China could hold key to global financial woes

November 25, 2011 9:50 am


By Chris Tedder, Research Analyst

Forex.com

It is obvious that action needs to be taken to prevent a collapse of the European banking sector and one idea making the rounds is the notion that China could pump money into the region and/or the EFSF to support debt laden nations like Italy and Greece. Yet, is it in China’s best interest to intervene in Europe using their massive FX reserves or let the situation play out and try and boost growth domestically? It is a complicated question because of the strong links between China and economies in Europe, China’s top trading partner is the EU and a deep recession in the region could significantly hamper growth domestically. On the other hand, is it actually possible for China to save Europe and benefit in the process?

Recently Chinese vice-premier Wang Qishan announced that he believes that the global economy will slip into a long-term recession and if China is to cope then it will have enact deep financial reforms. It sounds a bit like Beijing might be considering leaving Europe to its own devices and preparing for the aftermath of a possible banking sector collapse in the Eurozone. This could be the only way that China avoids a hard landing, given that current PMI data suggests that a hard landing might have already started.

China may focus on domestic growth

If authorities in Beijing decide to focus on supporting domestic growth they will likely have to soften their relatively tight monetary policy stance, if they haven’t started already. Last month China’s commercial banks extended Rmb587bn in loans, up from Rmb470 in the previous month; however, it is inherently hard to know what China is doing because almost all of its major banks are majority owned by the state and thus China can use non-conventional means to conduct forms of easing. For instance, China doesn’t have to alter interest rates to affect monetary policy, it simply holds a meeting with the larger domestic banks to tell them how much to borrow and lend.

China can also shelter itself by pumping more stimulus into the economy, in an attempt to boost domestic demand. If Beijing decides to do this it could focus on creating a stronger social safety net and boosting household income in order to spur consumer spending and turn growth away from the export sector, as opposed to the infrastructure spending we witnessed during the financial crisis which proved to be an issue for China post implementation.

China could invest in Europe through the EFSF

On the other hand, China might decide to invest in Europe through the EFSF and help the rescue fund to reach the required 2 trillion or so it needs to have adequate liquidity to support Italy and Greece. The biggest hindrance to this option is uncertainty that surrounds the crisis, which casts doubt over the ability of even a fully funded EFSF to control the large amounts of troubled sovereign debt.

This leads us to the obvious point that China is not going to invest in the Eurozone if it is going to accomplish nothing in the long-term. So, it could be in China’s best interest to withdraw into a corner and undertake measures to support domestic growth, rather than risk getting involved in an unwinnable situation.

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