How big a gamble will China take on Europe? (Reuters)

By Scott Boyd
The views expressed are his own.

Wen Jiabao at WEF Annual Meeting in Davos 2009

As news broke this month suggesting it was more likely than ever that Greece was headed for default, China extended an offer of assistance that beleaguered European governments may find difficult to refuse. Premier Wen Jiabao announced that China was willing to increase its holdings of European sovereign debt at a time when several Eurozone countries are struggling to raise capital.

In return, China seeks little–simply an assurance that profligate governments promise to get their financial affairs in order, and perhaps some other small favor that, in the words of Premier Wen Jiabao, “would reflect our friendship.” The Premier even suggested that a good way to demonstrate this new-found goodwill would be to support China’s bid to be reclassified as a “market economy” by the World Trade Organization.

Currently, anti-dumping tariffs are applied against products shipped from China that are deemed to be sold at below the true market cost. This is an attempt to counter the subsidies and other incentives the Chinese government provides to many manufacturers to ensure their competitiveness; a change in designation would remove most of these tariffs.

While lower costs may be good news for consumers, for European manufacturers, it could prove disastrous. Disadvantaging European manufacturers already facing weak domestic demand could lead to wider job losses and a further slowing of the economy. Eurozone officials would be well advised to consider carefully the potential impact on domestic manufacturers before agreeing to easing China’s access to the European markets.

Either way, change will come within a few years, as China is slated to be re-designated as a market economy in 2016. Nevertheless, there is a very good reason why Beijing is trying to move the date forward – each year China comes under increased competition from other emerging economies.

China’s ability to undercut other production centers has proven remarkably profitable, but outside events are forcing China to update its approach. By deliberately undervaluing its currency, China has created a massive trade surplus with its export markets which has resulted in the loss of manufacturing jobs in both the U.S. and Europe. These job losses have contributed to slower economic growth in Western economies, leading inevitably to an overall decline in consumer spending and, by extension, lower demand for China’s exports.

At the same time as wealth has increased in China, so too has inflation and workers are demanding better wages to maintain current living standards. Workers now have more opportunities then they did in the past and employers are being forced to increase wages to attract and retain workers. Combine this with competition from smaller nations like Viet Nam where wages are lower, and it is understandable why China is concerned that its low-cost monopoly could be at risk.

In mid-September, an official with China’s central bank said the bank intended to “liquidate more” of its U.S. assets currently estimated at about $2.2 trillion in total. The timing of this announcement, coinciding with China’s offer to buy more European debt, is noteworthy; selling its U.S. holdings is the only way China could finance a large purchase of euros.

However, this would not be without risk to China’s finances. Should China dump all, or even a large portion, of its U.S. securities on the markets, the value of the dollar would surely decline. For U.S. manufacturers, a weaker U.S. dollar would likely be beneficial as this would make American-made products more competitive both at home and abroad. It could be just what is needed to kick-start the economy. China, on the other hand, would suffer deep losses as the dollar declines.

There is also the risk that despite China’s support, there could still be a Eurozone default. How far the euro may plunge following a default is anybody’s guess but the losses would be substantial. Ironically, the resulting uncertainty would lead to a heightened demand for the dollar as investors move to the safety of U.S.-denominated securities.

Compared to the economies of Spain or even more likely Italy, Greece is so small, it barely registers. Yet over 200 billion euros have been committed to Greece in emergency funding so far with little to show in the way of progress. Using the experience with Greece as a guide, and understanding that Italy’s economy alone is more than six times that of Greece, the funding required to prevent an Italian default could easily reach into the trillions. The question for China is whether the potential increase in export sales is worth the risk.

http://blogs.reuters.com/china/2011/09/28/how-big-a-gamble-will-china-take-on-europe/