Should the BRICs ‘Save’ the Eurozone?

The BRICs cannot bailout the risky Eurozone economies. They can offer capital and jobs, but in return of hard assets and advanced technology. It is time for old barriers to crumble in Europe.

Not so long ago, Italy’s finance minister Giulio Tremonti used to write profusely about the threat of China’s “reverse colonization” of Europe.

Today, markets are demanding rising yields to purchase Italy’s sovereign debt, which is expected to soar to 120 percent of GDP this year, a ratio second only to Greece in the Eurozone. As a result, Tremonti has been courting China to attract investment capital.

In a curious reversal, many if not most European leaders are now seeking closer “strategic relations” with China, along with other large emerging economies, such as India, Brazil, and even Russia.

But can the BRICs “save” the Eurozone?

Why BRICs should be cautious

Currently, many euro economies are seeking for quick fixes, hoping to benefit from China’s large foreign exchange reserves of over $3.2 trillion. Naturally, they would like to see China engaging in substantial purchases in the European bond market. Conversely, China might want to diversify its dollar-denominated assets.

According to estimates, 20-25% of China’s foreign currency reserves or EUR 480-600 billion are held in euro assets, presumably in highly rated sovereign instruments like German Bunds. In addition, investors from China and Hong Kong bought 6% of the EUR 5 billion initial issuance of the EFSF benchmark bond in January 2011.

Earlier in the year, China already signed multibillion dollar agreements with debt-ridden Spain to invest in projects ranging from energy to banking and oil. China has also agreed to enter into numerous business contracts with Greece, the most severely affected European country.

Certainly, Brussels would like to see the BRICs, especially China, as the white knight. However, the task is not quite as attractive to the BRICs, especially as the bond market channel presents rising risks.

According to a recent IMF report, half of the €6.5 trillion stock of government debt issued by euro area governments is showing signs of heightened credit risk. The Eurozone paper is an option, but a risky one.

In order to further facilitate trade and investment, European countries have been asked to recognize China as a market-oriented economy ahead of the World Trade Organization’s scheduled date for doing so in 2016.

In effect, any major BRICs investments in the Eurozone should go hand in hand with appropriate concessions in the international organizations (World Bank, IMF, WTO), in which the voice and representation of the BRICs in general and China in particular remains inadequate.

Time to move from financial paper to hard assets

Setting aside the brutal historical legacy of European colonialism, contemporary Europe has played a vital role for and in the BRICs, vis-à-vis trade and investment, science and technology, finance as well as aid and assistance. In the long-term, the European markets and industries will play an increasingly vital role for the BRICs.

From the BRICs standpoint, a thriving euro is also beneficial to counter-balance the increasingly hollow U.S. dollar. The euro is part of China’s envisaged co-existence of the US dollar, euro, and Chinese yuan as three leading global currencies. In the nascent multipolar world, monetary risks should be diversified with a multipolar basket of leading currencies – not with a singular basket currency, whatever it might be.

But how should China approach the Eurozone crisis? The region is China’s most important trading partner and takes up 20% of China’s total exports, which is slightly higher than the US share in Chinese exports.

China has a vital interest in a stable Eurozone, as exports (and export-related investment) account for a substantial share of GDP growth and employment. In the future, however, the most important opportunities are in foreign direct investment, through mergers and acquisitions (M&As) or joint ventures (JVs) – hard assets rather than financial paper.

With its advanced economies, Europe can provide the BRICs advanced knowledge, high-tech and innovation capabilities. Additionally, there are strategic assets that are of interest to the BRICs, including stakes in the energy corporations in Italy, or the ports in Piraeus. In return, the BRICs can provide Europe what it needs the most: investment capital and jobs.

In this regard, much remains still to be done because the level of the BRICs investment into Europe remains low. China alone has a stock of only EUR 7 billion in foreign direct investments in the Eurozone (3% of its total outward FDI stock as of 2010).

In the past, many Europeans viewed Chinese industrial investments with suspicion, even hostility. Today, Europeans despair for Chinese capital, while Chinese producers seek for access to markets. It is time for old barriers to crumble.

Supporting Eurozone that stands on its own

The BRICs cannot bailout the Eurozone economies. In the latter, the challenges are too great, too pervasive, and too systemic.

In fact, the Eurozone is struggling with half a dozen overwhelming challenges: misguided fiscal policies, inadequate monetary easing, insolvency crisis (Greece is only the beginning), a grossly inadequate liquidity facility, recapitalization of major banks, the central bank’s toxic assets, as well as challenges in competitiveness and innovation.

Moreover, if a bailout is to be expected, structural reforms, which are desperately needed in the region, are unlikely to materialize – from Greece to Italy.

In 2012 alone, the eurozone needs around 17.5% of estimated GDP for refinancing; that is, EUR 1.7 trillion. In Western media, China is portrayed as awash with cash, primarily due to its large foreign exchange reserves. In reality, these reserves are for the most part invested in long-term sovereign debt instruments, with around 60-65% in U.S. dollar instruments, 20-25% in euro assets and the remainder split between other currencies. Only a small fraction is held in highly liquid short-term paper.

In theory, longer-dated instruments could be liquidated, but it would not make much sense from the Chinese standpoint and would severely destabilize the markets. In practice, China could accelerate the diversification of its foreign exchange reserves by investing more in euro assets; that, however, would be entirely inadequate from the standpoint of the Eurozone crisis economies.

Most importantly, Chinese public opinion would not support such risk-taking at a historical moment when China must cope with domestic development needs of its own.  Instead, Chinese investors are expected to seek long-term, high financial returns, within reasonable risk tolerance.

Chinese people are Beijing’s first priority. The GDP per capita of the Chinese is still relatively low relative to European living standards. As long as China remains open and grows at 8-9% per year, it can drive and support global growth significantly.

The euro zone debt crisis cannot be resolved with piecemeal solutions. Neither the BRICs nor China can save Europe; but they can support sensible efforts to sustain the major European economies.

Just like China and the BRICs, Europe must stand on its own; or it will fall.