China and Europe

Many observers mistakenly think that because China is not a parliamentary democracy that is it monolithic. Yet repeatedly we have seen this is not the case. Many officials at the PBOC, for example,seem more sympathetic to a more flexible currency regime, while officials more involved with commerce and trade are more opposed.

Most recently, diplomats and political leaders, including Premier Wen seems more sympathetic to the plight of Europe. Wen suggested in mid-Sept that China might be more prepared to lend the euro zone funds if it were to recognize the PRC as a market economy. This designation would make it more difficult to charge China with dumping.

Officials closer to financial issues seem less sanguine.The vice minister of foreign affairs explained over the weekend why China can not use its massive reserves (over $3 trillion) to aid Europe.

The reserves are effectively financed through borrowed funds. The reserves are the asset, but there is a linked liability. The PBOC forces commercial banks to transfer 20% of their domestic deposits to it, which it then uses to buy dollars in the foreign exchange to manage the RMB.

Commercial banks are also forced to buy PBOC bills that pay low rates and the proceeds are also used to fund its acquisition of foreign exchange. This is another example of how China's foreign currency assets have an associated RMB liabilities. To spend those reserves leaves a large unfunded liability.

The CEO of China's sovereign wealth fund also commented on the issue recently. He was very clear. The China Investment Corp is more interested in real assets, roads, bridges and other infrastructure projects. This is consistent with China's broad interest in fixed assets as opposed to helping countries finance budget deficits.

Separately, some Chinese officials opined willingness to contribute more money to the IMF and the preference for greater protection than lending directly to the euro zone, such as through the IMF.

Many observers conclude that Europe itself is bankrupt and cannot afford to address the debt situation. We remain skeptical of such a dour view of Europe's wealth. In a combination of portfolio and direct investment, the euro zone holds about 10 trillion euro of foreign assets. These can be sold. Another example is the household wealth in Italy it is many times more than the government's debt (~1.9 trillion euros). Europe needs to marshal its own resources and officials still seem reluctant to do so.

China has an interest in preventing the total collapse of the largest buyer of its exports, but it also has an interest in forcing Europe to divest its overseas assets. Chinese banks and companies are in a position to be a buyer of some of those assets.

There are three take-aways: 1. China is not monolithic and speaks in different voices. In terms of help for Europe, the politicos and diplomats seem more sympathetic than the finance folks. 2. China is unlikely to be the knight that rescues the euro zone. 3. China, as many other countries, may find it difficult to leverage its financial prowess for significant political gain.