French-German divide prolongs Greece’s woes

Even by the EU’s sad standards, eurozone finance ministers’ display of unity on Monday over the Greek crisis proved particularly short-lived. But a deep divide between France and Germany over how and whether to help Greece is accentuating the crisis and increasing the chances for worst case scenarios.

The ministers agreed on Monday at their monthly dinner meeting in Brussels on the broad outline for how the eurozone would extend bilateral loans to Greece if Athens were forced into needing them. However, the ink was barely dry on the communique before the agreement began unravelling with Germany raising the possibility of calling in the IMF and even the possibility that countries could be kicked out of the 16-nation shared currency union.

Germany’s reluctance to pony up any cash for Greece is more about domestic politics than anything else. With an election later this year, German politicians don’t want to be seen sacrificing German taxpayers’ cash to prop up a corrupt and profligate Greek benefits system after Germans worked hard to keep down their deficit levels. Therefore, Chancellor Angela Merkel and her Finance Minister Wolfgang Schauble have been doing everything possible to stall any firm and precise commitments to support Greece with cash. That’s why Schauble pushed the idea of a European Monetary Fund two weeks ago and why Merkel has opened the door to the possibility of calling in the IMF. They are hoping that stall-tactics will be enough to keep Greece solvent until it gets over a key debt rollover hump running through April.

Meanwhile, Nicolas Sarkozy’s France has been pushing for stronger eurozone commitment to Greece. The last thing he wants is for the IMF to have to come in and pick up the pieces in the Greek crisis as it just so happens that his biggest political rival heads the IMF. Shortly after he was elected, Sarkozy exiled Dominique Strauss-Kahn in Washington with the plump job of running the IMF in hope of keeping sharp and respected Socialist out of domestic French politics. However, the move has largely backfired because Strauss-Kahn’s absence in Paris has done little to hurt his ratings, with French opinion polls now ranking him as the most popular French politician. That makes him a formidable rival for Sarkozy if he decides to run in the 2012 presidential elections. That point is likely to borne home as soon as Sunday when Sarkozy’s ruling UMP party is due for a drubbing in regional elections, the last vote before the presidential election.

With Germany and France busy playing domestic politics, Greece is left wondering where its going to get the cash to pay its bills over the next six weeks. That’s why Prime Minister George Papandreou tried to force Germany and France to get serious and come up with coherent positions in time for a summit of EU leaders in Brussels next Thursday and Friday. If they don’t then the markets are probably going to drive up Greek bond yields and ultimately there may be little choice but calling in the IMF for an emergency rescue. And that will be sorry sign that the eurozone is not mature enough to sort out its most pressing problems.

China will not be bullied into revaluing the yuan

China will eventually let the yuan rise, but not because its trade partners told Beijing to do it. When China’s leaders let the yuan rise it will be because they perceive it to be in the interest of the political establishment.

With the US Treasury due to issue its annual report on currency manipulators soon and elections around the corner, a new rash of China bashing has broken out in Washington. But China insists as much as ever that the yuan is not undervalued. As a result, a dangerous game of brinkmanship has emerged at the heart of the most important economic relationship in the world, raising the chances of a nasty trade war.

The new push in Washington for sanctions against China is more about domestic politics than anything else, with China an easy target for politicians eager to build up political capital ahead of the mid-term elections amid high unemployment and general anxiety about China’s rise. But likewise, China’s refusal to revalue the yuan is also driven by Chinese politics. Chinese leaders don’t want to be perceived by the population as kowtowing to the United States or other western countries, which would undermine their credibility and make cracks in their power.

It is frequently said of China that the Chinese have a much longer sense of history than in the West, which makes them see the world through the prism of history. Therefore, the Chinese consider it vital to put the last 200 years of foreign domination behind them and restore China’s position as one of the world’s pre-eminent powers — a position China enjoyed for millenia until the Europeans arrived. Prior to the arrival of Europeans, the Chinese leadership considered it to be at the centre of the world, literally the Middle Kingdom. However, a student of Chinese history will quickly see that the central powers have long struggled to maintain authority over the country and surrounding territories, causing the imperial leadership to frequently collapse and uprisings to break out.

The current Chinese leadership know that to retain authority, and therefore credibility, with the population they must firstly deliver prosperity through rapid economic development and secondly they must be perceived as restoring China to its former glory as a pre-eminent power. And, as Americans themselves know perfectly well, pre-eminent powers do not let their policies be dictated by foreigners.

That is why the Chinese leadership are refusing to re-value the yuan even as it increasingly makes sense for the Chinese economy. With inflation in China becoming a problem and asset bubbles getting bigger every day, relaxing the yuan’s exchange rate makes good economic sense. But it does not yet make good political sense. It will make political sense when the economic damage from the yuan’s overvaluation becomes more of a domestic threat to the Chinese leaderships credibility than the perception in China that revaluing the yuan is kowtowing to Washington and other foreign powers.

In the mean time, bullying China to revalue the yuan can only be counterproductive because it would only make the Chinese leadership look weak if they actually did it.

China not dumping dollars… yet

The press has made much out of US Treasury data last week indicating China’s holding of US treasury bonds fell by 34.2 billion dollars in December, suggesting either openly or by implication that Beijing is dumping the dollar. While the drop in Chinese holdings does raise many questions, such speculation ignores the basic facts about why China purchase’s treasury bonds in the first place.

China buys US treasury bonds in order to keep the value of the yuan to the dollar fixed. Therefore, if the Chinese suddenly got cold feet about the dollar and dumped a chunk of their holdings then the yuan’s exchange rate to the dollar should have changed in December. That clearly did not happen as it would have been huge news. The yuan is just as fixed to the dollar as ever although there are good reasons to expect that to change in the coming months.

There are other explanations for the fall in Chinese holdings. One possibility is that the Chinese central bank chose to purchase treasuries indirectly through US or foreign banks, which would keep the purchase from showing up in the Treasuries data for direct purchases by China. Indeed, holdings of US treasuries by Britain — with London the home of many international banks — rose by 24.9 billion dollars in December, which would offset a big chunk of the fall in Chinese holdings.

The question then arises why would the Chinese opt for a more roundabout way to manage their US holdings, especially since it would increase the transaction costs for them. Perhaps, it is a new way of sending Washington a message. Chinese officials have been voicing concern about the dollar and the spiraling US deficit for sometime. So maybe this is a way of putting their money where their mouths are, both figuratively and literally, since actually dumping the dollar is not possible without relaxing the yuan’s peg to the dollar. Moreover, tensions between China and Washington have been high and rising, getting in fact substantially worse since the December period covered  by the data.

But there is also another more mysterious possible reason for the fall in Chinese holdings of US treasuries. Since the Chinese have to buy dollar assets in order to keep the yuan pegged, perhaps they have bought US assets other than low-yielding treasury bonds. In which case, what did they buy? Corporate bonds, stocks… One can hardly blame the Chinese for trying to get a better return on their investments in US assets given the rock-bottom rates on offer from the Treasury. Indeed, even in regard to its treasury holdings, China has been cutting down on low-yielding treasury bills in favor of higher-yielding, longer term notes. That can also be said of all foreign holders of US government debt.

While sharp for one month, the drop in Chinese holdings also has to be put into context of the trend over several months. Chinese holdings peaked in May 2009 at 801.5 billion dollars and have been drifting down since then although December’s fall was bigger than previous months. However, that fall in Chinese holdings has easily been offset in increases by Britain and Japan, which regained its title as the US government’s biggest foreign creditor from China in December.

Therefore, the US is still having no problem attracting the foreign capital it needs to finance its vast current account deficit.

Greek crisis kills off Europe’s nascent reserve currency ambitions

European hopes that the euro could rival the dollar in the coming years as a new reserve were effectively killed off by the current crisis engulfing Greece, which has shown that the euro is by no means ready for such a role.

One may very well lament Washington’s poor management of its finances, but the Greek crisis has shown a light on just how weak Europe’s management of its finances are in the absence of a “federal” structure to impose spending limits on the eurozone member countries. The Stability and Growth Pact, which is supposed to impose fiscal discipline, has proven far too weak during the last two recessions, allowing countries  to run up unsustainable deficits with utter impunity.

While fears that the Greek crisis might threaten the very survival of the eurozone are excessive, their existence shows that the euro is by no means ready to take up a role as an international reserve currency. Why would authorities want to seriously stockpile a currency if they considered that there was even a vague risk that the country or country it belongs to might break up? One might fear for the fiscal state of the United States, but nobodies worries that it might break up, which helps underpin the dollar’s status as a reserve currency.

The case for a new reserve currency has been driven more by the logic of international relations than the logic of international economics. China, Russia and France have pursued the idea mainly because it suits their aims of diluting American dominance. In China’s case, it has also served as a way to put pressure of Washington to better manage the dollar, which Beijing has a vital interest in on account of China’s vast assets in dollars.

Since a G8 meeting last summer in Italy, France’s Sarkozy has been the main proponent in Europe of an alternative to the dollar as a reserve currency. However, he has apparently failed to recognize that if ever the euro were to serve that role then central banks around the world would have to buy up vast amounts of euros, driving up the currency’s value and killing off the eurozone’s exports. It’s surprisingly that this fact has escaped Sarkozy, who has also decried their euro’s strength in the past because of the impact on exports.

Perhaps one day in the distant future, Europe will have more mature and sound fiscal management and the euro will be ready for a role as a reserve currency of choice. But that is unlikely to happen for many years and by then the Chinese yuan would probably be a better contender for such a role anyway.