Safety-first approach to aid

Stabilizing the euro important for international monetary system, but BRICS want guarantees on any investment

The eurozone debt crisis is continuing to spread. The Italian sovereign debt market has been shocked by sell-offs in recent weeks as the yield for 10-year government bonds rose to 7 percent; a figure that is unsustainable, because the cost to Italy of refinancing the debt is untenable. If this situation continues, Italy will have to follow Greece, Ireland and Portugal to the doors of the European Union and International Monetary Fund (IMF) to seek help.

But Italy is not like these other countries. It is the third largest economy in the eurozone. It is too big to fail. Yet the cost of rescuing it is too big to pay.

The root causes of the European debt crisis are slow economic growth and overspending by governments. Although, the causes of the big budget deficits and high government debt-to-GDP ratios are quite different across Portugal, Ireland, Italy, Greece and Spain (PIIGS), the reasons for their fall into the deep pit of government debt are similar. Their economic growth prospects are weaker than most other EU members and the markets are not convinced that their debt burdens will be downsized in the near future. So risk aversion, market speculation and manipulation have led to the selling of PIIGS bonds.

But how to develop and implement a rescue plan is proving a problem.

What price is the EU willing to pay to rescue the countries in crisis and how will the cost be divided among member states? EU members have so far not reached a consensus and it is taking them too long to respond to market doubts, greatly undermining the EU's ability to cope with the crisis.

By imposing stricter fiscal discipline on the heavily indebted countries, the Germany-led EU hopes the debt-to-GDP ratio in PIIGS will drop to the safety levels laid out in the Stability and Growth Pact by 2013. However, this will be difficult to achieve by increasing tax revenues as the economic growth prospects are not optimistic enough, this means cutting fiscal spending, which will inevitably meet domestic resistance and cause political turmoil.

Chinese President Hu Jintao has already correctly pointed out the EU has the ability and resources to solve the euro debt problem, but only the Europeans themselves can make the decisions. The key to the solution is in German hands. Some German politicians and scholars still believe in the solution of letting Greece and other troubled southern states withdraw from the eurozone so that those with strong fiscal discipline can ensure a healthier eurozone. However, Italy is too important to the euro and if it collapses there will be major chaos.

Only when the core members reach a consensus and mobilize enough financial resources can the crisis be effectively cured. One of the solutions would be to let the European Central Bank (ECB) act as the lender of last resort. It may cause some other problems, such as reducing the incentive for PIIGS to cut fiscal deficit and stimulating higher inflation as a result of ECB creating more money. But the eurozone will have to make a trade-off between survival and higher inflation.

Of course, the choice is difficult and it must be made collectively, otherwise the problems will last and the break-up of the eurozone will become a reality.

Some EU officials and media have expressed the hope that the members of BRICS (Brazil, Russia, India, China, South Africa), especially China, will buy eurozone country bonds to help it out of the crisis. IMF Director General Christine Lagarde also appealed to BRICS for help. But while both Russia and China have expressed their willingness to provide liquidity through IMF channels, they want certain conditions met before committing to help. Therefore, the EU's core countries need to guarantee any BRICS investment. A so-called orderly default is not a good way to assure others as there is possibility of future euro debt devaluation if the EU sees fit. If Germany and the ECB provided an ultimate guarantee that any BRICS investment would not be defaulted, BRICS would be willing to provide more help.

Clearly it is important to stabilize the eurozone in order to maintain stability in the international monetary system. As the second largest international currency, the euro plays a balancing role in the system. It also represents a multipolar trend in international currency reserves. If the euro collapsed, the US dollar, which has proved to be problematic and unstable, would regain its dominant position. So for the purpose of international monetary system reform, BRICS needs to help the eurozone countries in difficulty.

For China, the EU is its biggest trading partner and if the euro collapses, the negative effect on the European economy would make it very difficult for China to sustain and grow trade and economic relations. So if we can help the eurozone out of its debt crisis, it will also be good for China's trade.

China has huge foreign exchange reserves and needs to diversify its reserve investment. It cannot put all its reserves into US treasury bonds. If euro assets meet the investment principles of safety, profitability and liquidity, China should allocate some of its reserves to them. Government bonds, or European Financial Stability Facility bonds, could be other investment options and guarantees by Germany or the ECB would be ideal if we want to buy the troubled countries' debts. I think China may also invite the EU to issue renminbi bonds in Shanghai and allow them to be converted to any other currencies on maturity. This would not only help eurozone countries get finance, it would also promote internationalization of the renminbi.

To sum up, China and the EU are economically interdependent. Helping the eurozone countries overcome their debt crisis would also be in our own interests. We should help by investing in European assets as long as the risk is controlled and the profit is reasonable.

The author is senior research fellow and deputy director of the Institute of World Economy at Shanghai Academy of Social Sciences.

(China Daily 12/20/2011 page9)