China to the Rescue?

The idea of Asia extending a helping hand to Europe has been around ever since the G20 summit in Cannes, France in early November, when world leaders failed to organize exceptional contributions to the International Monetary Fund (IMF) that could help support the eurozone. The hope was revived, however, by European leaders at their latest debt crisis summit in December. 

Of course, there is something shocking in the idea that Asia should help rescue the eurozone. Europe is remarkably rich by world standards — and not only in income terms. According to data compiled by the consulting firm McKinsey, Europe accounts for 30 percent of the global financial market, compared with 12 percent for Japan and less than 8 percent for China. It thus seems strange to wonder whether Europe can rescue itself without a helping hand from distant and, in the case of China, considerably less wealthy countries. Furthermore, the politics of helping Europe is dicey in Asia, as countries such as South Korea and Indonesia remember all too well that Europe’s advice at the time of the Asian financial crisis in the late 1990s was (except for limited direct assistance to South Korea) "go ask the IMF."

Yet Asia may nonetheless need to come to the rescue, either directly or, most probably, by equipping the IMF with the means to step up its operations in Europe. Why? For starters, Europe is bound by an extraordinary series of self-imposed constraints. First, the European Union and the eurozone do not have taxing power and therefore cannot borrow against the promise of future tax receipts. Second, eurozone member states have not really pooled their resources. Instead, Europe’s financial assistance arm, the European Financial Stability Facility (EFSF), relies on guarantees provided by individual member states up to a pre-set limit (limitations also apply to the EFSF’s successor, the European Stability Mechanism (ESM), though the set-up is different). Third, the European Central Bank (ECB), which, as a central bank, can create money at will, is uncomfortable doing so in the form of purchasing bonds issued by national governments. As long as these constraints prevail, fiscal resources will be scarce and monetary resources will barely be available.

European leaders unequivocally expressed a desire for outside contributions on Dec. 9, 2011, and European finance ministers voiced support for one or more co-investment funds to attract capital and enhance the EFSF’s capacity a few days earlier. The need for financial contributions from emerging countries only became more apparent on Dec. 19, when Britain refused to help increase IMF resources in the absence of a broader international effort. While the Europeans have refrained from naming the countries that they would like to see provide support, China and other Asian countries are in everybody’s mind. And while European leaders have also refrained from mentioning numbers, a widely held expectation is that, at minimum, the €200 billion Europe itself is willing to offer the IMF would be matched by the emerging world.  

The need for Asian assistance may now be more evident to European leaders, but why should Asian leaders lend their support? After all, Europe’s self-imposed constraints are no argument for providing help. What matters instead is Asia’s own interest. And there are two reasons why Asia has a major stake in diffusing the debt crisis: to protect itself from Europe, and to protect itself from the United States.

In the short term, the fallout in Asia from a further aggravation of the European debt crisis would be serious. This is not only because a European recession immediately affects Asia through reduced demand for its goods — as experienced in 2009 when global trade contracted sharply, triggering a severe growth slowdown in East Asia — but also because of financial linkages. European banks are major players in Singapore and Hong Kong — as well as major providers of trade finance in the region. But as these financial institutions confront tighter capital and leverage requirements, they’re curtailing credit and deleveraging aggressively, with serious consequences for Asia. Taking into account these linkages, the IMF has produced illustrative but frightening enough numbers: In a stress scenario that sees growth in the euro area decline by 1.3 percentage points, Asian growth declines by 0.4 percentage points. Asia, in other words, needs Europe to overcome this crisis.

In the medium term, financial turmoil in Europe would also deprive China and other Asian countries of a key hedge against a depreciation of the U.S. dollar. For the time being, the euro remains the only possible alternative to the U.S. dollar if Asian countries want to at least partially diversify their investments. Before the outbreak of the crisis, the euro was a successful regional currency, reaching out beyond its borders and seemingly en route to becoming a second global currency. For those in Asia who believe that the world’s natural evolution is towards a multipolar global economy, the euro also provides a natural building block for a multipolar currency system. Should it disappear, the transition to a multi-currency system would be lengthier and bumpier.

There are therefore both short-term and longer-term motives for Asian support of the euro area. One way to accomplish this goal would be for Asian investors to buy eurozone bonds, which may be a better investment than one might think. In spite of the series of constraints Europe has created for itself, the eurozone’s aggregate budgetary situation is certainly not worse than that of the advanced economies taken as a group. The eurozone, however, does not currently offer Eurobonds benefitting from the "joint and several" guarantees of all its members, and the investment vehicle European leaders are developing does not have the certainty and the durability that Eurobonds would presumably have. Investment options are therefore still largely limited to national bonds, and Asia does not trust Europe enough to invest much directly in these types of securities.

The alternative for Asia is to lend to the IMF so that the fund can embark on large-scale European operations. The IMF is certainly still looked at with much suspicion in Asia — where its failings in Indonesia and South Korea are vividly remembered — but at the moment it may be the only institution that can guarantee the minimum level of risk management needed to reassure Asian contributors about the safety of their investment. The IMF is becoming more and more independent from EU institutions in dealing with the eurozone crisis, and it is equipped with a governance system in which Asia has a voice. It is also clear that regardless of the form of aid, Asian countries cannot be asked to step in without something in exchange. Were they to rescue the core of Europe through the IMF, Asian countries would have reason to demand enhanced representation and voting rights in the Fund, potentially producing a governance reshuffle in which the eurozone receives a single seat on the IMF’s board of governors instead of five as is currently the case (a move that has long been contemplated and long resisted by developed economies). The weight of Asia in the Fund could grow fast, with Asians soon lecturing Europeans on the need to turn to the Fund. Ironically, it may take a European crisis to reconcile Asia with the IMF.

It is not yet clear what exactly will happen next in the debt crisis and when. But the very fact that these issues are being discussed is indicative of the magnitude of the crisis and the geopolitical changes it has wrought. In retrospect, this is a crisis Europe could have avoided by acting earlier and more forcefully. It has now tied its hand to such a degree that it will struggle to succeed without external support.