It refuses to die. Buckets of ink are still being spilt on the will-China-save-Europe-narrative, looking at the political quid pro quos on offer, the incentive structure behind the EFSF and the relative size of China’s monetary fire-power.
But the elephant in the room is surely the following question: how could China save Europe if its currency is not convertible? In short, structural deficiencies in China’s currency regime could torpedo any bid to be a large and efficient provider of global liquidity.
This challenge is hugely relevant since the ECB has ruled out being a provider of unfettered liquidity to sovereigns and, for now, the only way the IMF could play this role is through SDRs – a move that would require US approval during an election season.
In this context, it’s no surprise that so many market participants reckon all roads lead to China, by default.
So let’s add another portion of scepticism onto the China-EFSF-IMF-shaped plate and ponder the mechanics behind China boosting the eurozone’s fire-power.
On the plus side, if the EFSF debt is transacted in RMB – an option China has indicated it would prefer in any large-scale issuance – this would establish an interesting precedent of the country aggressively marketing the currency as a store of value, a move that to-date it has been more cautious on. Opening up offshore RMB centres, notwithstanding.
The emphasis in recent years has been on making the RMB a medium of exchange through currency agreements with emerging trade partners. So fair enough, China might have an incentive to make financial intermediaries gain trust in its currency and this EFSF vehicle might be one way to do it. So that fact could give China, at the margin, some extra motivation to dish out cash (even if Europe would be reluctant to take on debts in an appreciating currency that offers no real hedging opportunities).
But the problem is China can only really be a large provider of global liquidity through its hard currency holdings since its currency is not convertible. So any large-scale lending in RMB either to the IMF – its avowed preference – or the EFSF itself would require a currency swap if the supplicant requires dollars/euros. And that’s a given since the PIIG’s liabilities are predominantly in euros.
But the question is what FX arrangements would work?
- In short, China would be the only large enough – and authorised – player to provide the necessary currency swaps to the borrower whose liabilities are in euros. But for China to provide large amounts of hard currency resources, it might have to sell its USTs or European government bonds – a counter-productive move in the latter’s case especially.
- Alternatively, as the chief official sector advisor at a global investment bank told us, China could go to the Fed/ECB and deposit government securities at the respective central banks in return for cash. Let’s call it a sort of long-dated repo and reverse sterilisation trade since it would be using its existing developed country bonds as collateral in return for hard currency credit.
- This move would have the benefit of not necessarily disrupting the secondary market and distorting yields. But are there any precedents for this?
- Another way to do it would be for China to go to the spot FX market and buy dollars, a move that could depreciate the RMB. Imagine that! It would surely be noticeable in the open market. Still, China could communicate this policy to the market to reduce the negative psychological impact caused by the fact that at the other side of the trade was the Chinese central bank as a net FX seller. Expectation management would be the name of the game here.
- Or perhaps commercial operatives could play a role in providing hard currency, like, say export-import banks.
All we are saying here is that because China does not have a convertible currency, the net impact of providing large amounts of hard currency could be quite noticeable on the dollar/euro/RMB as well as hard currency government bond yields. Unless there are better ways of swapping RMB for euros? And it’s not clear China would be willing to raid dollar/euro cash reserves parked in any government-backed capital provider or that this FX warchest would be big enough. So open market operations is probably the name of the game here.
If only Greece and Italy had the foresight to issue RMB debt back in the day and have its liabilities matching the assets of one of the world’s richest creditors.
So if China is ruled out, that probably just leaves one institution with a three-lettered acronym that rhymes with Me See Bee…
In other words, wanted: global liquidity lender of last resort for sovereign balance sheets. Must have: convertible currency.
Related links:
Coverage of the EFSF – FT Alphaville
China to Europe: that’s a sure nice EFSF you have there – FT Alphaville