China and Europe: Where to Look for Support

Currency in Crisis

China President Hu Jintao was very polite in pubic comments as the 14th Sino-EU summit began yesterday. He made pleasant remarks about China's willingness to support Europe. The foreign exchange market initially bought euros on the headlines, but alas the twists and turns of the Greek saga exert the stronger pull. Still, it seems that many observers misunderstand what is happening.

China has about $3.2 trillion in reserves. It is one of the few countries that do not reveal the currency composition for its reserves. Economists assumes that around 25% of the reserves are invested in euro denominated instruments. That means that China holds roughly $800 bln of European bonds. For numerous reasons it seems unlikely that it is about to increase its holdings of peripheral bonds and to the extent it buys core bonds, like German bunds, it aggravates the pressure by widening the intra-European spreads.

The ever colorful Dennis Gartman advised as the crisis just was emerging to buy things that hurt when you drop on your foot. China appears to be taking this advice. It has little interest in expanding its holdings of paper. It wants real assets.

Many may not appreciate the extent to which the combination of cheap credit and "bargain" pricing is encouraging Chinese companies and funds to buy assets in Europe. Here is just a short list of some recent transactions.

1. A China state fund agreed to buy for 387 mln euros a 25% stake in Portugal's national electric grid.

2. China's largest construction equipment maker bought a German family owned engineering firm for 360 mln euros.

3. China's sovereign wealth fund bought a stake in the UK's Thames Water.

4. China's Three Gorges bought a 21.3% stake for 2.2 bln euros in a Portuguese energy company.

5. A Chinese company bought a 25% stake in the Ferretti Group, an indebted Italian yacht manufacturer.

6. China's National Chemical Corp bought a stake in Norway's Elkem for $2.2 bln.

7. Manganse Bronze makes London's famous black taxis. It is owned by Geely, the Shanghai-based car manufacturer than owns Volvo

8. China's sovereign wealth fund has the third largest stake in Songbird Estates which owns the Canary Wharf Group.

9. Chinese banks have bought or leased 28k meters (300k square feet) of office space in the financial district in London.

To be clear, China is not invading Europe. Last year, its direct investment in Europe as about $4.3 bln, almost double the 2010 figure. However, it terms of stock,only about 3.5% of China's foreign direct investment is in Europe.

China's current five year plan calls for direct investment outflows to grow at an annualized rate of 17%, so that in 2015, its stock of foreign direct investment will be a little more than $560 bln. China's shopping plans and financial wherewithal finds a Europe that wants to sell assets. The privatization programs are an integral part of the recovery plan for the periphery.

Yet there is political resistance too. The conservative Heritage Foundation found that last year almost $33 bln in deals were blocked by officials in the target country, including Bright Food Group's attempt to by France's Yoplait. China's Ministry of Finance estimates that some $60 bln in deals were approved.

In a similar way that the US triangulated, using China to help check the Soviet Union, so to is China using Europe to triangulate the US. Europe offers China a way to, at last partially diversify away from the US dollar. Europe is also a important buyer of China's goods, allowing it to diversify away from the largest consumer market in the world (the US).

One important political concession that China is seeking is for Europe to classify it as a market economy. The current designation of as a non-market economy makes it easier for European companies to seek redress against Chinese trade practices. Yet China is likely to find what other great powers including the US, have found. It is difficult to translate financial prowess into political leverage.