Deng’s orchestrated tear down of the command economy in the early 1980s to contemporary analysts who forecast a financial crisis because of speculative, corrupt lending practices, China has defied the doomsayers because of the energy and dynamism of parts of its leadership and the rapacious money making abilities of its private sector.

Beijing has changed beyond recognition. Its streets and landmarks of today bear little resemblance to the memories of former residents who now find themselves foreigners in their own birthplace. It is a similar story in Shanghai and Guangzhou and almost any other city or town in the world’s second-biggest economy. Some say this orgy of property and infrastructure building is profligate. Others say it is necessary for a country rapidly modernising and now an integral part of the world’s economy.

Until a few years ago a popular saying was that if the US sneezed the rest of the world caught a cold. Now all eyes are on China. It has managed to shrug off real and imagined illness, some at great cost to its long-suffering people, but has ultimately forced those who predicted a dire condition to eat humble pie.

Over the weekend, business commentators offered us reflections on a week that included the latest production reports from the big miners and a cataclysmic announcement from Orica, a company tied somewhat to their fortunes.

The broad conclusion is that the big miners are well prepared for China’s slowdown and that this isn’t so much an end to the boom, but an evolution of it. Nonetheless mining companies and their supporting cousins aren’t going to reap profits as they have in previous years. The price you pay for failing to be on top of your business is huge.

Firstly, The Australian’s Barry Fitzgerald notes that the June quarter reports from BHP Billiton and Rio Tinto more than anything else underline the “new era” of prudence over expansion.

“The focus now is very much on ‘sweating’ the enlarged capacity base put in place during the unprecedented investment splurge on new capacity across the past 10 years. Where companies used to wear their capital expenditure commitments to new capacity as a badge of honour, pride is now taken in how much capex has been reined in, and how much production has grown from capital invested in previous years. The transition from an investment-led charge by the industry to a production-led focus has not been enough to protect the resource sector's profits in the June year/half. But because of the massive decline in capex commitments, investors can look forward to improved dividend returns, particularly when the benefits of the falling dollar and easing cost pressures for labour, materials and equipment are added in.”

Fairfax’s Malcolm Maiden brings word from Goldman Sachs, the investment bank that first predicted the rise of the BRIC nations (Brazil, Russia, India and China), that the resources super-cycle is far from over, but it is “evolving”.

“The investment bank does not believe newer emerging economies including India, Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, Turkey, South Korea and Vietnam can replace China's infrastructure boom for intensity. It does, however, believe there is enough demand coming through to keep the demand-supply equation tight and the super-cycle alive. Mining will be harder to do in the next decade of the super-cycle as environmental concerns grow and development approvals become more time consuming. It's going to be increasingly a game for heavyweights, too. The size of individual projects will continue to grow to lock in economies of scale, and the big groups that have the funding lines will dominate.”

Which brings us to Orica, a company that is hardly one of the big resource houses. The Australian’s John Durie illustrates the job ahead of Orica boss Ian Smith – once the darling of the gold industry as Newcrest boss, until the post-Lihir purchase era kicked in.

It was thought that Orica would be “somewhat immune” from the easing resources boom because its explosives business could ride it out.

“The collapse of US gas prices hit that theory because cheap energy meant coal demand collapses, although Smith was talking up the US yesterday. In typical Smith style, the real cause of the profit downgrade was hard to fathom because it was sheeted home to many factors from problems in Indonesia, to higher-than-expected integration costs and weaker-than-expected demand. Take your pick, but integration costs is as good as any because it continues the line that past management wasn't doing the things it should have to make the most of its overpriced Minova acquisition. The admission that profits will be 10 per cent below last year's effort added to the sense of gloom ahead of the upcoming reporting season.”

The Australian Financial Review’s Chanticleer columnist Michael Smith explains how Orica’s episode on Friday serves as a reminder to company boards that are sitting on bad news in the lead-up to their profit reports.

“Directors are particularly worried at the moment about litigation funders with deep pockets, what with gold miner Newcrest facing a potential class action over its disclosure practices. It is a delicate balancing act. Move too early and you risk undermining your company’s share price with information that has not been thoroughly checked out. There was a grim reminder to boards on Friday about how a jittery market will react to an earnings downgrade when shares in explosives-maker Orica fell 15 per cent on a 10 per cent cut to forecasts. Leave it too late and the shareholders and regulators will be baying for your blood. Not everyone is erring on the side of caution though.”

In other company news, Business Spectator’s Stephen Bartholomeusz says the greatest loss for Woolworths from its botched rollout of hardware chain Masters is not to its bottom line, but its reputation.

Fairfax’s Adele Ferguson is back on the Commonwealth Bank financial trading scandal, this time through the prism of Nationals senator John ‘Wacka’ Williams, who is having a crack at the corporate regulator after a bunch of retirees lost their savings.

Elsewhere, The Australian’s economics editor David Uren writes that the Reserve Bank of Australia and Treasury are reviewing economics forecasts they made just two months ago, as they face the question of whether these need to be downgraded.

And with growth forecasts in mind, Fairfax’s Ross Gittins puts on a clinic in growth, debt and deficit that puts both current treasurer Chris Bowen and would-be treasurer Joe Hockey to shame.

A spokesman for Prime Minister Kevin Rudd says the decision to ban Huawei from the national broadband network was risk-based and in the national interest, The Australian Financial Review reports.

The spokesman was responding to allegations by former head of the Central Intelligence Agency, Michael Hayden, that Huawei was a spy for China, published in the newspaper last week.

"In the case of the NBN, the government made a risk-based decision in the national interest to exclude Huawei," the spokesman said.

"As a significant strategic government investment, we have a responsibility to do our utmost to protect the NBN’s integrity and the information carried on it."

The AFR reports Huawei has strongly rejected the allegations, saying it was time for its accusers to "put up or shut up"

"Huawei meets the communication needs of more than a third of the planet and our customers have the right to know what these unsubstantiated concerns are," Huawei's global head of cyber security, John Suffolk said.

China’s decision to abolish its floor on lending rates isn’t regarded as a revolutionary piece of financial reform. It may, however, be the first of a continuing series of steps towards a wider deregulation of financial institutions and markets.

From Saturday, China’s banks have been freed to set their lending rates independently where previously there was a floor under what they could charge which had been set at 70 per cent of China’s benchmark rate. The People's Bank of China’s benchmark rate for one-year lending is currently 6 per cent, so the floor had been 4.2 per cent.

While at face value the move would appear to make cheaper funding available to China’s borrowers within a slowing economy (except for mortgage loans, where the floor remains so that the authorities can keep some control of housing prices) none of the China analysts appear to expect it to have much impact.

That’s because not much lending has been occurring below the benchmark rate, let alone at the floor price.

China’s authorities, trying to get speculative and sub-economic activity within their economy under control, are also more likely to tighten than loosen lending quotas, which would limit their banks’ capacity and appetite for new lower-margin lending, although the larger state-owned enterprises might gain more leverage over the banks to extract cheaper funding as a result of the PBoC’s move.

It is, however, a significant first move away from the regulated rate environment where the PBoC sets a floor price on bank loans and a ceiling (currently 3 per cent) on deposit rates. Deregulating deposit rates would be a far more meaningful, and difficult, step.

Full interest rate deregulation would mean the abolition of the old Chinese model of regulating bank margins by ensuring wide spreads in order to ensure funds flowed to state-owned enterprises and large businesses.

Deregulation of deposit rates would be the obvious next step but is a more difficult one given that competition for deposits could have threatening implications for some of the less well-managed institutions and for non-banks operating within China’s very large "shadow" banking system.

Apart from a long-term commitment to liberalising financial markets and promoting the internationalisation of the renminbi (which ultimately would require financial deregulation) the new Chinese leadership would be acutely aware that the tight regulation of bank lending has promoted the dramatic and destabilising growth in its shadow banking sector.

Whether via the banking system or directly, Chinese savings have been channeled into unregulated lending, much of it of questionable quality, and into high-yielding wealth management schemes that, because of the poor quality of the underlying assets, have sometimes been likened to Ponzi schemes, with the new money funding the interest on existing deposits within that shadow system.

There has been a growing concern that, as the economy slows and the authorities try to reign in speculative activity, those wealth management schemes will collapse and the losses will ultimately flow back to the banks – which would then have to be bailed out by the government.

An apparent attempt to shock the banks into more conservative behaviour and slow the growth of credit in the economy last month misfired when the banks experienced an acute liquidity squeeze. The PBoC initially did nothing to help them – but was then forced to step in.

By creating the potential for bank spreads and profitability to be reduced – at least for larger borrowers – by freeing up lending rates, the PBoC might also reduce the banks’ capacity to funnel funds into the shadow system, although clearly deregulation of deposit rates would have more profound impacts.

Given the unstable and potentially destabilising structures that have emerged within what is supposedly an intensely regulated system, it isn’t surprised that the new leadership is looking for better mechanisms for improving allocations of capital within China’s economy and some liberalisation of rates and markets is an obvious way to bring market disciplines and competitive forces to bear.

The internationalisation of the renminbi is part of that process, although it is also likely to be a driver of deregulation, the development of deep and liquid financial markets and freer capital flows.

For the moment the Chinese authorities are hastening slowly but their direction, at least, appears clear.

I don’t think China is yet heading towards an economic crash, but I do think that even current growth rates are too high, and sell-side researchers and the various official entities in China and abroad will continue, as they have in the past, to revise their growth numbers downward almost on a quarterly basis.

And because growth will consistently underperform expectations, many members of the Chinese policymaking elite, and their effective allies among the shrinking but still large contingent of China-bulls, will increasingly argue that the economic rebalancing is being mismanaged, thereby putting pressure on Beijing to go into reverse. This is the real risk. There is no way that China can rebalance its economy even at growth rates of 6-7 per cent, and attempts to keep growth above that level will simply mean that it will take much longer for China to fix the underlying problems in the economy, that the costs will be much greater, and that the risk of a disorderly crisis will increase.

So far Beijing has done a great job in resisting this pressure to backtrack. The increasingly nasty trade spats between China and Europe and between China and the rest of the world, including the US, may make it harder for Beijing to pull off the necessary reforms, but so far they haven’t. It would probably be in everyone’s best interests if policymakers on both sides worked hard to tone down the rhetoric, but as I have been arguing for many years, I think trade disputes are only going to get worse, not better. If Europe and the US truly want to help Beijing transform the Chinese economy into something more stable for China and better for the world, they should create a little more space in the external sector in which Beijing can maneuver.

This process of slower-then-expected growth has been confirmed by the latest set of economic numbers coming out of China last week, which shows that China’s economy is indeed continuing to slow faster than expected as Beijing struggles to get its arms around credit expansion. 

Credit expansion continues to be much too rapid. The good news of course is that credit growth is slowing, but we must put this slowing credit growth in context. Total social financing rose by 1.2 trillion renminbi in May, which is roughly 2.3 per cent of GDP. This of course is much better than the 3 per cent of GDP by which TSF rose during the first four months of the year, but the consequence is likely to be an increase in GDP of about 0.6 per cent. Credit growth of 2.3 per cent of GDP (and this does not include credit growth which occurred outside TSF, such as leasing and shadow banking, which may add another 0.5-0.6 per cent of GDP) generated, in other words, roughly one quarter of that amount on GDP growth. Even this GDP growth is not necessarily real growth – it depends on how much of this activity was genuinely wealth creating and how much was simply caused by more wasted investment.

Can China spend its way to growth?

This is way too much debt, and it continues to imply that real debt servicing costs are growing much faster than the debt servicing capacity. Clearly this cannot be sustained. There are still bulls out there who insist that China is out of the woods and making a strong recovery, for example former deputy governor of the Reserve Bank of Australia, Stephen Grenville, who argues in his article (Sages fall flat when chiding China, May 22):

The missing element from the low growth narrative is that unemployment would rise, provoking a stimulatory policy response. China would extend the transition and put up with low-return investment (recall that when unemployment was the issue, Keynes was prepared to put people to work digging holes and filling them in) rather than have unemployment rise sharply. To be convincing, the low-growth scenario needs to explain why this policy response will not be effective.

It seems to me that the reason why simply “provoking a stimulatory policy response” won’t help China has been explained many times, even recently by former China bulls. Of course more stimulus will indeed cause GDP growth to pick up, as Grenville notes, but it will do so by exacerbating the gap between the growth in debt and the growth in debt-servicing capacity. Because too much debt and a huge amount of overvalued assets is precisely the problem facing China, it is hard to believe that spending more borrowed money on increasing already excessive capacity can possibly be a useful resolution of slower Chinese growth.

Perhaps Grenville is confused by what seems like low government debt and a low fiscal deficit, but these numbers are wholly irrelevant. Most fiscal expansion in China does not occur through the fiscal account but rather through the banking system. In that light recent comments by David Lipton, IMF deputy managing director, are relevant.

Lipton was in China two weeks ago when I had the chance to discuss some of these issues with him, and there is little doubt in my mind that he understands the pressures facing China, especially the growing gap between Chinese debt and its ability to service that debt. He also made clear that he recognises the confusions in the fiscal account. On June 9, during his press conference, in which he warned of the “important challenges” China was facing, he went on to say:

Fiscal reforms are also an integral part of the agenda to support rebalancing, improve governance and raise the efficiency of investment. Including local government financing vehicles, an estimate of the 'augmented' general government debt has risen to nearly 50 per cent of GDP, with the corresponding estimate of the 'augmented' fiscal deficit now on the order of about 10 per cent of GDP last year. While part of this deficit is financed through land sales and the “augmented” debt is still at a quite manageable level, it’s important over time to gradually reduce the deficit to ensure a robust and sustainable fiscal position and debt profile. 

With an “augmented” fiscals deficit already of 10 per cent of GDP (the IMF explains what it means by an augmented fiscal deficit here), and with so much excess investment in infrastructure, real estate, and manufacturing capacity, it probably isn’t necessary to explain a whole lot more why further fiscal stimulus might create growth in the short term but would be harmful for China in the medium term.

The slew of economic data released last week will have been much discussed and analysed in the media so I won’t add much more than I already have. Yes, Chinese growth is slowing, but by now this cannot have been a surprise to any but the most determined of bulls. The small possible uptick in retail sales might imply slightly stronger household consumption growth, but this is nowhere near enough to compensate for the decline in the growth of fixed asset investment.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.

AAP

China has introduced a five-year ban on the construction of new government offices, state media reports, following public anger at reports of extravagant official buildings.

The move came as part of a publicity campaign led by newly-installed President Xi Jinping, aimed at showing that the ruling Communist Party is cracking down on corruption and not wasting public money.

The ban, ratified by the State Council, China's cabinet, also covers expensive structures built as training centres or hotels, the official news agency Xinhua reported.

Reports of extravagant public buildings - including a local government office in poverty-stricken Anhui province covering an area larger than the US Pentagon, and a government building in central Jiangxi province with a $US45 million ($A48.9 million) mechanical clock tower - provoked anger online in recent years.

As well as being linked with official graft, the buildings were seen as signs of the ruling party's reliance on construction projects as a means of boosting growth, which economists have said is unsustainable.

The government has said it hopes to reduce the proportion of its economic growth generated by investment, and boost the share taken by consumption.

Officials will still be able to spend money on restoring government offices, Xinhua said.

Plans for the building moratorium were first announced by Premier Li Keqiang at a press conference in March.

Xi has pledged to crack down on corruption at all levels, saying it threatens the future of the communist party.

A number of low and mid-ranked officials have been investigated for corruption since he took the top party post in November.

Analysts have said it will be difficult to clean up politics without reforms such as removing restrictions on the media's reporting of corruption and making courts independent.