Australian Financial Review
September 18, 2011
by John Lee
When the Asian Financial Crisis hit regional economies in 1997, China emerged as a White Knight by refusing to devalue its currency to help its "Asian friends in their time of need" as then President Jiang Zemin put it. It could be happening again. Although Premier Wen Jiabao admitted that "We have been concerned about the difficulties faced by the European economy for a long time," he nevertheless reiterated China's "willingness to extend a helping hand and increase our investment" in Italian issued Euro-bonds.
Italy is the largest issuer of Euro-denominated bonds. If Italy stumbles, Europe could fall. But far from an act of economic largesse or else pity, China's offering a helping hand is more a statement of Beijing's acute awareness of its economic and strategic vulnerability than its strengths.
At first glance, Beijing's motivations appear somewhat altruistic. China's economy in many respects has 'decoupled' from the West since its economic growth is more dependent on domestically funded fixed- investment than net exports or foreign direct investment.
But politics rules economics in China and political priorities for the Chinese Communist Party (CCP) are more complex and self-regarding. When it comes to economic policy, the primary calculation is always based on what is needed to enhance regime security and remain in power.
Officially, unemployment in China is at a very manageable 4-5%. But these statistics measure less than one tenth of the population. Unofficially, unemployment could be at least double that. This does not even include the estimated 200 million itinerant workers who fall in and out of work constantly. All this means that preserving and creating jobs is the main priority for a regime that primarily holds on to power on the basis that it can provide economic prosperity to urban elites throughout the country.
Even though domestically funded fixed-investment is the primary driver of economic growth in the country, the export manufacturing sector which employs between 150-200 million people remains the most efficient generator of jobs in the country. China remains the world's sub-contractor of choice and is the central hub of the production chain rather than the end-consumer. An estimated 50-70 % of China's trade is processing trade – that is products entering into China to be assembled before being shipped out again for consumers in other markets.
While the state-owned-sector received three quarters of all the country's formal finance, SOEs are around three times more inefficient than export manufacturers when it comes to creating jobs.
This is where helping to stabilize the EU by buying Italian bonds come in.
China is committed to a SOE-led fixed-investment model of growth for the foreseeable future. The CCP is desperate to ensure that it remains the primary dispenser of business and economic opportunity throughout the country. Since the private domestic sector – which received less than 10% of the country's formal finance from 2008-2010 - is being deliberately suppressed, Beijing cannot afford any further deterioration in the European consumer market since the export sector is still relied upon to pick up the slack of job maintenance and creation throughout the country. Indeed, Europe (receiving 35% of China's exports) and not America has been China's largest and most important export market since 2004.
There are other reasons why China is offering to buy Italian bonds.
Since the America dollar remains the de facto reserve currency, bonds in Euros offer higher yields in comparison.
Interestingly, there are also other geo-economic and geo-strategic issues at play.
Finance ministers from the group of 20 are scheduled to meet in Paris next month. There are credible rumours that French President Nicholas Sarkozy is pushing other G-20 members to put renewed pressure on China to end its policy of massive market intervention designed to artificially suppress the value of the yuan relative to currencies such as the greenback and Euro.
It is therefore telling that in return for buying Italian bonds, Beijing has asked European leaders to formally acknowledge that China is a 'market economy' that 'follows free market practices'. Any such declaration by Europe's leaders will give Beijing breathing space should the value of the yuan be raised.
Finally, as the holder of about US$1.3 trillion in American treasury bonds, and a possible further US$1 trillion in other dollar denominator assets, it is well known that China would like to hedge by diversifying away from the greenback. Since it cannot convert its foreign currency reserves back into yuan without overseeing the rapid rise of its own currency, Euros is the only other potential alternative.
But there is the matter of asset vulnerability if tensions with the United States were to escalate into war – a scenario taken very seriously by planners in Beijing. If that were to occur, Chinese holdings of US assets would almost certainly be 'quarantined' by Washington, meaning that an immense proportion of China's wealth would effectively be frozen. In the extreme and worst case scenario of total war with America, Washington could void Chinese holdings of American debt. Gradually diversifying into Euros – provided the Euro Zone survives - would partially alleviate this potential threat.
There is no such thing as a 'free lunch' in international economics. In coming to Europe's rescue, the Chinese Communist Party is helping to save itself.
John Lee is a Hudson Institute Visiting Fellow and an Adjunct Associate Professor and Michael Hintze Fellow for Energy Security at the Centre for International Security Studies, Sydney University. He is the author of Will China Fail? (CIS, 2008).
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