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The basic
market problem is there is too much sovereign borrowing for the money
available, which would normally drive interest rates sharply higher. Some countries
have got round this by printing money while pretending they are issuing
bonds. A few countries are unable to do this, because they lack their own
printable currencies. And that is the root of the problem faced by the weaker
eurozone members.
This
problem for some of them has become so acute that they cannot now fund their
deficits. What is less obvious is that these highly-indebted states also have
to roll over existing debt as it matures. Traditionally this debt has been
absorbed on a replacement-basis in the markets, but that only works as long
as the markets are fundamentally confident, which they are no longer: the
inability of the political classes to resolve their difficulties has seen to
that. Therefore, as bonds mature, investors and banks are unlikely to
re-invest, preferring cash. Even if the weaker states are able to fund
redemptions, from an expanded European Financial Stability Facility (EFSF)
for example, this will be used to reduce euro-denominated bank credit and
improve capital ratios.
This need not be a bad outcome, because the economic effect is to simply
transfer the funding of sovereign debt to the EFSF. The question is who is
going to fund the EFSF, which with its gearing is a risky proposition? There
are only two possibilities: the ECB (which should not be assumed at this
stage) and those with trade surpluses to recycle, particularly China. And
since she is the only major source of this potential funding in the running,
she is in a position of enormous negotiating power.
Looking at
the proposition from China’s viewpoint is instructive. She is being
asked to bail out profligate nations, who have run out of credit and whose
citizens enjoy a far higher standard of living than their own. It amounts to
a position of power ahead of her economic development. Furthermore,
China’s economists were brought up with the Marxist dictum, that
capitalism ultimately destroys itself, so they are being invited to merely
delay something that is inevitable. Will they fund the EFSF? Beyond perhaps a
token amount, it seems unlikely. But will they stand back and let Europe
sink? That would be a missed opportunity to wield her enormous power, and we
need to give this thought some historical context.
The one
thing the Chinese have learned is that they cannot guarantee their own
security through military means alone, they also require economic strength.
This was the reason old-style communism failed. It has taken them only thirty
years to acquire that strength. To consolidate it, they now seek to eliminate
their dependency on the US dollar. Therefore, the price Euroland
will have to pay for funding is that either the Chinese are given some
control over the euro, perhaps by having permanent representation at the ECB,
and/or there must be a material advancement for the yuan
in trade settlements. And it is unlikely loans will go through the EFSF,
because China will want to set her own terms.
This
describes the strength of her position. It remains to be seen how China uses
this longed-for escape route from dollar domination, and how she plays a
winning hand. Initially, she may wisely play for time, letting the Euroland situation deteriorate further, to get the terms
she requires.
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