A lot has been said about China being a potential rescuer of the eurozone. One view that has been put forth is that of Yu Yongding, a former member of China’s central bank monetary policy committee, who wrote in the Financial Times (Oct 31, 2011) that ‘Beijing will not ride to eurozone’s rescue’.
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China should help Europe
By WU ZHIJIAN
22 November 2011
A lot has been said about China being a potential rescuer of the eurozone. One view that has been put forth is that of Yu Yongding, a former member of China’s central bank monetary policy committee, who wrote in the Financial Times (Oct 31, 2011) that ‘Beijing will not ride to eurozone’s rescue’.
I would argue the opposite.
To understand this issue more deeply, one needs to start with a few numbers. As of October 2011, China held total foreign reserves worth about US$3.2 trillion, far ahead of other governments with large foreign reserves, including Japan (less than US$1.5 trillion) and Russia (about US$500 billion). During January-September 2011, China accumulated US$354 billion worth of foreign reserves, equivalent to about US$1.3 billion per day or almost US$1 million per minute.
The obvious question is: What is the optimal way to manage such a huge pile of reserves? To start with, China would not be willing to invest these vast amounts within China domestically, as that would be equivalent to selling US dollars and buying yuan, which would be contradictory to the effort of Chinese government to manage the exchange rate of the yuan. It would also add to inflation at home.
This means that the bulk of foreign reserves must be invested abroad. It would be interesting to go through the major asset classes that could be considered for China’s foreign reserve investments, namely bonds (sovereign bonds and corporate bonds), listed equities, commodities, gold, and foreign direct investment.
Unfortunately, given the scale of China’s foreign reserves, only sovereign bonds and foreign direct investment could meet the purpose of meaningful deployment. The other asset classes are either not deep enough (such as corporate bonds), too risky (such as listed equities), or both (such as commodities and gold).
Foreign direct investment, however, is not without its flaws. The major obstacles preventing China from investing more aggressively abroad include political resistance and anti-monopoly regulation, which have been reflected in the failed acquisition efforts such as Chinalco’s US$19.5 billion bid for Rio Tinto in 2009 and CNOOC’s US$18 billion bid for Unocal in 2005 (both of which failed).
By June 2011, China has invested a total of about US$377 billion abroad, according to Heritage Foundation, which accounted for about 12 per cent of China’s total reserves. Which leads to the reality - the bulk of China’s reserves (more than 80 per cent) will still have to be invested in foreign sovereign bonds.
In today’s world, there are three biggest sovereign bond markets that provide enough depth for China’s reserve management, namely Japan (almost US$12 trillion), the US and EU (both around US$9 trillion). Due to historical reasons and current political tension, China never invested heavily in the market of Japanese government bonds and will never do so, which leaves the US treasury market and European sovereign debt markets as the only realistically viable options.
The major problem with European debt market, however, is that the sovereign debts of different countries have vastly different risks. While all the US treasury notes and bonds are rated AA+ by the rating agencies such as S&P, European countries have a wide range of ratings, ranging from AAA (for Germany and the Netherlands), A (for Belgium and Italy) to B and C (for some of the peripheral economies). As a result, China cannot invest as aggressively into the European debt market as it did in the US debt market. It is widely estimated that China holds about 60 per cent of its foreign reserves in US dollar assets, followed by about 20 per cent-30 per cent in euro assets which reflects this reality (the actual weighting is a state secret).
As Mr Yu rightly pointed out in his article: ‘China’s faith in the US dollar has been proved misplaced.’ The downgrading of US debt by Standard & Poor’s, the continual expansion of the US Federal Reserve’s balance sheet and the debacle of the two major political parties regarding the lifting of the debt ceiling, all suggest that it is probably not wise for China to increase its holdings of US debt.
What is the takeaway from the above analysis? First, the European debt crisis poses a serious challenge to China’s foreign reserve management, as China is facing the possibility of losing a critical diversification option should the euro fail. Second, it is in the best interest of China to support the euro, and even consider bailing out European indebted governments at a reasonable cost, to avoid the consequence of the US dollar being the only major reserve currency left in the world.
Note that there is no moral judgement here: It is purely a cold calculation of the costs and benefits that suit the best interests of the Chinese government.
A commonly raised question regarding whether China should ‘rescue’ Europe is: If Germans do not want to contribute more money, why should China bother? This argument is misleading.
A contribution, by definition, is a voluntary gift made to someone without recourse. This does not apply to the case of China’s purchase in European bonds (as China would receive interest and could sell the bonds at any time at the market price) or direct investment (as China would become an equity holder in invested projects).
As Lord Palmerston once said: ‘Nations have no permanent friends and no permanent enemies. Only permanent interests.’ China and Europe need to support each other in the current period, because this would be in the best interests of both.
The writer is the chief executive officer of Woodsford Capital Management Pte Ltd. Mr Wu is also the managing editor of www.chinatells.com and the author of a forthcoming book called ‘China 88K’
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