South China Morning Post
EDT17 | EDT | Caixin View | By Edited by Hu Shuli
There’s still no end in sight to the euro-zone crisis. Last week, ratings agency Fitch downgraded Irish sovereign debt to BBB+ from A+, suggesting the market is still bearish about the country’s economic outlook.
Amid the uncertainty, it is critical that affected countries determine the causes of the crisis, and weigh their risks and opportunities. And, since China is not immune to the upheaval, it too must be ready to act.
Ireland finally bowed to market pressure last month, becoming the second euro country after Greece to seek foreign help. The European Union, the International Monetary Fund and Ireland agreed on a ??85 billion (HK$886 billion) rescue package. But the market’s response was tepid.
Few people would be surprised if Portugal was the next domino to fall. If that really happened, how much longer before Spain, too, was affected? Since Spain is the fourth-largest economy in the euro zone, the cost of a rescue could be very high, and the ??440 billion euro-zone fund could run out.
We have not yet come to that, mainly because the European Central Bank has bought more bonds issued in the euro area. But this emergency measure is only palliative – once the ECB considers withdrawing the liquidity support, or the market perceives it has such a plan, market panic will follow.
Sooner or later, volatility in the euro area will affect China. The ECB’s expanded acquisition of euro-zone bonds is in fact no different from the over-issuance of money. And although the central bank’s mission is to maintain the euro’s stability, its policy against inflation is far tougher than that of the US Federal Reserve. The euro, as the world’s second-largest reserve currency after the greenback, draws a major share of China’s foreign exchange reserves in the country’s drive to diversify its currency holdings. China, therefore, has reason to be concerned about the likely loss of its investment and other indirect effects.
Beijing has increased its investment in euro debt since the onset of the global financial crisis in 2008. From a purely economic perspective, investing in euro government bonds could generate fabulous returns if a default or debt restructuring do not occur. But most analysts believe a default or debt restructuring is unavoidable.
At present, countries such as Ireland and Greece offer very high coupon rates for their debt, so they will shoulder heavier debt burdens, slowing the rate at which they get out of the woods. Worse, the countries have to carry out fiscal austerity measures at the request of the EU and IMF in return for their loans. This will upset their efforts to boost short-term economic growth, plunging the countries into the vicious cycle of a deeper recession with a higher debt burden. Therefore, debt restructuring could be the least harmful option for the long-term benefit of these countries and the entire euro zone.
If this happens, China’s investments will inevitably suffer a loss. But if it is the price to pay for breaking the vicious cycle and bringing stability to the world economy, China could hardly complain about the loss. This is the dilemma it faces.
The key to ending the crisis is to win public confidence in European Monetary Union and government policies aimed at tackling economic imbalances in the euro zone. However, the measures designed to do that have so far failed.
Of particular concern is the deteriorating image of the euro in Europe. A unified currency represents the dream of a unified Europe but this point is not much comfort to its citizens who have suffered greatly in the crisis. Political leaders must restore a consensus on this issue in their countries, knowing that any withdrawal of peripheral European countries from the euro currency system would only cause even greater instability. At the same time, we should not underestimate the determination of European countries to integrate their political and economic systems. At least for now, disintegration of the euro currency seems very unlikely.
For China, supporting the euro could be of great strategic significance. This not only relates to asset allocation of China’s foreign investment portfolios, but also the future make-up of the international monetary system. Should the euro – the most powerful competitor to the dollar – fall, the US would become more unrestrained in making its monetary policies. If this happened, China, as the biggest investor in US treasury bonds, could sustain even greater losses.
Since the financial crisis hit, China and other major economies have pursued loose monetary policies. So far, the US and European economies have shown no sign of recovery, but China already faces mounting inflationary pressure. It is therefore necessary to bring China’s monetary policy back to normal. If European economies continue to be sluggish, capital will flow more rapidly into China and it will be even more difficult for the country to cope with inflation. It makes sense for China to support the euro to ease its inflationary pressures.
European countries are painstakingly reforming their financial systems, and that will help improve their competitiveness in the medium to long term. The United States, in contrast, is still seeking to use cyclical policies to resolve structural problems. It has failed to map out any feasible, long-term solutions to cut deficits. China should, therefore, prepare for the risks and opportunities to come.
In the long run, China should accelerate the transformation of its economic model, gradually turning its excessive trade surpluses and foreign reserves into a new force to drive domestic consumption. Meanwhile, the central government should allow monetary authorities to work more independently and deepen the reform of the renminbi exchange rate mechanism. All these will help achieve the free float and full convertibility of the currency, making yuan-denominated assets more important to international investors.
This article is provided by Caixin Media, and the Chinese version of it was first published in Century Weekly magazine. http://www.caing.com Copyright (c) 2010. South China Morning Post Publishers Ltd. All rights reserved.