Word got out last week that China is gonna step up its game, play superhero, and save the euro zone from its debt crisis. If I’m not mistaken, the rumor started when news hit the airwaves that Chinese officials discussed their plans of buying Italian debt.
Unsurprisingly, a few market junkies got excited with the news. After all, China had previously helped Europe before when it bought Portuguese bailout bonds and it has constantly showed its support for the region.
However, after looking at the facts, I believe they are all nothing but hype. China alone will not be enough of solve euro zone’s solvency issues.
But before we look at why this is the case, let’s first take a look at the reasons why China is even considering helping the euro zone. I’ll first answer the question: What’s in it for China?
Reason 1: Euro zone is China’s largest trading partner
Euro zone takes in about 20% of China’s exports, a bit higher than that of the U.S. This means that China needs to make sure that demand from euro zone does not falter, as it benefits not only their GDP, but domestic employment as well. It is estimated that each 1% drop in GDP in the euro zone leads to a 6-7% decrease in China’s export growth.
Reason 2: China is deeply invested in the euro zone
Around a fifth to a fourth (or 480-600 billion EUR) of China’s foreign exchange reserves are held in EUR assets like low risk highly-rated German Bunds. Moreover, the Chinese bought roughly 6% of the first issuance of EFSF bonds.
Finally, China has 7 billion EUR in euro zone FDIs or foreign direct investments. FDI refers to the acquisition or construction of physical structures by a firm from one country (China) in another country or region (euro zone).
Now, let me get to the meat of the topic: Why China can’t be euro zone’s knight in shining armor.
First of all, it will take about 730 billion EUR to refinance the PIIGS nations. Sure, the country has amassed a whopping 3 trillion USD in foreign reserves, but they are stored in long-term debt financial instruments.
Three-fifths of its reserves are said to be in USD, a fifth in EUR, while the rest in other currencies. These are assets can’t really be touched because they can’t be easily liquidated.
The only thing really feasible for China to do is step-up future investments in euro-denominated financial instruments or “forex reserve diversification.” But even if China does manages to increase the share of euro assets in its reserve to – to a realistic 30% for example – it would only mean around 150 billion EUR in financing. Clearly, that isn’t enough.
The reality is, China’s pockets aren’t really as deep as what is largely perceived. It doesn’t have enough cash to give the euro zone and keep the region afloat amid its debt crisis.
Besides, even if China did have sufficient money to save the entire euro zone, would China take the risk? Given all the uncertainties in the market, I think the commitment is too big to take even for an economic giant such as China to take.