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China and Australia: How closely linked are our economies really?

China and Australia: How closely linked are our economies really?

Like my colleague Steve Grenville, I was lucky enough to attend the Reserve Bank of Australia (RBA) Conference on China last week.

The RBA managed to assemble a gold-plated line-up for the conference. It was a truly impressive effort.

Several discussions I had focused China’s connections to the Australian economy; this was usually in the context of what a hard landing in China would look like.

It got me thinking about how strong the connection is. It turns out, by some measures, not terribly. First, below is a graph of year ended Australian GDP growth. Can you see the mining boom? It’s quite tough. If you knew nothing of the history of the Australian economy, before being told there had been a massive mining boom, you would be hard pressed to pick it.

To be sure, you could see it in the composition of GDP. But aggregate GDP shows little trace.

More systematically, we could look at the correlation of Chinese and Australian GDP to gauge the influence of China. The graph below shows how this correlation has changed through time, by showing ten-year rolling correlations — that is, each point in the graph shows the correlation between the economies for the previous 10 years. [fold]

I’ve shown the correlation between the US and Australian economies as well. Up until the early 2000 recession in the US, the US and Australian economies appeared tightly linked. Now, according to this graph, China has overtaken the US. New era, right?

Not so fast. This increase in the correlation between Australia and China owes much to 2008-09, when the two economies both had a relatively short patch of soft growth, followed by a rebound. If we were to use a shorter window, say seven years instead of ten, then that period drops out from the calculations more quickly. The results are below.

There has essentially been no correlation between Chinese and Australian GDP over the last seven years. That was certainly surprising to me. The primacy of the US economy is restored, although not to the previous highs we saw before the millennium.

What does this mean? It depends upon your interpretation of the 2008-09 period. It was volatile, and volatile periods have a big influence on correlation statistics. So in periods of volatility, would we expect the Australian economy to be more correlated with the Chinese economy, or the US economy? I suspect it would depend upon the nature of the shock underlying the volatility.

Nonetheless, there are linkages between Australia and China that do not necessarily show up in high-frequency GDP movements. In particular, Australia’s fiscal position is heavily influenced by commodity prices, and China's role in commodity markets is clear.

Photo courtesy of Flickr user Paul Englefield

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