Murray addressed a point we've been banging on about here for a month now: when you have to import your capital from the rest of the world, you become dependent on global banks to fund your domestic economy. And if those banks don't like what you're doing with your borrowed money-if they think you are using it to bid up house prices rather than build investments that will generate higher returns-they may decide to invest elsewhere.

What does it mean to be capital poor? "We ask them [global banks] for the money to build larger houses...more square metres per house, year-on-year...and we ask for the money to put less and less people per house at the same time," Murray began.

"Why in Australia is that money not going to fabulous new infrastructure...public goods...why isn't it fuelling great companies?" he asked. We assume the question is rhetorical. The obvious answer is the country is in the grip of a housing hysteria, or at least the belief that everyone-banks, real estate, agents, government tax collectors, builders, and home buyers-can all get rich on houses.

"We're now going to have to invent a corporate bond market because this money isn't flowing right," Murray added. By 'flowing right,' we assume Murray means that instead of funding productive investment and enterprise, Australia's foreign borrowing addiction could eventually threaten the supply of credit provided by foreign banks.

"I think that our friends around the world who have a habit of saving and helping us with it are entitled to ask, 'Is this the best return for my precious savings dollar?'"

Lots to think about. For what it's worth, we think Murray is right on the money. The Chinese are already-and quite rightly-telling American officials to reduce their deficits or jeopardise the flow of credit coming from China.

This is a subject we expect to speak more about tonight. The American fiscal deficit is directly linked to Australia. The more the Chinese are worried about the value of their U.S. dollar assets, the more quickly they will look to diversify those assets or shed them outright.

That probably means increased Chinese investment in Australia's resource and energy sector. Australia is part of China's answer to "the resource question." Also, the Chinese already realise that making a buck of Aussie borrowing is not a bad investment strategy either. Dow Jones news wires reports that, "China's Bank of Communications will open a Sydney office as its first working branch in Australia.

"The move, announced by the NSW government today, underscores the growing ties in trade and business between Australia and China, a major export customer, and is part of a strategy by authorities to promote Sydney as a regional hub for financial services. The Bank of Communications, China's fifth-largest bank, is seeking a licence from the Australian Prudential Regulatory Authority to establish a branch delivering a full array of services."

Selling money can be a good business. China is also branching out with its global investment/expansion strategy, trying to diversify its sources of income. The profit margins in finance are probably a lot higher than the profit margins in making air conditioners (or most assembly and manufacturing industries.) If you want to increase national income, it's a good strategy (although it's not as good for full employment, which is also a big objective of the Chinese State).

Also, when you've accumulated a huge chunk of capital with a mercantilist trade policy based on keeping your currency artificially cheap so you can run a large trade surplus, you have to put that capital to work eventually and not just buy U.S. Treasury bonds. It will be interesting to see if the long-term strategy works.

But you get the feeling there IS a long-term strategy at work in China. In Australia? Murray says that under his direction the Future Fund will meet the unfunded liability of superannuation for public servants by taking a long-term view. He encourages all of Australia to do the same.

He says he is, "Taking a long-term view about saving, which is a critical problem in the Australian economy...taking a long-term view about our next generation, not just ourselves...taking a long-term view about the stability of employment and skills building...whether it's at the Future Fund or anywhere else...and a long term view about the pride in our institutions."

We find those comments quite encouraging actually. One of the big faults in the corporate world in the last twenty years-driven by quarterly earnings analysis and the 24/7 media cycle-is managing long-term institutions for short-term gains. To some extent, this just reflects the compression of time in a globalised world. The business cycle seems to have speeded up.

But shareholders and corporate management alike would both be better served by considering what's best for the long-term interests of the institution...and how to make sure that particular business continues to serve customers well. This goal might not always be compatible with short-term earnings management strategies that allow executives to meet targets which trigger extra compensation.

Essentially, we think Murray is suggesting that we all need to be better stewards of capital. He's also implying that for the last twenty years, we-the institutions of modern capitalism-have NOT been good stewards of capital. If you pursue that line of thinking, it might also mean that the expectation that you can make a lot of money very quickly without really doing any work or adding value is-as a cultural frame of mind-not very healthy for our long-term survival.

We'll have to leave it at that today! Tonight is the big night of the Debt Summit at the State Library of Victoria. We'll be back with a full report on Monday. Until then!

Dan Denning
for The Daily Reckoning Australia

• IMF Gold Up For Sale to Pay the Bills
• The Problem With a Well-Diversified Portfolio
• IMF Report Concludes Aussie Banks are “Very Sound”…
• The Inevitable Path Toward Capital Controls in America
• You Can Never Be Sure How Fabricated Income and Earnings Are These Days

Phew! Thank goodness that whole thing about toxic assets is over. Now we can get back to passively investing in stocks that only ever go up.

There is a serious case of denial coming from institutional investors and the financial media about what's ahead. Sure, it's tempting to think that because things have been so bad they won't get any worse. But what exactly emerged yesterday that changed the situation banks and investors face?

Not much, that we can tell. But that's because this is not a subjective crisis. Whether the situation has really improved does not depend on how you perceive a bank's balance sheet or a company's earnings. It depends on whether that balance sheet is actually healthy and the company can actually grow earnings.

But let's not quibble. The job of the Bear is to lure investors back in so he can smack them back down later. Frankly, the bear was gorging himself a bit anyway and getting a bit lazy.

Stocks were down on average about twenty percent in major Western markets. Consumer confidence levels were low and getting lower. The Bear needs fresh meat. And he can only get that if he can attract more investors back to the market. In you go!

The major economic news released yesterday is at odds with the way the market behaved. We're talking about the news from China that exports dropped 25.7% in February. Imports were down 24.1%.

If China makes and the world takes, China is making less because the world is taking less. And of course, China takes from Australia to make for the rest of the world. If China is making less, it will take fewer Australian resources.

There is a raft of data that need sorting, though. First, fixed asset investment in China actually grew by 25%. Fixed asset investment could be roads, bridges, and buildings-the sort of investment that needs copper, nickel, zinc, coal and iron ore. Or it could be commercial real estate-the kind of shovel-ready government busy work that doesn't lead to any bottoming in commodity prices ore sustained resource demand from China.

Also comes the news from Japan on thermal coal negotiations between Chinese utilities and major coal sellers Rio Tinto and Xstrata. It now looks like thermal coal prices for 2009-2001 are going to come in around US$70-72 per tonne, according to Matthew Stevens in today's Australian.

That's a 44% decline from last year's price of around $125 per tonne. But it's still higher than the spot price of US$60. And it's still 25% higher than the price for 2007-2008. So, as big as the percentage decline is, it's coming off a large base.

That doesn't make coal stocks an instant buy. But here is a clear difference between the extractive resource industries and the financial industries. Prices are responding to changes in demand. Resource producers are not being bailed out or directly subsidised by the government. There is a lot more transparency about what's going on the industry.

What's missing, to use a word analysts love, is visibility. No one can see that far ahead for the economy. This makes reliable price forecasts for commodities difficult to make, which makes earnings estimates hard to make, which makes valuations difficult to make.

Our suggestion? Keep it simple. Focus on companies with cash, little debt, and world class ore bodies (poly metallic for metals miners).

It's a bit nauseating to be told over and over the problem is confidence. We suspect this is a political tactic. Blame the credit bubble and resultant insolvency of the financial system on confidence! Then, give the people a dose of free money, which may numb the pain of the approaching second freight train to hit them.

That freight train is the credit market not responding to increased central bank liquidity in the desired fashion. "Libor's creep shows credit markets at risk of seizure," reports Bloomberg. "The cost of borrowing in dollars is rising as the global recession deepens and central bank efforts to prop up the financial system fail to prevent a growing number of banks from requiring government bailouts."

It is still a bear market in trust within the financial system. Central Banks are more than willing to lend to banks. But banks are hoarding reserves. The only upside of this is that banks haven't relent expanded reserves into the real economy. That would be the engine of inflation.

The downside is that increased bank reserves don't do much to improve the value of the assets on bank balance sheets. To address that, expect G20 finance ministers meeting in London to make a lot of noise about mark-to-market accounting. They want to change the rules so that firms don't have to constantly revalue assets to their current market value.

In any event, the action in the credit markets-Vikram Pandit's ray of sunshine not withstanding-suggest that the financial system is just as vulnerable to trillions more in losses and failures now as it was six months ago. Not a single thing has changed in the last few days to alter that fact.

Nonetheless, the market may rally anyway. The G20's political leaders meet in London in early March. This could be a world-historic event, but not for any positive reasons. We are pretty sure the leaders of the G20 nations are not going to gather together to ratify and sign an agreement that solves all the problems.

On the other hand, all their quarrels and divergent national interests will be on full display for investors and savers the world over. Investors are going to realise this problem is bigger than even big government's ability to contain it. What happens after that should be interesting...

Dan Denning
for The Daily Reckoning Australia

• Rising Coal Prices to Increase Electric Bills in Australia
• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• Australia & China: Already Partners in the Commodity Boom
• Australia’s Next Big Export Industry
• Australia Presents Investors With Great Portfolio of Energy Choices

Reserve Bank economists now reckon that the recent coking and thermal coal deals inked between Aussie sellers and overseas buyers will haul in another $30 billion to the economy this year. That is not the kind of news the RBA wants to hear while it's busy putting out inflationary bush fires in the economy. But facts are facts.

Thirty billions dollars in coal and iron ore earnings, where will it go? To producers? To investors? To mining service companies like Walter Diversified Services (ASX:WDS)?

While you think on that, let's talk about "terms of trade" for a moment. "Terms of trade" is one of those terms of the trade that gets throw around by economists all the time. But what does it mean?

The simple definition is this: it's the ratio between export prices to import prices. If you get more for what you sell and pay less for what you buy, your terms of trade improve. And guess what people? Thanks to this particular moment in history, Australia gets a lot more for what it sells and pays a lot less for what it buys (except for crude oil).

The chart below is taken from a 2005 Reserve Bank research paper called "Long-Term Patterns in Australia's Terms of Trade," by Christian Gillitzer and Jonathan Kearns.

But we'll save you the trouble and tell you what it means in laymen's terms. The chart shows that the terms of trade exploded in the 1950s as Aussie exports of wheat and wool increased export earnings. Today's terms of trade ratio, by the way, is around 130, where those two dots on the right margin are. Will the index go to 1950s levels? And if it does, what will it mean for domestic spending in Australia?

In a speech given in February of last year, RBA assistant governor Malcolm Edey showed how an improvement in the terms of trade can lead to a rise in national income and, gulp, domestic demand. Think inflation.

"One of the consequences of the strong global economy, and particularly the growth of Chinese industrial demand," he said, "has been sustained upward pressure on a range of commodity prices. Over the past three years this has lifted Australia's terms of trade by around 30 per cent, the largest cumulative increase that we have experienced since the early 1970s."

"It is not hard to appreciate that this provides a significant boost to incomes and spending. With exports representing about a fifth of GDP, each 10 per cent increase in the terms of trade adds about 2 per cent to the value of national income," he concluded.

Whose income, though? This is the key question. Will the rise in export earnings lead to more spending (and if so, by who?). The answer will help determine if and how big future interest rate rises are.

According to today's Age, "While senior Reserve Bank and Treasury officials forecast last month that Australia was heading for a boost of 10% to 15% in the terms of trade in 2008-09, the Posco deal suggests the rise could be more like 20% to 25%. Next year could see the terms of trade - the ratio of export prices to import prices - overtake the record levels of the Korean War boom in 1951."

That's interesting. Yesterday we mentioned that the current rise in Chinese steel production (and growth in Aussie exports of iron ore and steel) happened during the great post-war expansion in Korea and Japan, when both countries effectively industrialised and built up their manufacturing bases.

Base metals demand grew in both countries, driving them south to Australia, where Lang Hancock was flying over the Pilbara in 1952, noting that all that red earth might just possibly be iron ore. The rest, as they say, is history. But as they also say, the past is prologue. China is coming south these days too, looking to build out its industrial and manufacturing base with Aussie coal, base metals, and minerals (heck, let's throw uranium and LNG in there too.)

Here are two scary charts for the RBA that suggest the terms of trade may improve even more in coming years, leading to more inflationary pressure in the economy via business spending.

First, when the terms of trade spiked in the 1950s, commodity prices were in a secular downtrend. What Australia was selling went up in price, while the general trend in prices for manufactured goods was down. Aussie ore went to Japan and Korea and came back, eventually as cheap manufactured goods.

Today, real commodity prices appear to have bottomed from a 200-year low around 2003. It was certainly a 20-year low. Whether the price of real commodities keeps going up, we'll have to see. But you have a situation where the price of manufactured goods continues to go lower (more global producers) at the same time the price of raw materials is going up.

As the chart above shows, Australian export prices are rising faster than commodity prices, while Australia's import prices are declining faster than world manufacturing prices.

Why that exactly would be the case is a bit of mystery. The paper's authors suggest that, "Australia's traditional mineral exports had been high value-to-bulk commodities such as copper, lead and zinc. Japan's prominence in Australia's commodity exports at the time is illustrated by the fact that by 1969/70 Japan imported 65 per cent of Australia's metal ores, coal, gas and petroleum exports."

The simpler explanation is that what Australia is exporting today-iron ore, coking coal, zinc, copper, and gold-is in greater demand than wool and what were 50 years ago, as reflected by higher prices. If anything, a recovery in the agricultural sector (rice and wheat especially) would deliver an even bigger boost to the terms of trade.

If China is the new Japan (and our theory of great post-war periods of industrialisation suggests that it is), then you see why the trend is sustainable and the terms of trade will grow even more. Export income should grow as export prices (and production volumes grow). They will only grow, of course, if business investment picks up. Business investment is the big driver of all wage and income growth, though. So if business investment grows, wages are going up.

Do you see why inflation is largely out of the Reserve Bank's hands now? It can control domestic consumption. But it cannot control foreign consumption of Australia's mineral exports. That's the demand driving business investment and Aussie wage growth.

On the import side, it's easy to see in a picture why Aussie import prices have been falling even faster than the average price of global manufactured goods: we're getting more stuff from Asia and less from Europe. Shipping costs are much lower. But prices are lower in the aggregate because low labour costs in Asia have led to a big decline in the price of manufactured goods globally. Wage and price disinflation from Asia, you could say.

So what does it all mean? It means export earnings will grow for commodity producers unless they run into the brick wall of rising energy costs, labour market constraints, or infrastructure bottlenecks, all three of which are possible.

There are other factors too. Rising global energy prices affect producers and prices. That could crimp global demand, Asian production, and thus Aussie resources. It's also possible that rising food and fuel prices trump falling prices for manufactured goods and lead to greater Aussie inflation. After all, food and fuel make up a greater portion of the household budget than DVDs and toasters.

Plus, 60% of Aussie GDP is consumer spending. If export earnings benefit mostly industrials and manufacturers, and they represent just 26% of all economic activity, then the effects of a huge boost in the terms of trade might be muted. Consumers will be hit hard by rising food and fuel prices while businesses, flush with export earnings, will hoard cash for the duration of the credit crunch.

And of course there's the possibility we could have big trouble in big China. We have speculated that China's long-term ambitions in Australia are…ambitious. But China itself a seething bundle of internal contradictions.

It is 1.2 billion people growing with great energy. But demographically, Chin is also getting old quickly and facing the health challenges that come from running an economy at breakneck speed without regard for workplace safety or the environment. It is a closed system trying to unleash the energy of economic growth but remain static politically.

Trying to move while standing still is neat trick. The only way we've ever seen it done is in a rocking chair, where you find motion and stasis at the same time. China's very attempt to industrialise right now may put the raw materials it needs to do so out of its strategic reach. This means price pressures on global energy and minerals.

It leads us to a world of energy haves and energy have-nots and of agricultural haves and have-nots. Where it takes us is anyone's guess. For Australia, for right now, it looks like it's taken us higher.

Dan Denning
The Daily Reckoning Australia

• Australian Trade Deficit Grows for 75th Consecutive Month
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Wage Pressure in China to Drive Up Cost of Goods in Australia
• Australia’s Current Account Deficit Up 4%
• China Performs a Kind of Financial Alchemy