Who is helping who in the China-Europe relationship?

January 24, 2011

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

PORTUGAL/

The saying goes that you only really know who your friends are during times of crisis. Well European officials must have been beaming after two of the world’s largest economies promised to purchase the debt of the currency bloc’s most troubled nations. China came out first and pledged to “support Spain’s financial sector”, through participating in its upcoming debt auctions. Likewise, Japan pledged to purchase a quarter of the upcoming euro zone bond sale that will help fund the bailout of Ireland.

Who wouldn’t want China as a friend right now? Its growth rate is in double figures, 10.3 per cent for 2010. The Chinese authorities want to rebalance the economy toward domestic demand, and with hundreds of millions of people embarking on shifting from an agrarian to urban way of life the growth rate is set to remain high, even if the authorities try to set policy to avoid the economy from overheating.

On top of that it has huge FX reserves – more than $2 trillion. This makes the 85 billion euro bailout loan provided by the EU/IMF to Ireland look like pocket change. Essentially, China has the financial firepower to help provide all of the bridge loans necessary for European sovereigns in trouble. This is the friend you want when you have the market breathing down your neck and the world’s largest bond fund saying that it will stop purchasing peripheral nations’ government debt, which is the position that Europe found itself in at the start of this year.

So on the surface it looks like this is a fairly one-sided relationship: China buys up the bonds of troubled nations reducing their immediate financing issues. This leaves it with peripheral debt that Beijing will hopefully, one day, turn into a profit. But is this relationship really so simple, and could Europe be doing China just as much of a favour?

There is a strong argument to say yes, and it boils down to three factors. Firstly, since the onset of the financial crisis there has been a dearth of relatively risk-free assets that also provide a decent yield. Voila, the debt issued by Europe’s rescue fund, the European Financial Stability Facility (EFSF). This is not only rated triple A by the rating agencies, but it has a yield that is at a premium of approximately 50-90 basis points above German Bunds. This is an appealing prospect; it is essentially protected against default by Germany, the Eurozone’s largest economy, which continues to post record rates of growth – the 3.6 per cent registered in 2010 is the highest level since reunification. For sovereign wealth fund managers the EFSF bonds are like finding the Holy Grail after the recession when yields on fixed income products in the developed world had reached record low yields.

The second factor is that Europe’s crisis helps China diversify its reserves out of the US dollar. After the Fed, China has one of the largest holdings of US Treasuries. While the spotlight might be on Europe’s indebted nations today, who is to say that it won’t shift to America and its $14 trillion debt mountain tomorrow? Already the financial positions of some of America’s most indebted states are hitting the headlines. For example, Jerry Brown, the new governor of California, declared a state of emergency due to the $24bn budget gap for this year. Going forward, a persistent high rate of unemployment means that the debt position is likely to get worse. This is the first year when baby boomers will be retiring, over the next decade the burden on social security and Medicaid will be greatly enlarged. This makes higher yields and falling prices a near certainty for US Treasuries.

Lastly, rather than act in the interests of its Western friend, China might want to protect its own interests. For a controlled economy the size of China’s it needs stability not just at home but abroad too. A default in Europe would no doubt throw the spotlight on the US’s debt problems, forcing Washington to impose harsh austerity measures. A weak US economy would crush investor confidence and cause a global slowdown; but couple that with a collapse of the Eurozone and it could precipitate a global depression that would hit Asia hard. It’s this scenario that China needs to avoid at all costs.

China has every reason to buy the debt of Europe’s troubled nations and its relationship with the euro zone is far from as one-sided as it looks like on the surface.

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