Why China isn’t Buying Eurozone Bailout Bonds (Yet)

Memo #128 (Chinese translation available here)

Xu Hongcai – xuhongcai [at] sohu.com

China has still not committed to invest in the European Financial Stability Facility (EFSF), the stopgap fund created to tackle the European sovereign debt crisis. Officials have said that China will not use its $3.2 trillion (USD) in foreign exchange reserves to rescue other countries. Why is this so?

Christine Lagarde, the head of the International Monetary Fund (IMF), recently hinted that China has not closed the door either. Rather, the issue of China’s involvement in the Eurozone’s bailout is at the centre of complex global negotiations that will have an important impact on the IMF’s governance and global politics. And while China is willing to be a “responsible stakeholder” in the global economy, European countries and the IMF must offer a credible investment mechanism to China (and other would-be investors).

For China, a solution to the crisis requires three key ingredients. First, the European Central Bank (ECB) must play the leading role as the lender of last resort. Yet, due to concerns about moral hazard and inflation, Germany has opposed such a role and slowed the process.

Second, European leaders must make the EFSF operational and safe for outside investors. The EFSF is in effect a temporary risk-sharing mechanism guaranteed by European Union (EU) members. It is similar to jointly issued bonds and isolates risks more effectively by limiting liability. But the EFSF faces three major challenges: a downgrade by Standard & Poor’s from AAA to AA+ following the French sovereign downgrade; German resistance to an increase in its amount; and a lack of operational details.

Third, European countries and the IMF must design a credible mechanism to channel contributions by countries such as China. Facing the uncertainty presented by the EFSF, China’s leaders have indicated their preference to help Europe through the IMF. Yet, so far, nobody has given a formal reply to China’s proposal. The reason could be that this issue relates to the IMF’s corporate governance, coordination among leading countries, and quotas reform. The rigidities within the IMF’s governance and the preference of key countries are constraining this process.

In conclusion, it is likely too early to talk about China’s investment in the EFSF. Firstly, the troubled countries could adjust their industrial structure and make more efforts to achieve fiscal balance. Nevertheless, in the short run, the ECB would have to play a more active role.

Xu Hongcai -is a Visiting Scholar at the Institute and Professor in Finance and Deputy Director of the Information Department of China Center for International Economic Exchanges (加拿大不列颠哥伦比亚大学亚洲研究院访问学者,金融学教授,中国国际经济交流中心信息部副部长). Chinese translation of this memo is available here.

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