Europe Looks to China

First of all, a personal note and quick explanation:  last week, I had a medical emergency — nothing life-threatening, but enough to put me in the hospital and lay me low for a while.  I’m slowly on the mend, but for the past week I have had neither the energy nor the focus to author any blog posts, although I have been trying my best to keep up with the news.  So apologies for being “radio silent” while so many interesting things have been going on.

The news these past couple of days has been dominated, of course, by the efforts of European Union leaders to reach a bailout agreement — and the fact that, immediately after the outlines of such an agreement were reached, the first thing the EU did was dispatch an envoy to Beijing, to persuade China to help fund the plan.  Arvind Subramanian, a scholar at the Peterson Institute and author of a new book called Eclipse: Living in the Shadow of China’s Economic Dominance (which argues, among other things, that the Renminbi will emerge as a global reserve currency sooner than anyone expects), caught the mood of the moment with a prominent op-ed in the New York Times titled “Why China Should Bail Out Europe.”  In it, he argues that China’s moment as a Great Power has arrived: that it can and should save Europe, and in doing so, ought to demand political and economic concessions, including a dominant role in running the International Monetary Fund:

China should demand nothing less than a wholesale revamping of the governance of the I.M.F. to reflect the current economic realities. Governance reform can no longer be just about the nationality of the I.M.F.’s managing director but should fundamentally be about who will have the greatest voice and exercise the most power in the new world . . . Supplicants, China should insist, cannot have veto power in a financial institution. The Chinese government could then trumpet a nationalist achievement — equal status as the United States, and a greater status than that of Europe, in running the world’s premier financial institution — as the return for investing its cash abroad.

I haven’t had the chance to read Subramanian’s book in full (although I look forward to doing so), so I’m not going to undertake here to rebut his broader thesis.  But in this particular instance, China’s role in the EU bailout, I find his take — which admittedly seems to be the prevailing interpretation among both European leaders and their publics — more than a little misconceived.  I’ve expressed this before, but let me restate it again:

Many people inside and outside of China are of the mistaken impression that China’s $3 trillion in FX reserves make it a massive investor in US Treasuries, Euro sovereigns, etc. at its own discretion, able to turn on or off the flow at will and therefore requiring to be courted and appeased.  In fact, unless China (wisely in my view) were to consciously break its dependence on exports and captive savings, it must accumulate ever-growing reserves and has little choice but to put them somewhere.

Some media accounts make it seem like China could single-handedly recapitalize European banks and bond markets, by deploying its $3 trillion reserves, should it choose to do so.  In truth, China can’t reallocate the deployment of those reserves (among currencies or recipients) to any sizable extent without also reallocating the global payments imbalances they reflect and support.  Shift your reserves from dollars to euros, shift your holdings from the U.S. to Europe, and you shift your trade/capital flow surpluses with it.
 
Those who are looking to China as a short-term savior for Europe would do well to ask themselves why China has such a ready pool of investable cash on hand.  It does so because it runs a chronic surplus with most EU countries (besides Germany and Ireland) much like it does with the U.S.  China produces more than it consumes, the US and most of the EU consume more than they produce — hence their growing dependence on debt.  The ultimate solution to the EU debt crisis is not more debt, but growth, so countries can earn their way out of debt.  Certainly there are internal imbalances at work in Europe (Germany’s surpluses with the rest of the EU) but China’s surpluses, and its reserve accumulation, are part of Europe’s growth deficit, part of the underlying problem. 

If China really wants to do European countries a genuine favor, the best way is not to continue running surpluses with the EU, then turning around and lending the proceeds back to the Europeans to keep them on life support.  It is to use the proceeds from what China sold to Europe, or received as investment from European companies, to buy European goods and/or make productive investment in Europe, thereby generating jobs, growth, and earnings that can get Europe back on its feet and back buying Chinese-made goods on a more sustainable basis.  But that would require a significant mental and policy shift from China’s current growth paradigm.

Such a shift, however, would be squarely in China’s own interests, not just that of its trading and investment partners.  The popular, conventional view sees China as a vastly wealthy bank sitting on a pile of money, and the deficit nations of the US and EU as “supplicants” (as Subramanian puts it) desperately hoping that bank will lend them some.  In fact, China is more like a shopkeeper who keeps allowing his customers to run up higher and higher tabs on credit, for fear that if he doesn’t, they won’t be able to keep buying and he will go out of business.  That certainly isn’t good for the customers, who end up getting into greater and greater debt, but it isn’t a particularly good position for the “creditor” to be in either.

I have heard some argue, in reaction to Subramanian’s op-ed, that China participating in the EU bailout would somehow hasten the acceptance and credibility of the Renminbi as an “international” currency — a key development Subramanian sees as heralding the dawn of Chinese economic and political supremacy.  Regarding that goal, however, I would rank, in order of importance, the following as far greater priorities and/or obstacles:
 
1) Giving people outside of China some way to earn and accumulate RMB by becoming a net exporter rather than massive net importer of currency (i.e., running a balance of payments deficit, either on the current or capital account)

2) Making the RMB “useful” for far more than a highly constrained/regulated set of purposes (i.e., freely convertible)

3) Offering those who do earn RMB somewhere to hold them until they want to use them (i.e., developing deep, liquid, transparent, and freely accessible capital markets, particularly bond markets).
 
I would not rank recycling China’s surpluses as debt-financing for deficit countries, which it is already doing and must do in any event, high on that list — even when it appears to be extending much-needed “help” in a crisis.  In fact, the “help” that China is able to extend — its massive accumulation of dollars and other hard currencies — is itself testament to the marginal status of the Renminbi in China’s own international trade and investment transactions, much less the world’s.

It is entirely possible that China will declare, in response to European entreaties, that it will deploy some fraction if its annual balance of payments surplus — say $50 billion — to support the European bailout fund or bond markets.  Such an allocation — which it may well have had to make anyway, given its ongoing accumulation of reserves — will no doubt win it media kudos and perhaps favors from a grateful Europe.  For China, the optics will be fantastic, and the widespread misunderstandings regarding China’s role will only exaggerate, rather than diminish, the political and PR benefits for the Chinese as “saviors.”

The reality, though, is a long way from China “saving” Europe.  Not that I disagree with involving the Chinese — it is a good idea to involve China as a “responsible stakeholder” in organizing a response to any crisis that affects the global economy.  But if China truly wants to be a “responsible stakeholder,” the most responsible step it could take would be genuine movement towards a more sustainable balance of trade and investment.  That means not merely a more market-based approach to currency exchange rates — the U.S. Senate’s current obsession — but far more importantly, a renewed commitment on China’s part to market openness, even regulatory playing fields, and freer capital flows.