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Treasury Too Rosy on China

John Lee

In October 2009, a former top Treasury official at the Australian embassy in Beijing slammed the Rudd government for a “dysfunctional China policy”. Stephen Joske went further, saying “there’s no one in Treasury who can tell up from down on China, beyond what they read in the newspapers”—a serious charge given the importance of China to our national income and taxation revenue.

Four years later, the resurrected Rudd government and senior Treasury officials are again being criticised for inaccurate forecasting. Much of the criticism now and since 2009 is directed towards the consistent failure of Treasury officials to present accurate forecasts of Chinese economic conditions and demand for commodities. Unfortunately, and despite the impartiality and competence of its senior officials, significant inaccuracies remain likely.

First some facts on the forecasting record. Take Treasury predictions about growth in commodity export volumes, which is mainly driven by demand from China for iron ore. Since 2003-04, Treasury has significantly overestimated commodity export volume growth in every year except for 2009-10, when Beijing began an unprecedented expansion in construction as a result of the global financial crisis. In 2010-11 and 2011-12, Treasury predictions of non-rural export volume growth overshot by more than 7 per cent and 8 per cent respectively; problematic errors of scale when one considers actual growth was only 1 per cent and 5 per cent in those years.

True, Treasury officials are on a hiding to nothing when it comes to forecasting anything to do with China. Part of the difficulty is the complexity of assessing the changing supply of commodities available to the Chinese market, which will affect both price and volume of Australian exports. But there is still no denying that Treasury has been systematically overestimating Chinese demand for mineral resources since about 2005. There are a number of reasons why this has occurred.

The main problem is that Treasury appears to have bought uncritically into the narrative spruiked by the large mining companies that rapid Chinese urbanisation will drive fixed investment (and therefore commodity demand) for decades to come. But if Chinese steel demand is driven by urbanisation, then something does not add up. From 1980 to 1995, genuine urbanisation increased more rapidly than it did from 1995 to 2012. In that first period, crude steel production in China increased by about 5 per cent each year. Yet, from 1998 to 2012, crude steel production shot up to growth rates of about 18 per cent a year and steel production doubled from 2008 to 2012.

The point is that Chinese steel demand bears little historical correlation with urbanisation, and the latter cannot primarily account for the huge increase in demand for Australian iron ore from this century onwards. When exports dramatically declined some months before the GFC in 2007, Beijing responded with the largest fixed investment stimulus in economic history by demanding that the state-controlled banking sector pump the economy with credit. Whereas fixed investment contributed 20 to 25 per cent of GDP growth in the 1990s, it was behind 55 per cent of growth in 2007 and 90 per cent in 2009.

Transfixed by the urbanisation narrative, Treasury treated this as the new normal when it was instead an unsustainable and desperate policy response by the regime. This bled into much of its modelling, which diplomatically takes the veracity of Chinese data at face value, and continues to incorrectly assume that Chinese lenders and investors respond rationally to price and market signals when these signals are either grossly distorted or are ignored in the country’s command political economy. Consultations with mining industry and financial executives publicly betting on China’s new normal—until only recently admitting that the best of the mining boom was probably over—merely reinforced the over-optimistic bias. Finally, eminent institutions staffed by highly credentialled officials, such as Treasury, tend to seek internal consensus and external confirmation from other august organisations such as the World Bank and the International Monetary Fund before offering a final assessment. The problem with such consensus-seeking is that it presupposes majority opinion to be the most accurate. In reality, the problem of herd intellectualism in all these organisations which have been behind on developments in China is immense.

It is not fatal to the career of a researcher or official—or the reputation of an organisation—to be wrong, provided that they share the error with the majority of experts and peers. But to be in error when you have stuck your neck out in a minority position is potentially fatal to one’s personal or institutional standing. Remember that it was fashionable, until recently, to buy into the story of a paradigm-busting China run by a peerless coterie of authoritarian technocrats who could do little wrong. With human psychology being such, Treasury’s forecasting errors on China are better understood as a product of uncritically recycling received wisdom about the enlightened capacity of capitalism with Chinese characteristics to meet its challenges than individual incompetence or political bias.

Replacing the top few officials in Treasury will not improve the accuracy in China forecasts but preparedness to challenge consensus-based economic approaches, particularly when flaws in the economic model means China is at a genuine crossroad, might well help.

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