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China Will Rescue Europe—Eventually

John Lee

Euro zone bailout fund head Klaus Regling’s mission to China received a polite but non-committal response from his hosts. Eventually to be built up to €1 trillion (S$1.74 trillion), the European Financial Stability Facility (EFSF) fund is critical to the rescue plan and European Union (EU) leaders need China to inject some of its estimated US$3 trillion (S$3.8 trillion) in reserves for the plan to work. An adviser to French President Nicolas Sarkozy indicated on Monday that China will not receive any significant ‘special concessions’ to sweeten the deal, raising questions as to whether Beijing will come to the party.

This might be the last throw of the dice for the euro zone but Beijing’s negotiating position is still weaker than many realise.

My bet is that China will eventually lend a helping hand—not because of any altruism but because Beijing is as aware of its economic and strategic vulnerabilities as it is of its obvious strength.

Technically, China’s economy has largely ‘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 to 5 per cent. 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 the urban elite 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 million and 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 to 70 per cent 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, state-owned enterprises (SOEs) are around three times more inefficient than export manufacturers when it comes to creating jobs.

This is where helping to stabilise the EU by bulking up the EFSF comes in.

China is committed to an 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 per cent of the country’s formal finance from 2008 to 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 in job maintenance and creation throughout the country. Indeed, Europe (receiving 35 per cent 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 will eventually offer help even if it holds off for the moment.

Since the US dollar remains the de facto reserve currency, bonds in euros offer higher yields in comparison.

Geo-economic and geo-strategic issues also come into play.

Beijing is feeling the heat from industrialised Group of 20 members putting periodic 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 likely that Beijing will be eager to demand that European leaders formally acknowledge China as a ‘market economy’ following free market practices. Any such declaration by Europe’s leaders will give Beijing breathing space should the issue of the value of the yuan be raised again by American senators.

Finally, as the holder of about US$1.3 trillion in American Treasury bonds, and a possible further US$1 trillion in other dollar-denominated 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, the euro is the only other potential alternative.

Then there is the matter of asset vulnerability if tensions with the US 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. If China comes to Europe’s rescue as it is likely to, the CCP is helping to save itself.

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