China Plays Hard Ball on Debt

Sep 22, 2011

China could now be taking to Europe the hard game it’s played for some time with Eurozone periphery states. In a recent speech to the World Economic Forum in Dalian, Premier Wen Jiabao asked Europeans along with the United States to “put their houses in order,” almost as a condition for China “extending a helping hand.”

While there is no doubt that China holds 60 percent of its foreign currency reserves in dollars, statistics are unavailable in China or Europe to confirm that the euro accounts for up to 30 percent of its reserves, in fact leaving little room for other currencies such as the Japanese yen.

Wen came perilously close to asserting a political condition for that help, by noting that Europe granting market economy status to China would be “the way a friend treats another friend.” In reality, the European Union would give up rights to bring anti-dumping charges against subsidized Chinese exports.

The quid pro quo was direct enough, unprecedented in China’s relations with either Europe or the United States. For some time, Europeans, caught in the debt crisis, had found bland expressions of support for the euro by Chinese leaders reassuring. And the governments struggling most have eagerly sought direct purchases of their national debt by China or even the psychological uplift of generic promises. In quick succession, Greece, Portugal, Spain, Hungary – the last unabashedly currying political favor from Beijing – have pleaded for China to rescue national budgets. The first publicly announced purchase of Spanish bonds in July 2010 did engineer a turnaround in market sentiment. For that reason perhaps, several governments – Spain, Hungary and now even Italy – have directly or indirectly overstated purchase commitments, bringing denials from Beijing, which steadfastly declines to cite figures in any case.

Beijing’s “support” and “friendship” have actually taken the form of asset buying in sectors evidently designed to benefit future trade and the interests of Chinese enterprises. Container ports and terminals, airports and logistical or industrial assembly bases are targeted, besides firms with interesting technological or marketing content.

Nations have also been conditioned to move away from anti-dumping charges against China and towards support for its longstanding claim of market-economy status from Europe. Greece, Spain and Portugal, once vocal advocates of anti-dumping, have now fallen silent. Ironically, they may not support the efforts by some Northern European countries, including Germany, to improve access for their firms on China’s service and public procurement markets.

China, which will get market economy status in 2016 in any case, is still hell-bent on removing any anti-dumping risk against its firms. Such removal is conditional on China respecting its terms of entry into the World Trade Organization: Some trade negotiators suggest a case exists for charging Chinese state firms with dumping for using state subsidies in their financing. So the issue is alive and well, not just a historical relic from China’s accession to the WTO in 2001.

China’s readiness to use the granting or denial of lending to governments as a credible weapon is far from certain. Opacity in numbers, the use of third markets and off-shore centers leaves much room for bluff.

Despite earlier media hype, there is no sign that China has actively purchased bonds of crisis-hit countries. The Bank of China for example – one of three main Chinese public actors in this game – actually decreased its ownership of Greek, Spanish and Portuguese bonds during the first half of 2011. Given Beijing’s obsession with losing out on its large currency reserves, cautiousness makes economic sense. It’s probable, but not certain, that China has been investing – in proportion with its rising tide of reserves, but not above that tide – in safer European public bonds from the core countries. Let’s remember, until the last few weeks, those bonds paid more than US treasury rates.

Even so, we lack specifics. Wen merely declared last June in Budapest that China owned “not insignificant amounts” of euro reserves and “hadn’t cut back on our euro holdings.” In the absence of more confirmations, the market lift from rumors of Chinese purchases has become short-lived, lasting but a few hours in Italy on September 13. The same day ended with a report that Chinese funds had in fact been window-shopping for potential asset purchases in Italy, an altogether different purpose.

Wen’s public gambit could therefore be a bluff. China has excelled in public diplomacy of vague assurances designed to leverage its partners, accompanied by hard deals and asset purchases rather than gifts. As long as the Eurozone holds together, supporting a bipolar currency order – or a tripolar order if one includes the yuan in addition to the dollar and euro – is strictly in China’s interest, along with avoiding a major recession in its main overseas market.

But if China had decided to deleverage its euro reserves, Wen’s statement would also be setting the ideal pretexts. That he relays, however obliquely, political conditions for Europe is another disturbing sign of Europe’s collective weakness. Making Europe lose face would help satisfy Chinese public opinion, already fed daily with news about their nation’s rise.

Only 48 hours after Wen’s statement at the World Economic Forum, five major central banks stepped in to assuage the European banking system’s liquidity fears, immediately prompting a step back by China. Successive statements by its Foreign Ministry and Ministry of Commerce have pointed to support for the euro in China’s own interest – without citing the conditions laid down in Wen’s speech.

It’s highly improbable that Wen misspoke. Statements of China’s top leaders are carefully phrased, especially on sensitive issues like China’s financial strategy. Rather, Europe’s urgency temporary receded; China could not press the conditions it might extract as a lonely savior.

The episode should serve as a warning to Europeans. Political unity is essential, lest other players begin to take advantage of the obvious divisions. If the eurozone’s less directly challenged economies pocket windfall benefits of quasi-zero interest rates for their own budgets, while denying support to less well-endowed economies, the eurozone will crack up. If the European Union’s management of its external economic relations – trade, investment, finance – can be held hostage over Europe’s incapacity to reach a collective deal on public debt, the fundamental justification for the Union will disappear. The one and only realistic argument that European sovereignty hawks have always held was that the European Union as such was not a viable or even legitimate political actor.

In today’s global currency wars, China is a unitary political actor and so is the United States, despite the transaction costs of its political democracy. Europe seems bent on making the political demonstration that it cannot get its act together. In the last few days, Germany’s government, usually credited with a sensible decision-making process, has exploded with contradictory statements on Greece, eurobonds and the European Central Bank, and the Union has displayed collective folly.

This period might one day go down in history books as the moment when politicians lost Europe.

If China is now moving its pawn across the chessboard, Europe has only itself to blame. The show of European disunity, the apparent ignorance of market play by the leaders of Europe’s core economy, is staggering. China’s national interest alone dictates that the proceeds from its trade surpluses and hot money inflows must at least be partially invested into the euro. But Europe’s weakness invites into the game irrational market sentiment and potential heavy-handed pressure by a better organized player.