They don't make them like they used to. Margaret Thatcher died yesterday aged 87. As Prime Minister of Britain from 1979 to 1990 she transformed the British economy and reasserted her country as a major global power. She did this by loosening the State's grip on the British economy, which by the time she took power had degenerated into the 'Winter of Discontent'.

She drew heavily from the Austrian school of economics. At a party meeting in 1975, she pulled a book out of her bag and held it up for everyone to see. 'This is what we believe,' she said as she slammed it down on the table. The book in question was The Constitution of Liberty by F.A. Hayek.

We no longer have tough leaders like Maggie Thatcher. We have populists, central bankers and puppets handing out more free lunches than the saps in the kitchen can muster up. And for that, in years to come, we'll all be much the poorer...

Today we take up the topic of trade and its relevance to Australia. We think it's going to be a particularly important subject in the next few years given the precarious state of Australia's two largest trading partners, Japan and China.

What follows also provides a nice contrast to the news that China and Australia have agreed to trade directly between yuan and Aussie dollars. The development is taken as a bullish one, which will supposedly deepen the trade links between the two countries.

But the real issue here is the bypassing of the US dollar as a medium of international trade. According to the Sydney Morning Herald, 'Australia's commodity trade with China, however, is now done almost exclusively in US dollars. More than 98 per cent of coal and iron ore exports were sold in US dollars last financial year.'

This agreement simply removes the greenback from the trade equation. It's a part of China's long term strategy to become a trade-based currency, not a reserve currency like the US dollar. China knows that having a global reserve currency is the beginning of the end of that currency. The vast privileges such a role bestows in the early years evaporate suddenly in the end...as the US will soon find out.

But let's get back to the topic at hand...Australia's trade situation with Asia and why the next few years are crucial to our future.

Last week, Japan announced that it is embarking on an historic monetary experiment. With an ageing population and a government debt-to-GDP ratio of over 200%, such monetary radicalism is bound to end badly...it's just a matter of time.

You're seeing the early signs of that with trading in the Japanese Government Bond (JGB) market halted twice in the two days since the Bank of Japan's (BoJ) announcement because of excess volatility. No one knows what's going on.

But let's assume for a moment the JGB market doesn't collapse just yet. Rather, assume it's the yen that will absorb the pain. This is of course the aim of the authorities. Weaken the yen, boost exports, create inflation and strong nominal economic growth. Viola! These misguided Keynesians think monetary inflation will set Japan on a path to economic revival.

The reality will likely be much different. For starters, significant yen weakness against the major currencies like the US dollar and the euro will draw the ire of China.

These two countries don't like each other at all, and if Japan goes down the currency war route, the old animosities will be further inflamed. The recent tiff over a barren set of islands (the ones with both a Chinese and a Japanese name) will seem mild in comparison to what could eventuate if Japan tries to take market share off China.

The irony of course is that Japan has been on the wrong side of the currency wars for years. Due to its rapid and efficient industrialisation, Japan accumulated capital and had high levels of savings, which put upward pressure on the yen. To remain competitive, Japan's famous export industries led the world in innovation.

But with the rise of China and the mercantilist trade policy of Asia in general (which advocates holding the currency down to gain an export advantage) Japan finally lost its once-enduring competitiveness in manufactured goods.

Now it's resorting to mercantilism on a grand scale itself, and China won't like it at all. Japan's moves come at an especially difficult time for China. Its economic growth model is widely recognised as unsustainable yet no one is prepared, or perhaps capable, of setting China on a lower growth path. To do so would be highly risky.

If Japan's currency does plummet over the next few years (hedge fund manager Kyle Bass reckons it could fall 50% against the dollar) then the drums of war could get much louder as each country points the blame for their economic woes at the other. It's a time-tested strategy...play the nationalism card and blame a long term foe for your problems.

And this is where Australia comes into it. China and Japan are our two largest trading partners. According to data from the Australian Bureau of statistics, in the 8 months to February 2013, China took in 30% of our exports while Japan accounted for 19%. That's half of our exports going to two countries...both of which are facing considerable headwinds.

Now you may respond that Japan has been in and out of recession for 20 years, and that never had a big effect on our trade relationship. That's true, but Japan ran consistent trade surpluses and had a strong currency throughout that time, giving it considerable international purchasing power.

In other words, the Japanese could afford to buy all the food (and energy for that matter) it needed. Japan is not self-sufficient in energy, raw materials or food, which is why it buys so much of this stuff from Australia.

The following is a profile of Japan from the Australian Government's 'Australia in the Asian Century' White Paper published last year:


'Japan is a key and enduring market for Australia's agricultural products, buying 14 per cent of all agriculture exports in 2011. It is by far Australia's largest beef market, accounting for 35 per cent of all exports and Australia's largest market for natural cheese.

'Australia supplies 15 per cent of Japan's sugar imports and 20 per cent of its wheat imports, with almost all of Japan's famous Sanuki udon noodles made from Australian wheat

'Australia is the third largest exporter of energy to Japan, supplying 12 per cent of Japan's imports in 2011, including 61 per cent of its coal imports. In 2011, Japan also took about 70 per cent of Australia's liquefied natural gas (LNG) exports.'

Now we're not suggesting Japan will suddenly stop buying our raw materials or agricultural products. But if Japan's experiment goes wrong, and it probably will over the next few years, then the loss of international purchasing power of the yen will be significant.

It's the middle class that take the brunt of these policies, and there's a good chance the Japanese middle class will re-assess their eating and consumption habits when costs soar and their standard of living drops.

These effects will play out in time. But what we wanted to highlight today is the importance of both China and Japan in generating income for Australia. In the 2011-12 financial year, Australia generated a merchandise trade surplus with China and Japan of $33.4 and $30.9 billion respectively.

Australia's overall trade balance in 2011-12 was a surplus of $4.7 billion thanks in no small part to the trade between China and Japan. It was also thanks to booming iron ore and coal prices, which have since come off the boil. So far in the 2012-13 financial year, Australia's overall trade position is a deficit of $12.3 billion.

If China's economy continues to transition away from a commodity intensive one, as we think it will, that will impact trade via lower commodity prices, especially iron ore. And if Japan steals from its middle class through the effects of inflation, it will impact trade via lower volumes on a range of products.

In both cases it will lower Australia's trade income. A nation can earn foreign income in two ways; by selling goods and services to the rest of the world, and/or by generating income from foreign assets.

Unfortunately, Australia buys more than it sells and it earns less from foreign investments than it pays out to foreigners who own our assets. That's why our current account deficit was $14.7 billion in the December 2012 quarter alone.

But it's not a problem at the moment. We just put the difference on the tab. So far, the rest of the world has extended us credit of around $870 billion (as at 31 December). As long as we're earning income and our creditors think we can repay, they'll keep our line of credit open.

But they may reassess the terms of our credit line if our two largest trading partners (and more importantly, our two largest trade surplus partners) take a turn for the worse. And in the next couple of years, that's exactly what we think will happen.

Regards,
Greg Canavan
for The Daily Reckoning Australia