Merkel Meets Wen
Mrs. Merkel has just visited China, a big delegation in tow, for extensive talks with Wen Jiabao and his government. Germany has good reason to keep in close touch with China: it is one of its biggest export destinations these days. Since 1999 Germany's exports to China have risen nearly ten-fold and today amount to 2.5% of its GDP. The rest of the euro area is also exporting quite a bit to China, and conversely, the euro area is also China's biggest customer.
Back in 2007, when Berlin invited the Dalai Lama, the relationship with Beijing chilled considerably, but that is all forgotten today. Business has become the major issue, and China is understandably worried about the crisis its main trading partner goes through.
Mrs. Merkel's visit was the second in the past six months and it mainly served to reassure China's leadership about the future of the euro. As Beijing sees it, Mrs. Merkel is the 'go-to' leader in Europe these days, a fact that has already produced some grumbling by other European leaders.
China is nowadays confronting considerable economic problems of its own and the deepening recession in euro-land obviously contributes significantly to its economic slowdown. China remains highly export dependent – a slowdown in exports is felt disproportionally throughout the production structure of its economy, much of which is geared to trade. If Europe is a stock, then China is akin to a warrant on it.
The growth of European exports to China, indexed. Germany is in the lead, but trade between China and the rest of Europe has also grown significantly – click chart for better resolution.
Germany exports the equivalent of 2.5% of its GDP to China – click chart for better resolution.
China the Savior?
In the months and weeks before Portugal's caretaker government 'got the begging bowl out' in April of 2011, China had been an avid buyer of Portuguese debt. Apparently it believed prime minister Socrates when he insisted for many months that that 'Portugal would lose its dignity and prestige' if it were to apply for a bailout, and that hence it would never happen.
China has yet to break even on the bonds it bought at the time. Ever since, Lou Jiwei, the head of China's sovereign wealth fund China Investment Corporation (CIC) has stressed that China is no longer interested in buying European sovereign debt. The most recent announcement from the CIC chief in this context was made on June 12 – in his first interview with Western media in five years:
“The head of China's giant sovereign-wealth fund sees mounting risks of a breakup of the euro zone, and says the fund has scaled back its holdings of stocks and bonds across the continent.
The comments by Lou Jiwei, chairman of China Investment Corp., are among the most bearish pronouncements yet on Europe by a senior Chinese official. They reflect growing dismay in Beijing at how European leaders are handling the escalating crisis in China's largest export market, and anxiety over the potential for global contagion.
"There is a risk that the euro zone may fall apart and that risk is rising," Mr. Lou said in an interview.”
(emphasis added)
It was quite astonishing then to hear Mr. Wen make a u-turn on the issue after his pow-wow with Mrs. Merkel. However, a closer look beyond the headlines shows that China's offer of help is actually tied to conditionality, similar to the recently proposed ECB intervention, or rather similar to Finland's frequent collateral demands. China wants to be sure it will get its money back.
“China is prepared to buy more EU government bonds amid a worsening European debt crisis that is dragging on the world economy, Premier Wen Jiabao said, in the strongest sign of support for its biggest trading partner in months.
The debt crisis, which has dented demand for Chinese exports and dragged China into its worst downturn in three years, was the primary focus of talks between Wen and German Chancellor Angela Merkel who arrived in Beijing on Thursday.
[...]
Wen said Beijing is willing to continue supporting the debt-stricken euro zone, and will step up talks with the European Union, the European Central Bank and the International Monetary Fund – also known as the troika – to help struggling EU nations.
"China is willing, on condition of fully evaluating the risks, to continue to invest in the euro zone sovereign debt market, and strengthen communication and discussion with the European Union, the European Central Bank the IMF and other key countries to support the indebted euro zone countries in overcoming hardships," he said after meeting Merkel.
Wen, who did not elaborate, said he remained worried about the crisis in the euro zone. "Recently, the European debt crisis has continued to worsen giving rise to serious concerns in the international community. Frankly speaking, I am also worried," Wen told a news conference.
[...]
China's latest promise to buy more European sovereign debt if certain conditions are met encapsulates Beijing's hitherto cool response to Europe's requests for financial aid.
Attempts by the head of one of Europe's rescue funds to get funding from China last year floundered on Beijing's fear that it was not getting sufficient protection against losses.”
(emphasis added)
In fact, what is not mentioned in the Reuters article is that China's support of the euro-area's bailout circus, whether by increasing its contributions to the IMF or buying euro area sovereign debt outright, is deeply unpopular in China and hasoccasionally produced veritable storms of outrage via internet postings. Chinese citizens rightly consider the proposition that China should help to bail out rich Europe absurd.
Evidently China's leadership has not forgotten the losses China suffered by buying euro area sovereign debt at an earlier stage of the crisis, hence the demand for guarantees. Not surprisingly, the markets yawned when the reports about China's willingness to buy more euro area debt came over the wires. 'Been there, done that'.
China Has Bigger Problems
We would add to this that China has far bigger problems to contend with closer to home. As the most recent manufacturing PMI from Japan shows, its major trading partners are clearly beginning to feel the pinch from China's slowdown. In a similar vein, iron ore prices continue to crash, as China's steel mills are cutting back production. Steel futures in Shanghai fell to a new record low as well.
“Shanghai steel futures hit a record low on Wednesday, exerting more pressure on prices of the raw material iron ore whose freefall has forced Chinese steel producers to skip contracted cargoes.
Chinese mills, the world’s biggest iron ore buyers, have either cancelled or deferred shipments of up to 4 million tonnes this month after iron ore prices tumbled to their lowest in more than 2-1/2 years, the latest evidence of a slowdown in the world’s top steel market.
(emphasis added)
The crash in iron ore prices (via Business Insider) – click chart for better resolution.
Iron ore (yellow line) compared to the Australian dollar's exchange rate vs. the US dollar – click chart for better resolution.
We think China's focus will be on different things than peripheral European sovereign debt. Just as a major leadership transition is looming, its economy is undergoing a sharp slowdown, the severity of which has surprised most observers, including China's planners themselves. It was easy to set the big bubble into motion – it won't be so easy to 'soft-land' it. In fact, we remain convinced that this will prove to be nigh impossible.
A so-called 'soft landing' essentially means that renewed credit expansion is employed to arrest the liquidation of capital malinvestments that have been amassed during the boom. The government of China's grip on its large domestic banks means of course that it can simply order them to lend, whether it makes economic sense or not.
However, the more often this is done, the worse the eventual denouement will be. There is no way out – either the credit expansion is abandoned voluntarily and the bust is allowed to play out, or there will be an even bigger catastrophe down the road. We don't know the extent to which China's planners are familiar with this concept, but they must surely be worried in light of the results of their last massive stimulus program.
Contrary to Keynesian lore, the massive 2009/10 stimulus program has not brought about a sustainable economic expansion – instead it has created an even bigger bubble, and now the bills are coming due.
This is of course the inevitable fate of every Keynesian stimulus program. Paul Krugman would probably tell us the Chinese 'didn't spend enough' in 2009-2010, or that a credit expansion of more than trillion in a single year was 'too small' and that China's leaders should now consider to fake an alien invasion, so to speak implement 'Plan 9 From Outer Space' so they can spend even more. However, the real world doesn't work like Krugman's new-Keynesian fantasies.
Our friendly uncle Wen from China promises to buy more euro area debt. But not without a money back guarantee.
(Photo via Reuters)
Charts by: Economist, Bloomberg, Business Insider
Source: Acting Man
