Europe desperate to woo China

In: Uncategorized

27 Feb 2012

This is my latest Perspective column for Fund Strategy.

It may not have been a coincidence that the most recent annual summit between the European Union (EU) and China was on Valentine’s Day. Eurozone leaders are trying desperately to woo their Chinese counterparts in the hope of securing some bail-out money.

Indeed many European commentators seem to think it is only a matter of time before China succumbs to the EU’s charms. Europeans apparently believe that their region is so important that China will sooner-or-later have to agree to handing over some of its substantial reserves. A more likely outcome is that the relationship status of the two regions will end up as “It’s Complicated”.

In broad terms there are three sets of reasons why China might want to bail out troubled eurozone countries: moral, economic and political. None of them is as straightforward as the euro-pundits assume.

The moral case is essentially that many Europeans are suffering as a result of the crisis and China has loads of money. The latter part of the story appears true, China had an estimated $3.3 trillion (£2.1 trillion) in reserves at the end of December, but the overall picture is more complex.

China may be wealthy in absolute terms but this needs to be set against it population of 1.3 billion. For every millionaire in Shanghai or Guangdong there is a huge number of poor Chinese.

Living standards in much of Europe, notably Greece, are falling but they are still way above average Chinese levels. The average GDP per head in China in 2010 was only $7,544 compared with $28,495 for Greece and $36,081 for Germany. These figures are at purchasing power parity so they take into account the lower cost of living in China.

A salutary indication of China’s lack of development is that only last year the country crossed the threshold of becoming more urban than rural. It still has many hundreds of millions of mainly poor citizens living in the countryside.

In effect the relatively poor Chinese are being asked to bail out the comparatively rich Europeans. This replicates the more general pattern between the developing world and Europe at present. Emerging countries are being asked to put more funds into the International Monetary Fund (IMF) to help it bail out the eurozone.

Asians have not forgotten that when their region suffered an economic crisis in 1997-98 the Europeans did not take such a benign attitude. Back then Asians were often told that, for their own good, they had to accept austerity rather than receive more funds to soften the blow.

If the moral case for a Chinese bail-out is weak, the economic argument is often seen as unassailably strong. The IMF’s most recent China Economic Outlook, published in February, was widely quoted as saying that China could be badly hit by a European downturn:

“The channels of contagion would be felt mainly through trade, with knock-on effects to domestic demand. In the downside scenario outlined in the WEO [World Economic Outlook] Update – which would see global growth falling by 13/4 percentage points relative to the baseline – China’s growth would fall by around 4 percentage points. The risks to China from Europe are, therefore, both large and tangible.”

However, European commentators often forgot the important caveat included in the IMF report. China’s reserves mean it has substantial resources to use a fiscal stimulus to offset any fiscal shock coming from a European downturn.

There are also other reasons to suggest the impact of a European downturn would be less than many expect. Although China has a large amount of trade with Europe as a whole it is diversified across many countries. Its largest European trading partner, Germany, accounts for about 4.3% of its exports compared with South Korea at 4.4%, Hong Kong at 13.8% and America at 18%. A downturn concentrated on a few European countries would therefore probably only have a limited impact on China.

A more fundamental weakness in the European argument is that it focuses on total trade levels instead of the value-added element. To understand why this is important take the Apple iPhone as an example. Although the iPhone is assembled in China most of the components come from overseas. Yuqing Xing, a professor of economics at the National Graduate Institute for Policy Studies in Tokyo, estimates that in 2009 only 3.6% of the $2 billion of iPhone exports to America was accounted for by Chinese value added (“How the iPhone widens the US trade deficit with China” Voxeu.org. April 10, 2011).

In other words if Europe bought fewer iPhones from China the Chinese manufacturers would only take a small part of the hit. The effect would be spread across companies in other countries that supplied components including America, Germany, Japan and Korea.

China’s exports would fall but so would its imports as it would need fewer components in the first place. The net impact of a fall in European demand would not be nearly as great as often assumed.

One reason why China may want to divert some resources to Europe is to diversify away from its over-reliance on American assets. The eurozone may have problems but China is conscious of its high exposure to American Treasuries.

Similar considerations explain why China has become an important lender to Latin America. It is not for love of Latin Americans but to develop what China sees as a more balanced approach to its economic relationships.

Finally, there are political reasons why China may want to help Europe. Such an action would help raise China’s status as an important player in international affairs.

Ultimately China is likely to provide some kind of finance to Europe to help tackle the eurozone crisis, although it may well impose strict conditions. But it will be pursuing its own motives rather than those that many European leaders regard as important.