Why China’s support for Europe comes with a caveat…

June 17, 2011

Investors are breathing a sigh of relief that it looks like Germany, France and the ECB are singing from the same hymn sheet about a long-term solution to the Greek debt crisis. But while most people think that the key to Athens’ fate is held by Europe’s powerbrokers in the core, there is another fulcrum of support that is vital for the survival of the euro.

That is China. The Asian powerhouse has been steadfast in its support for the Eurozone since the onset of the crisis. It purchased a significant amount of EUR440bn EFSF rescue facility that started auctioning bonds earlier this year. Although it is difficult to clarify how large its European debt holdings actually are since this data isn’t published by China’s Sovereign Wealth Fund, it is thought to include Greek, Portuguese and Spanish bonds.

The relationship is so strong that Chinese authorities are making a visit to Europe next week, possibly a sign they will continue to support their largest trading partner.

However, while this is a mutually beneficial relationship: Europe gets financing while China can diversify its vast reserves out of the US dollar, the Chinese  are not passive investors. Last week China’s central bank sent out a warning note to the currency bloc’s leaders.

In no uncertain terms it said that the efforts so far to contain the crisis have not been enough and “the root cause that triggered the sovereign debt crisis has not been resolved.” The lack of resolution, it said, was eating away at market confidence and threatened to cause the debt crisis currently enveloping Greece to spread.

The impact of the Chinese support for the currency bloc cannot be underestimated. Back in January when it first announced its pledge to purchase EFSF bonds, the euro was lingering below 1.3000 versus the dollar.

Chinese participation in Europe’s bond auction was a green light to buy the euro, and since then it has rallied more than ten big figures against the dollar and 5 big figures versus the pound. While we don’t know how large China’s holdings of European debt actually are, its involvement must have contributed to the change in investor sentiment towards the euro.

Added to this, even as things in Greece seemed to reach a climax last week and rioters took to the streets in Athens, the single currency didn’t collapse below 1.4000. This suggests that investors were confident that Europe’s leaders would ride to the rescue once again. But Europe can’t do this alone. There can be no rescue of Greece without China – hence the visit of Chinese Premier Wen Jiabao to the continent from 24-28 June, which is a potent symbol of Chinese support for its largest trading partner at a critical moment in its history.

But it is no wonder that China is voicing its concern that firstly, a long-term solution to the sovereign debt crisis is still elusive and secondly, that debt levels are only getting worse. While China is willing to prop up Europe during this crisis it might not be for the next one.

The bigger crisis that lies ahead is the entitlements crisis. Europe’s rapidly weakening demographics and the pensions and medical expense that goes with that could eventually bankrupt the entire currency bloc. China is notoriously long-term in its investment profile and in the next 20/30 years, without serious reform, Europe will be in trouble.

China wants reforms in Europe today to manage the crisis of tomorrow and if EU leaders don’t get that then they can kiss good bye to Chinese support in the long-term, leaving the euro in no-man’s land.

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