--As the global economy cools, political tensions will begin to boil. Against all economic common sense, China will continue to produce goods for a market that doesn't exist. It will then dump those goods on other markets, forcing retaliation.

--China's trying to maintain some semblance of economic control. But we're running on the theory that control of post credit-bubble economies is an almost impossible task. Keep in mind we're still in the early stages of China's economic adjustment. This will take years to play out.

--In a worrying development for the Middle Kingdom, balance of payments data for the second quarter, released yesterday, indicate that China is beginning to suffer from capital outflow. The data indicates that for the first time since 1998, the balance of payments was in deficit.

--For many years, the standard for China was to run a balance of payments surplus. That is, a trade surplus plus a financial and capital account surplus. To balance this inflow, you saw constantly increasing foreign exchange reserves. This was effectively just the trade and capital inflows sent back overseas in order to keep the yuan pegged to the US dollar at a competitive rate.

--But in the first quarter of 2012, capital and financial outflows of US$71.4 billion were greater than the current account surplus of US$59.7 billion. This necessitated an $11.7 billion contraction in China's foreign exchange reserves.

--This is not a big deal...yet. An $11.7 billion contraction in a US$3.2 trillion pile of reserves is nothing to get too worried about. But if it's the start of a larger trend, it will be.

--You see, China's (until recently) constantly growing foreign exchange reserves were the source of its domestic liquidity. The burgeoning pile of reserves provided the fuel for China's extraordinary rise in nominal GDP growth over the past decade (you know, the constant 9-10% growth rate everyone grew accustomed to)

--Now that the pile is no longer growing, now that it's starting to contract, China has an additional challenge to controlling its slowdown and bolstering growth.

--The real risk is if capital flight starts to pick up from here. That shouldn't be too much of a problem in a country that has a closed capital account (meaning China controls inflows and outflows). But as FT Alphavillve reports, China watcher Victor Shih of Northwestern University says that US$1 trillion dollars represents less than 30% of the wealth of China's top 1%.

--If China's wealthy panic and look to move a third of their wealth out of the country (which they could probably do, as the rules don't apply to them) then China's banking system and economy would be in real trouble.

--It's a classic positive feedback loop. Bad news on the economic front causes capital flight, which restricts liquidity in a credit dependent economy. That causes more economic weakness, which causes more capital flight.

--As we said, we're nowhere near that situation at the moment. It's an extreme outcome. But in these times, extreme outcomes are the norm. It's something to keep in mind.

--Getting back to the manufacturing data, guess how Australia fared?

--We came in at a dismal 40.3. Well, at least we're doing better than Greece and Spain, you might think.

--You'd be wrong. Greece recorded 41.9 for July while Spain's reading was 42.3. The only strength in Australia's report was wages growth. It soared 12 points in July to 71.4. But rising wages on lower demand is not a good combination for profit margins.

--Our manufacturing sector is dying, and yet our national angst (if the media is any guide) is directed towards the state of James Magnussen's mind.

--The only difference between Australia and the European countries that we often ridicule is that the market hasn't shut off our tab yet. We're still at the bar drinking. The market thinks we'll remember to pay our bill in the morning.

--This view pushes our currency to levels that choke manufacturing and render us globally uncompetitive. Bizarrely, it improves our relative wealth at a time when the basis of that wealth (the commodities boom) is clearly faltering.

--Nothing makes sense anymore. Global capital is in the hands of the speculators, rushing around wildly, playing a mad game of hide and seek. They think Australia is a good hiding spot. It won't be long before they're caught.

--In other news, last night Fed chairman Ben Bernanke didn't throw the market as big a bone as they were hoping. Now it's all eyes on 'Super' Mario from the European Central Bank tonight. Because when everything's screwed, your friendly central banker is all you have to rely on. Nick Hubble will have more on Mario tomorrow.

Regards,

Greg Canavan
for The Daily Reckoning Australia

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