Analysis - Chinese demand could hasten euro zone bonds

PARIS Mon Sep 19, 2011 9:05am EDT

European flags are seen outside the European Commission headquarters in Brussels June 30, 2010. REUTERS/Thierry Roge

European flags are seen outside the European Commission headquarters in Brussels June 30, 2010.

Credit: Reuters/Thierry Roge

PARIS (Reuters) - While European politicians battle over whether to issue common euro zone bonds to help resolve the currency area's sovereign debt crisis, China could influence the outcome.

Europe is Beijing's biggest export market and Chinese leaders have a declared interest in avoiding a financial meltdown in the European Union that could trigger a world recession.

They want to diversify their $3.2 trillion (2.03 trillion pounds) in foreign exchange reserves away from U.S. Treasury bonds and started long before Standard & Poor's downgraded U.S. debt last month due to Washington's political gridlock over reducing its deficit.

"European countries are facing sovereign debt problems. We've said countless times that China is willing to give a helping hand, and we'll continue to invest there," Premier Wen Jiabao told a World Economic Forum conference last week.

But he cautioned that the major developed economies should put their fiscal houses in order, and urged Europe to take a reciprocal step by recognising China as a market economy -- giving Beijing better protection against EU anti-dumping action.

The Europeans have so far baulked at that concession, given China's managed exchange rate, state-steered industry and trade irritants such as disregard for intellectual property rights.

Yet China will automatically receive the status in 2016 under its World Trade Organisation, so awarding it ahead of time could win Europe political goodwill at little economic cost.

"The Europeans haven't been sensitive enough regarding China's needs and giving them 'face' by granting them market economy status," said Etienne Reuter, a business consultant and former EU envoy to Hong Kong and Japan.

China also wants the EU to lift an arms embargo imposed in 1989 after the crushing of the Tiananmen Square pro-democracy movement. That is more difficult because it requires unanimity.

EU officials managing the debt crisis say privately that China is one of the few big foreign investors continuing to buy bonds of some euro zone countries in the secondary market, although its purchasing practices are shrouded in secrecy.

A senior EU official described as "in the ballpark" a report in the French newspaper La Tribune in January, based on a rare leak about Chinese currency holdings, suggesting that Beijing held just over seven percent of euro zone government bonds.

China is also believed to have gobbled up a big chunk of the AAA-rated bonds issued by the euro zone rescue fund to support Greece, Ireland and Portugal under EU/International Monetary Fund assistance programmes.

Beijing's problem is that there just isn't enough top-notch European paper to meet its demand.

Yields on German bunds and British gilts have fallen below the rate of inflation due to investors' flight to safety.

"It is in China's interest to have a stable euro zone with the creation of euro bonds, but can China have an impact on the decision of European countries? I doubt it," said Bei Xu, a Chinese economist with French investment bank Natixis in Paris.

"In the Chinese mentality, a crisis is always an opportunity. The Chinese word for crisis is made of two characters: one is danger, the other is opportunity," she said.

In the short term, she said it would make sense for China to buy Italian government bonds, which are among the largest-volume, most liquid assets in Europe offering an attractive yield "if we exclude an extreme crisis scenario."

Beijing is not alone in thirsting for a deep, liquid pool of jointly guaranteed European debt instruments.

"There is other demand for such assets -- Middle East sovereign wealth funds, the Japanese and big players inside the euro zone such as the big insurers which need to place their money in safe, guaranteed debt," Xu said.

Russian Finance Minister Alexei Kudrin told Reuters that Moscow would be happy to invest if the euro zone extended its financial stabilisation mechanism and created euro bonds, but he said there were no talks on specific purchases.

There is clearly a debate within the Chinese establishment about the advantages and drawbacks of riding to Europe's rescue.

At the same conference where premier Wen spoke, a central bank advisor, Li Daokui, said China should refrain from buying large amounts of European bonds.

The overseas edition of the People's Daily, the official newspaper of the ruling Communist Party, said China should not act single-handedly but work with other creditors including the IMF, and demand that the euro area guarantee its investments.

"Confronted with the latent systemic risks in European debt, China must both play the role of a responsible major power, but must also make security a precondition for investing," said the editorial written by Li Xiangyang, a foreign policy researcher at the Chinese Academy of Social Sciences.

Reuter, co-editor of "EU-China, A Common Future," said that while Wen wanted to open China up more and support Europe, conservative voices in the leadership argued that Beijing should be prudent and not get too involved with foreigners.

Chinese public opinion, to the extent that it is reflected by Internet bloggers, is mainly buzzing with warnings to be careful about investing in Europe, Xu said.

David Bowers, managing director of financial consultancy Absolute Strategy Research, said that although the euro bonds solution made sense, neither China nor Europe was yet quite ready to take the plunge.

The Chinese were unlikely to take big strategic initiatives before next year's leadership change and Europe had not yet mustered the political will for greater fiscal integration, now being fiercely debated in Germany.

"The people that China has to deal with are the Germans. They are a AAA nation like China, mercantilist like China, and the Chinese could help them avoid crystallising major liabilities for German taxpayers," he said.

China is on course to overtake France within two years as Germany's biggest trade partner, Bowers noted.

"They are going to have to wait for Germany to be clearer about what it wants in Europe," he added.

(Writing by Paul Taylor; Editing by Ruth Pitchford)