Wednesday, September 28, 2011

Why China Won't Bail Out Europe

With $3 trillion in foreign currency reserves, China holds the largest single pot of investment funds in the world. The EU's sovereign debt crisis, which threatens to derail the world's financial system and foster worldwide recession, may require as much as $2 trillion to resolve (see It's not surprising that some have nominated China to be Europe's white knight, contending that the Chinese are so deeply integrated into the world's economy that they can't afford to stand by while the West belly flops. This is wishful thinking.

China has its own problems. It is stuck with a huge imbalance in its own economy, being way too dependent on exports. The economic slowdown in America and other Western nations is hurting growth in China. Unemployment is rising, while the commodities inflation caused by the U.S. Federal Reserve's easy credit policies is spurring consumer price inflation in China. Real estate values have bubbled up deliriously in China, and the bubble could burst soon as China's central government now tries to rein in overly enthusiastic bank lending. Since the Chinese have invested heavily in real estate, the bursting of that bubble could be very painful. From the times of emperors, the central government in China has been expected during crises to alleviate the difficulties of the Chinese people. Its failure to do so has typically meant the overthrow of a dynasty. Today's Communist government is well aware of this history.

Longer term, the Chinese have a severe demographic problem. The Communist government's one family, one child policy has constrained the numbers of younger people. Gen X and Y, and Millenials in China are proportionately fewer than they are in America. That means a smaller number of younger workers to support retiring older folks. The $3 trillion the government has in the piggy bank could play a valuable role in keeping generational warfare to a minimum in China.

Then, there's the question of optics. China's per capita income is about $4300, just a fraction of America's $47,000 and the EU's $32,000. China's government couldn't afford politically to bail out wealthy (from the perspective of the ordinary Chinese) Westerners while a majority of its people still don't have central heating or indoor plumbing.

The possibility that the EU needs $2 trillion to extract itself from the swirl in the porcelain bowl illustrates the intractability of the EU sovereign debt crisis. There simply isn't that much hard cash floating around to pay the debts Europeans incurred to live large for the past decade. The EU's latest talk of establishing a special purpose vehicle to leverage the capital of the EU bailout fund is simply another maneuver to shuffle paper and kick the can down the road. It tries to solve a problem of too much debt by creating more debt, and could increase the EU's overall debt load without providing any means for actual repayment. Indeed, the only concept under consideration for actual resolution of part of the EU's debt problems is forcing creditors to take haircuts on Greek debt (of somewhere between 21% and 50%). Haircuts, in this instance, means losses. These losses, and perhaps many more to follow, may be the only way to truly end the EU sovereign debt crisis. The losses would land initially in Europe's big banks, and then flow through the European Central Bank and Europe's governments to taxpayers. Slow growth and recession could follow. Europe is a long way from Lake Wobegon. There simply isn't a happy ending to every story.

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