From Magic Dragon to Menacing Bully

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AUSTRALIA'S magic dragon does more than puff. Canberra's China crisis is a rude geopolitical shock to the shining economic hope that Australia can decouple from the global crisis.

The brilliant economic relationship has grown too big for its political and institutional supports. Beyond resolving the immediate crisis surrounding the arrest of Rio Tinto executive Stern Hu, building these supports must become a national priority for Australia.

For the past year, the Australian debate has been about whether it is in the national interest to allow Chinese customers to buy ownership stakes in our mining sector. Australia is savings poor; China is capital rich. But, rather than acting commercially, China's state-owned enterprises might do the bidding of the Chinese state and exploit access to the pricing and marketing plans for Australia's iron ore treasures.

Humiliated by rejection, Chinese state security has locked up one of Australia's top iron ore negotiators in its cells for the alleged theft of state secrets and taken possession of the computer hard drives from Rio Tinto's Shanghai offices. And it has refused to indulge in reasonable dialogue with the Rudd government over the matter. Talk about many ways to skin a cat!

Yet Hu's unexplained jailing is a prisoner's dilemma on an international scale. The mutual gains from trade are enormous given the productivity to be unlocked from moving hundreds of millions of Chinese peasants into factory work. China's one-party political leadership needs the momentum of the world's greatest industrial revolution to withstand the collapse of American export demand and ethnic unrest in its outer Xinjiang province. Put under pressure, however, the Chinese state has again reverted to heavy-handed form, whether through its super-effective fiscal stimulus, its crackdown in Urumqi or the apparent slapdown of its dishonourable resource suppliers. In the process, Beijing has weakened the Australian voices who have argued that engagement is the best way to encourage the dragon into the legal, commercial and diplomatic norms of market-based economies. In short, both sides have acted against their mutual self-interest or, at best, neglected it.

Remember that only a decade ago China was a second-level export market for Australia. In 1997-98, China bought only 4 per cent of Australia's merchandise exports, one-third of what we sold to the European Union and less than half what the US bought from us. But China's global merchandise exports have almost quadrupled and its imports more than tripled since it formally joined the world trade system in 2001. It has become the world's second largest exporter (primarily manufactured goods) and the third largest importer (mostly of raw materials). And the huge foreign exchange reserves generated by the world's biggest trade surplus were siphoned back into US Treasury bonds, in turn financing what turned into the US subprime housing bubble that produced the global recession.

Along the way, China quickly became the world's biggest consumer of key raw materials such as iron ore, coal and copper. By 2007-08, China became Australia's second biggest merchandise customer behind Japan. Australian merchandise sales to China expanded more than five-fold in real terms to more than $27 billion, or 15 per cent of our overall merchandise exports. By 2007-08, China was buying 26 per cent of Australia's mineral exports, up from 5 per cent a decade earlier.

By the time the Rudd government came to office in late 2007, China was looking to invest its foreign surplus in its long-term resource security. Australia has the world's most efficient mining industry and huge reserves of iron ore, coal, copper, uranium and so on. From a very low base, so began the new era of Chinese outward-bound direct investment in Australia.

The Chinese urgency was fuelled by the supply bottlenecks that forced them to accept the stunning 85 per cent increase in iron ore contract prices from April last year. Emboldened by the China boom, BHP Billiton made its audacious takeover bid for Rio, which in response paid too much for Canadian aluminium producer Alcan. The Wall Street crisis turned into the global financial crisis, prompting BHP to drop its Rio bid. State-owned Chinese aluminium company Chinalco offered to rescue debt-burdened Rio by doubling its 9per cent stake in the Anglo-Australian miner.

But the Rudd government was lukewarm to Chinese investment, the opposition was opposed and other big Rio investors were agitated over being excluded from the deal. Canberra's foreign investment approval system again showed itself to be opaque and subject to political veto. Rio dumped its Chinalco deal in favour of combining its Pilbara iron ore operations with BHP, the worst possible outcome for the spurned Chinese. And, after Japan folded early, Rio and BHP are holding to demands to keep this year's iron ore contract price cuts to 33 per cent. The Chinese have been left humiliated, isolated and incensed.

Yet, at the end of all this, China is actually buying more Australian iron ore and coal than before the global financial crisis hit, this time to produce steel for infrastructure, transport and housing rather than exports. Beijing's authoritarian control has delivered the world's most effective fiscal stimulus. Rio Tinto says it is "flat out" shipping out the ore. It's the main reason Australia has been spared the worst of the global recession, avoiding a sharp contraction in consumer spending and housing prices. And the assessment that China's development path has decades to run is central to the federal Treasury and Reserve Bank optimism over Australia's medium-term growth prospects.

But the present China crisis demonstrates that this economic opportunity needs political reinforcement. Both sides need to be able to show they individually benefit from the relationship, just as Australia profited by feeding Japan's 1960s industrialisation. Both sides need confidence that the other will behave according to agreed norms. But Japan is a democratic member of the broad Western alliance, not an authoritarian strategic challenger to the West.

Kevin Rudd has rightly encouraged the rest of the world to give China a bigger role in global economic governance. But we clearly need to invest more in supporting our own China relationship.

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