Why China isn’t buying Eurozone bailout bonds (yet)

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

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 actually stated that China will not use its $3.2 trillion in foreign exchange reserves to rescue other countries. Why is this so?

As hinted at by Christine Lagarde, the head of the IMF, in recent days, China has actually not closed the door either. Rather, the issue of China’s involvement in the Eurozone’s bailout is at the center of complex global negotiations that will have an important impact on IMF 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 EFSF operational and safe for outside investors. The EFSF is in effect a temporary risk-sharing mechanism guaranteed by 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 the China’s proposal. The reason could be that this issue relates to IMF’s corporate governance, coordination among leading countries, and quotas reform. The rigidities within IMF governance and the preferences of key countries are constraining this process.

In conclusion, it is likely too early to talk about China's investment in 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.

(Author: Prof. Xu Hongcai is the Deputy Director-General of the Information Department at China Center for International Economic Exchanges)