Friday, December 24, 2010

Can China peg the euro to the dollar?

China has $3 trillion in external reserves (and growing). China is the world’s exporter and investor of last resort. China’s vast reserves are an artifact of its monetary policy: the dollar peg. To prop up the dollar versus the yuan, China must continually buy dollars.

The other big currency in the world is the euro. The relationship of the yuan to the euro is of course identical to the relationship of the dollar to the euro. When the dollar is weak vs the euro, that’s good for China. When the euro is weak vs the dollar, that’s bad for China.

Lately the euro has been weakened by the sovereign debt crisis. It is not in China’s interest for Europe to have a financial crisis, or for the euro to collapse in value. China has said that it will buy the bonds of the troubled eurozone members.

But here is an intriguing question: Does China have the resources to peg the euro to the dollar, in effect resurrecting Bretton Woods by creating a global dollar zone?

Obviously, the ECB could fight such a policy. However, it would not be easy, and more importantly, it might not be in Europe’s interest to fight such a policy. (And the ECB does not have an exchange rate policy.) The ECB would be free to conduct its monetary policy free of foreign exchange concerns, while the People’s Bank would do the heavy lifting of maintaining the euro-dollar peg. (The Fed could make this difficult, but it does not have any exchange-rate anchors or policies either.)

How would this work? First of all, the People’s Bank would never admit that it was targetting a dollar-yuan-euro peg. It would simply buy or sell euros or dollars as necessary. Yes, George Soros could push hard against the People’s Bank, but he doesn’t have $3 trillion. The Chinese would win, so long as they are prepared to stand with an open bid for euros at their preferred exchange rate.

The forgoing is more of a thought-exercise than a prediction, but I am sure that it has already occurred to the Chinese that they may want to informally add the euro to their “price support” program.

Tuesday, December 21, 2010

Europe must protect government bondholders

Klaus Regling is the head of the European Financial Stability Facility. He recently published an op-ed in the FT titled “EMU’s critics will eat their words again”.

In the column, he does his best to advance the argument that EMU will survive without fiscal union. It is more of an assertion than an argument. He then goes on to state the following (emphasis added):

A monetary union needs a safety net to respond to a crisis. The European Council decided therefore to prepare a permanent crisis resolution mechanism, called European Stability Mechanism (ESM). It will be established in 2013, and will be based on the temporary resolution mechanism, the European Financial Stability Facility (EFSF). The key difference between the two will be the involvement in the future permanent mechanism of private creditors in a crisis resolution on a case-by-case basis. It will follow established IMF policies, which means that debt reduction would be required in cases of insolvency. This will be rare. No industrialised, advanced economy has defaulted since the second world war. The ESM would, as does the EFSF, provide loans – under strict conditionality – to euro area countries that lose access to markets.

This is the problem, which he does not even acknowledge: unless the ESM exists to backstop private creditors, it serves no purpose. It is like a guarantee that is good unless called upon.

The EU will learn next year that the ESM and austerity will not have restored investor confidence and that the markets remain closed to Greece, Ireland and Portugal. At that point it will have to choose between lending with strict conditionality or to involve private creditors in the resolution. My prediction (my hope) is that they will blink, and bail out the bondholders.

One recent ray of hope: China says that it will buy the bonds of the peripherals when they re-enter the market. China exports to Europe, and doesn’t want a European debt crisis. So just as they lend to the US to finance Chinese imports, they would do the same for Europe. If true, this is not trivial. China has almost $3 trillion in foreign exchange reserves. They desire to diversify their currency exposures, and so investing in the government (and bank?) debt of the peripherals serves a number of useful purposes.

Saturday, December 18, 2010

Is there a "muddle through" scenario for Europe?

I may have been too confident that the eurozone will inevitably break up.

It may be that Germany and France will indeed “guarantee” the peripheral countries, such that maturing government debt will be backstopped by the EFSF, and maturing bank liabilities will be funded by the ECB on the basis that the banks are backstopped by their governments which are in turn “guaranteed” by the EFSF.  Then, as the peripherals balance their budgets, market access would resume.

If the markets remain closed to the peripherals and their banks, the next step would be fiscal union and the issuance of union debt. There is a body of opinion (in Europe) that this is exactly what will happen, because the alternative is supposedly worse. The French fall into this category, but Germany does not, not yet.

Fiscal union will require a new eurozone treaty, and a national debate in Germany on this issue.  Fiscal union is unpopular with German voters, but if it becomes necessary to save the euro, it is possible that that the two main parties will bite the bullet.

So what I am saying is that there is the possibility that the euozone will muddle through without default or redenomination. It is difficult to predict which outcome is more likley, because they are both hard to imagine. And the “muddle through” scenario only works if the peripherals implement their austerity plans to Germany’s satisfaction. That will be hard. Given the degree of pain that these countries suggests that their voters may give up before Germany does.