There will be slim pickings if China loses its appetite for Western debt

There will be slim pickings if China loses its appetite for Western debt
Last week I argued that the idea of large Asian economies "decoupling" from the West was unhelpful. Globalization makes nations more interrelated, not less. So export-oriented nations like China and India were always going to feel the impact of a massive Western contraction.

By Liam Halligan
Last Updated: 6:11PM GMT 21 Feb 2009

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But I have to admit that China, with its massive 1,400m population, isn't doing badly. Retail sales remain strong – up 17pc in real terms. Growth has slowed, but GDP still expanded by a pretty spectacular 6.8pc during the fourth quarter of last year.

Japan – that other Asian giant – continues to suffer. Tumbling exports have sparked the worst slump in 35 years. Japanese GDP contracted 3.3pc during the last three months of 2008 – equivalent to a 12.7pc annualized drop. The Nikkei 225 index of leading Japanese shares is down 16pc since the start of 2009. Chinese shares, in contrast, have gained 25pc this year – the best return of any stock market in the world. London's FTSE-100 shed 12pc over the same period, with New York's S&P 500 down 15pc.

Optimism in China has been boosted by the government's Rmb4,000bn (£405bn) support package. Unlike Japan and the cash-strapped Western nations, China is funding its fiscal stimulus using reserves, not extra borrowing.

As the West's predicament has worsened, and China's relative strength has punched through, the political mood music has changed. Just a few weeks ago, in his first speech as US Treasury Secretary, Timothy Geithner accused Beijing of "manipulating" its currency. So what if the renminbi has appreciated more than 20pc against the dollar since 2005, undermining Chinese exports? Wanting to appear tough, "Tiny Tim" attacked China.

Last week's G7 Finance Minister's meeting in Rome produced far more measured tones. "We welcome China's fiscal measures and continued commitment to move to a more flexible exchange rate," purred the post-Summit communiqué.

Hillary Clinton also perfected her "China bashing" rhetoric as she bid for the White House. But now, as US Secretary of State, and on a visit to China, she insists "a positive co-operative relationship" between Beijing and Washington "is vital to peace and prosperity, not only in the Asia-Pacific region, but worldwide".

So, what's different – apart from US politicians no longer being in election mode? Well, behind the scenes, the Chinese government has started demanding guarantees for the $700bn of US Treasury bills on its books.

China has been keeping the States afloat for the best part of a decade, buying up vast quantities of T-bills to fund America's enormous budget and trade deficits. At any point, China could seriously damage the world's largest economy – by refusing to lend more money. So reliant is America on funding from Beijing that, by turning off the cash taps, China could spark an instant run on the dollar.

The Chinese haven't done that as it would harm their dollar-based holdings and they understand we live in an inter-dependent world.

But the ever-greater use of Asian savings to fund the "advanced" economies' deficits is unsustainable. And, as such, we're reaching the point where it will not be sustained. With Western governments intent on printing money and debauching their currencies, the big emerging market creditors – not only China, but Taiwan, Russia, South Korea and others – are now privately raising doubts about their future appetite for Western debt.

This demand drop-off will happen just as the West's dependence on such credit peaks. America and the UK are starting to issue sovereign paper like confetti, to fund highly-irresponsible "recovery programs".

The "rush from risk" that followed the Lehman collapse last September caused the repatriation of billions of dollars invested in emerging markets back to the "safe haven" of the West. That has so far allowed the US and UK authorities to get their larger debt issues away.

But the upcoming volumes are simply enormous. Last year, the US sold bonds to cover its $460bn deficit – around $200bn to foreigners, with China taking the lion's share. But America is on course to issue a staggering $2,000bn of debt in each of the next two years.

Over the same period, the UK will be flogging three times more gilts annually than during 2008. Right across the Western world, crisis-ridden governments will be issuing more and more debt.

Worried about falling currencies and rising inflation, the emerging markets – not least the Chinese – are demanding better returns to buy Western sovereign bonds. This is entirely justified. The debtor governments are weak, confused, and piling loans on top of loans with little sign of future growth.

But how will the Western world react when the creditor countries finally refuse to buy? How will America respond – with resignation, understanding, or aggression? That's the crucial question the world faces over the next three to five years. Just what happens when China stops buying US government debt?

This 'crank' sticks by his prediction that the single currency will not survive

The euro has just surged 2pc against the dollar, up from a three-month low. Why? Certainly not because the eurozone's economic prospects have improved.

New data shows a sharp drop in the 16-member states' PMI index – a bellwether for future growth. The single currency area is still contracting at breakneck speed, and now faces a 1.2pc fall in GDP during the first three months of this year.

So why did the euro strengthen? Because Peer Steinbrueck, Germany's finance minister, indicated the currency union's largest economy would consider bailing-out weaker members if they defaulted on their sovereign debts.

Since the euro was launched in 1999, those of us arguing it would eventually break-up have been dismissed as cranks. But now, by admitting it "will show itself capable of acting", Germany has acknowledged bail-outs may be needed, suggesting collapse is a genuine possibility. The only surprise is that it's taken so long for the politicians to face up to economic reality.

For some time now, eurozone countries with large budget and/or trade deficits have been forced to pay high interest rates when issuing sovereign debt. These problem nations – Portugal, Ireland, Italy, Greece and Spain – are known collectively in global debt markets by the unfortunate acronym of "PIIGS".

The gap between their average 10-year bond yield and the rate needed to sell German government debt – "the PIIGS-spread" – has just topped 200 basis points. Austria has also now joined this high-risk group – given the exposure of its banking system to the emerging markets of Eastern Europe.

German Chancellor Angela Merkel refuses to comment on whether Germany would help eurozone members in trouble. No wonder. As German exports suffer, unemployment is rising. And after years of budgetary restraint, German voters won't take kindly to paying for excesses elsewhere.

But signals coming out of the German Finance Ministry indicate a plan is anyway being hatched – for countries with better credit ratings to sell bonds and then lend the proceeds to the ailing PIIGS. In return for doing this, though, the stronger members will surely want some say over how the money is spent and when taxes will be raised to pay it back.

At that point, eurozone voters will become extremely nervous at an implicit transfer of sovereignty – and the central contradictions of monetary union will be exposed. I've predicted the demise of the single currency since long before it's launch. I'm sticking to that view.

http://www.telegraph.co.uk/finance/comment/liamhalligan/4741093/There-will-be-slim-pickings-if-China-loses-its-appetite-for-Western-debt.html