Friday, August 31, 2012

China Will Throw Away Money In Europe, But Why?

China is making some seriously strange moves for a country that used to have an excellent strategy for growth (until recent years).  Their political leadership is making noise about buying more European sovereign debt.  This is clearly a stupid move in the face of Europe's mounting inability to make its deadbeat constituents pay their bills.  I can only suggest the possible reasons.

Reason #1:  Bluff.  China really has no intention of buying a significant amount of these bonds.  This is one round in an ongoing geopolitical contest with the (U.S. (via the Federal Reserve) for strategic influence in Europe.  If this is the strongest card China can play, then they have a truly weak hand.

Reason #2:  Talking their book.  China has diversified some of its trillions in foreign currency reserves away from the U.S. dollar, so making public statements in support of European debt raises the confidence other investors have in that debt's value.  If China has pledged its euro-denominated debt as collateral for any aid to developing countries, this preserves their strategic strength (until the unstoppable euro breakup actually hits, of course).

Reason #3:  Desperation for yield.  This is the least plausible explanation I can think of but I'll throw it out there as a wild card.  China's U.S. Treasuries (more properly, the short duration portion of their holdings) aren't paying a whole lot of interest.  China's search for higher payouts will inevitably lead it to the junk bond universe.  That is IMHO where most European sovereign debt belongs and the ratings agencies are catching up to this realization.

Reason #4:  Quid pro quo.  The article also notes a flurry of trade deals that China recently finalized in Europe.  China's intent to buy productive assets outside its borders is well-known.  Perhaps Europe is dangling the carrot of keeping its real asset markets open in exchange for promises of more Chinese purchases of EU debt.  Europe knows of China's success in making deals in Africa and Asia, and China knows the value of Europe as an export market.

I'll go with reason #4 as the most likely explanation for China's stated intent, with #2 as the next most likely.  Both China and Europe are probably in severe recessions right now.  Two drunks can lean on each other for support until they both fall over sideways.

Full disclosure:  Long FXI with covered calls, but frankly not for much longer.  No holdings of European sovereign debt at this time.