By Greg Peel

Politicians in Australia have been quick to point out that Australia has pretty much no no exposure to European sovereign debt. While this is true, and such statements perhaps necessary to calm frayed nerves, the implication that Australia is thus immune from European shocks is a misleading one.

For starters, the fact Australian banks and wealth managers are not holding eurozone debt means no immediate impact on balance sheets but were global credit premiums to rise further on the back of ongoing financial market fears, the offshore borrowing rates for Australia's banks will rise. Fortunately the proportion of offshore funding Australian banks require to fund their loan books is now much reduced compared to 2008.

It is nevertheless a popular misconception that Australia doesn't have to worry about Europe because our most influential trading partner is China. But if this were true, why is the Australian share market where it is? We must remember that we now live in a "global world". I know that sounds tautological but it simply means that everything across the globe is connected to everything else. Europe is China's biggest export customer. Demand for Chinese goods from Europe is falling. If China is selling fewer goods it is manufacturing fewer goods. If China is manufacturing fewer goods it is using fewer raw materials. If China is using fewer raw materials then it doesn't need to buy as much from Australia. In other words, the trail from Athens or Rome still leads back to the Pilbara eventually.

The performance of Chinese exports has been resilient in 2011, notes DBS Group Research, despite the chaotic global economic environment. There has been some assistance in dollar terms from Chinese inflation and the appreciation of the renminbi which has allowed for consistent export receipts, and more recently commodity prices have fallen to offer relief on the import side of China's balance of trade. However, signs that the reduction in demand out of Europe for Chinese exports are very apparent in the latest data. In August, Chinese exports to the EU grew by 22.3% year on year, DBS notes. In September, that figure fell to just 9.8%. Exports to the US (second biggest customer) are also on a downward trend, and DBS expects more downside in the December quarter and into the March quarter next year.

"Make no mistake," warns DBS, "All financial crises in recent history had immediate negative repercussions on China's exports". DBS offers the following graph, highlighting the Asian currency crisis of 1997 (noting that the Russian debt default and the fall of hedge fund LTCM also occurred shortly after), the tech-wreck of 2001 (along with 9/11) and the GFC of 2008. Note that the 2011 and 2012 bars on this graph are based on DBS forecasts:

In all previous crisis episodes, Chinese export incomes experienced swift exogenous shocks from Asia, the US, and the world, notes DBS. This time around, however, the negative income shock is likely to be more gradual but persist for a few quarters.

There are nevertheless a couple of factors which will act as a dampener on that income reduction, suggests DBS.

The first is the recent reduction in commodity prices as the European situation has played out. As the prices of inputs fall, Chinese export prices can also fall as inflation subsides which should act to slow loss of demand. Evidence suggests export price reductions lag Chinese CPI movements by 4-5 months, DBS notes.

The second factor is a structural one but not as easy to quantify. From the humble beginnings of China's cheap-workforce-led export economy a couple of decades ago, over time Chinese industry has been gradually moving up the value-add chain. DBS observes the country's export mix has been shifting away from labour-intensive goods to relatively cheaper capital intensive goods, and as wages have soared in China industry has relocated away from the coast to cheaper inland provinces.

DBS believes this gradual process helped China survive through '97, '01 and '08, and believes the process has begun to speed up. That might explain why China's economy has not yet appeared to suffer too much from everything going on in 2011.

These two factors might be encouraging, but not enough to imply Chinese immunity from a Europe-led global slowdown, DBS warns. The DBS analysts are forecasting 10% Chinese export growth in 2012, down from 20% in 2011.

It is notable that in its monthly Statement on Monetary Policy released on Friday, the RBA took quite a knife to its Australian GDP growth forecasts for 2012-13. Previously the central bank had expected above trend growth and persistently high trade surpluses due to Chinese commodity demand, which would pressure inflation, but now those expectations have been trimmed at a time when the rest of Australia's economy is suffering from the strong Aussie and lack of consumer and investor confidence.

It all leads back to Europe.