The Chinese and the eurozoneNov 5, 2011·Alasdair Macleod
The basic market problem is there is too much sovereign borrowing for the money available, which would normally drive interest rates sharply higher.
Some countries have got round this by printing money while pretending they are issuing bonds. A few countries are unable to do this, because they lack their own printable currencies. And that is the root of the problem faced by the weaker eurozone members.
This problem for some of them has become so acute that they cannot now fund their deficits. What is less obvious is that these highly-indebted states also have to roll over existing debt as it matures. Traditionally this debt has been absorbed on a replacement-basis in the markets, but that only works as long as the markets are fundamentally confident, which they are no longer: the inability of the political classes to resolve their difficulties has seen to that. Therefore, as bonds mature, investors and banks are unlikely to re-invest, preferring cash. Even if the weaker states are able to fund redemptions, from an expanded European Financial Stability Facility (EFSF) for example, this will be used to reduce euro-denominated bank credit and improve capital ratios.
This need not be a bad outcome, because the economic effect is to simply transfer the funding of sovereign debt to the EFSF. The question is who is going to fund the EFSF, which with its gearing is a risky proposition? There are only two possibilities: the ECB (which should not be assumed at this stage) and those with trade surpluses to recycle, particularly China. And since she is the only major source of this potential funding in the running, she is in a position of enormous negotiating power.
Looking at the proposition from China’s viewpoint is instructive. She is being asked to bail out profligate nations, who have run out of credit and whose citizens enjoy a far higher standard of living than their own. It amounts to a position of power ahead of her economic development. Furthermore, China’s economists were brought up with the Marxist dictum, that capitalism ultimately destroys itself, so they are being invited to merely delay something that is inevitable. Will they fund the EFSF? Beyond perhaps a token amount, it seems unlikely. But will they stand back and let Europe sink? That would be a missed opportunity to wield her enormous power, and we need to give this thought some historical context.
The one thing the Chinese have learned is that they cannot guarantee their own security through military means alone, they also require economic strength. This was the reason old-style communism failed. It has taken them only thirty years to acquire that strength. To consolidate it, they now seek to eliminate their dependency on the US dollar. Therefore, the price Euroland will have to pay for funding is that either the Chinese are given some control over the euro, perhaps by having permanent representation at the ECB, and/or there must be a material advancement for the yuan in trade settlements. And it is unlikely loans will go through the EFSF, because China will want to set her own terms.
This describes the strength of her position. It remains to be seen how China uses this longed-for escape route from dollar domination, and how she plays a winning hand. Initially, she may wisely play for time, letting the Euroland situation deteriorate further, to get the terms she requires.