China Trying to Break the Euro?

Last week the Financial Times ran an article written by famous currency trader George Soros. His article was entitled the Eurozone Needs a Corporate Bond Market, and in it Soros touches on one of the greatest weaknesses of the Euro currency; the inability of the European Central bank to control monetary policy across the member states in the Union.

In the article Soros says:

"The euro suffers from certain structural deficiencies; it has a central bank but it does not have a central treasury and the supervision of the banking system is left to national authorities. These defects are increasingly making their influence felt, aggravating the financial crisis...

...The capacity of individual member states to protect their banks came into question and the interest rate spread between different government bonds began to widen alarmingly. Moreover, national regulators, in their efforts to protect their banks, were unwittingly engaging in beggar-thy-neighbour policies. All this is contributing to internal tensions...

...At the same time, the unfolding financial crisis has convincingly demonstrated the advantages of a common currency. Without it, some members of the Euro zone might have found themselves in the same difficulties as the countries of eastern Europe. As it is, Greece is hurting less than Denmark, although its fundamentals are much worse. The euro may be under stress but it is here to stay. The weaker members will certainly cling to it; if there is any danger, it comes from its strongest member, Germany..."

Soros isn't the only one thinking this. In Early February I was also turned onto an article about the deficiencies of the Euro zone which was written by John Mauldin of Safe Haven in his "Outside the Box" column. The article if you are into currency trading is fascinating and I think well worth the read; it's called "Can the Euro Survive." What's important for this post though is that Mauldin includes several very helpful statistical figures in visual format that I'd like you to see.

Mauldin says the following:

"There is nothing in the Maastricht treaty which prevents a member country from leaving the euro, yet the decision to join is effectively irreversible. There are a number of reasons for this, the most important being economic costs. Take Italy which has a history of compensating for lost competitiveness through regular devaluations. If Berlusconi did the unthinkable tomorrow (sorry - nothing is unthinkable in Berlusconi's world), Italy's borrowing costs would explode. My guess is that bond investors would demand double digit returns on a Lira denominated bond to compensate for the dramatically increased devaluation risk. Already in a precarious fiscal position, Italy could quite simply not afford that. So, if any country were to leave the euro, it would more likely be from a position of strength, and only one country possesses enough strength to pull that off in the current environment. That country is Germany. And, although the euro is not particularly popular in Germany, I believe it is extremely unlikely for Germany to make such a move unilaterally. There are several reasons for that - Germany's history in Europe being the most important.

At the same time, the fact that the euro has saved the bacon of more than one country in recent months - Ireland being the most obvious example - should not be ignored. For this very reason, the euro membership is actually far more likely to grow than to shrink as a result of the financial and economic crisis engulfing the world. The issue the EU has to deal with is whether the new applicants should actually be welcomed. Most of those who would want to join will bring plenty of baggage."

And now for some interesting stats to support the idea that the stronger European countries are growing increasingly discontent with some of their lesser neighbors.

Item 1 2007 Unit Labour Cost Index

(2000=100)

Original Source: http://stats.oecd.org/

Item 2: Actual Debt & Age Related Contingent Liabilities

Original Source: Goldman Sachs, European Weekly, 1/22/2009

Item 3: Sovereign Debt Spreads over Germany

Original Source: Goldman Sachs, European Weekly, 1/22/2009

Now for my thoughts on what someone or some country could potentially do to break the Euro or put extreme pressure on the Euro zone if they had enough money. Assuming there was enough capital to pull it off, the play here is to go short the debt of the weakest of the Euro zone members. (I'd say Italy or Greece with Spain not far behind). By doing this you would drive interest rates up on sovereign debt within the countries you targeted. This would create huge problems for them individually, may potentially push them to the brink of default (not unlike California) and would effectively ruin the European Central Bank's day.

In Table 3 above you can already see the staggering difference in debt spreads between Germany (arguably the strongest Euro zone member) and Italy, Spain, Greece, and Portugal (as above arguably the weakest). Increasing the borrowing cost on debt in the weakest countries would require capital infusions from the Central Bank, however the bank would be powerless to stop the pressure on the sovereign debt of the individual countries because, as Soros said, there is no unified European Bond Market.

After pushing borrowing costs upward in the weaker countries of the Union one would then begin shorting the Euro currency with as much cash as they possibly could. By doing this you would be adding additional downside pressure to the Euro, as the ECB in an effort to save the ailing countries you were shorting debt on, would have to be injecting more and more capital to keep them afloat. This would squeeze the entire Euro zone and, in my opinion, the strongest of the countries would begin to say "enough is enough." At which point nationalism would grow stronger, more thought would be given to the facts in Tables 1 and 2 above, and I would speculate some members would consider leaving or not assisting their ailing neighbors.

In either scenario you would be able to create a massive crisis and downside pressure on the Euro would grow significantly. Currently tensions are already high around the world as the economic crisis continues to unfold and many are starting to wonder about Europe's exposure to countries in the old soviet block which is already damaging the Euro's strength. In addition, as I am writing this, Germany just released a statement regarding its assistance to weaker Euro zone members so we know conversations are being had about this issue. The unified debt market problem exists, it's staring the world in the face, and someone with enough power could exploit it.

So who is large enough to do this? Who would benefit from this? China.

China could benefit from this strategy significantly because it has the largest cash reserve of U.S. dollars in the world. Since China holds between $1 and $2 trillion dollars' worth of U.S. currency it has more than enough money to start picking off the weakest of the Euro zone countries and to begin the execution of my plan above. In doing this China would be able to profit from its shorts on the sovereign debt as the nations it targeted began to fall. Then it would also profit on its shorts against the Euro because the Chinese are impossibly long U.S. Dollars. Additionally, if China was able to succeed the strongest states of the Union would end up standing on their own and allowing the weaker countries to go it alone and most likely fail.

If China could accomplish this it would ultimately gain the global financial political clout it is so desperately seeking, and wouldn't have to go to war to obtain it. Last week while trading the EURO / USD pair I noticed something strange. During the Asian market hours roughly between 23:15 and 7:15 GMT a very large player was dumping a tremendous amount of Euros onto the market and buying up dollars; so much so that the market was moving a few cents almost instantly which is HUGE in currency trading. I was not the only person to notice this, and it happened 4 out of 5 sessions (see graph below)

Who in Asia do we know that would want to keep the value of the dollar up? Who in Asia do we know that could benefit from the collapse of the Euro? Who do we know has funded the credit expansion of the United States for far too long, isn't getting any global respect, may have said enough is enough, and taken matters into their own hands? China.

Stock position: None.

Comments

[Nikola:]

Wow, it's interesting Soros would say last week that "Euro is here to say" when a few weeks back he said that "Euro may not survive the crises" See: www.investorazzi.com/2.../

I think George Soros is full of $hit.

Feb 24 09:16 AM

[mcadoo3312:]

Interesting points. I agree with everything you have to say; China's closed book policy would also allow them to do this. They know that in this environment, they are many countries' saving grace because they are one of the few entities that can actually buy debt, something every country in the world needs going forward. This does not come without risk, though. China is not yet in position internally to burn any political bridges. They must sustain their working class and financial markets before they can make more bold moves. Their stimulus will go directly to this source which may expedite this process. To be honest, I am not sure why they didn't spend more.

Feb 24 09:26 AM

[Roger Knights:]

Interesting. The steep run-up in gold from 920 or so starting about a week ago started with unprecedented buying during Asian trading hours, which was immediately marveled at on the Kitco gold forum. I wonder ....

Feb 24 10:00 AM

[Mad Hedge F...:]

My old friend, Stephen Roche, chairman of Morgan Stanley Asia, says that the current US bubble is four times larger than Japan’s, whose market is still down 80% from its 1989 high (no typos here). The American consumer, who at the peak accounted for 72% of GDP, has been left for dead. Japan’s bubble was caused by a collapse in capital spending, which never accounted for more than 17% of GDP. If we make China our whipping boy, as the Democratic Congress is historically inclined to do, they could come back to bite us in the hand. Treasury Secretary Geithner’s recent comment that China is a “currency manipulator” hasn’t helped. Our financial markets are now desperately dependent on the Middle Kingdom recycling their trade surplus into our bond market. A Chinese boycott would trigger a collapse in the dollar, and send US interest rates sky high.

Feb 24 10:45 AM

[Dave Wrixon:]

You seem to overlook the fact that the West is quite capable of screwing up on its own without any help from the Chinese who already have emissaries going from the USA begging for handouts.

The Chinese will be concerned about the security of their US dollar holdings, but getting in even deeper is probably not their preferred option. They could always make the Americans borrow in Euros or Yuan.

Feb 25 01:34 AM

[coreopsis:]

He's your old friend and you can't spell his name. Hmmm.


On Feb 24 10:45 AM The Mad Hedge Fund Trader wrote:

> My old friend, Stephen Roche, chairman of Morgan Stanley Asia, says
> that the current US bubble is four times larger than Japan’s, whose
> market is still down 80% from its 1989 high (no typos here). The
> American consumer, who at the peak accounted for 72% of GDP, has
> been left for dead. Japan’s bubble was caused by a collapse in capital
> spending, which never accounted for more than 17% of GDP. If we make
> China our whipping boy, as the Democratic Congress is historically
> inclined to do, they could come back to bite us in the hand. Treasury
> Secretary Geithner’s recent comment that China is a “currency manipulator”
> hasn’t helped. Our financial markets are now desperately dependent
> on the Middle Kingdom recycling their trade surplus into our bond
> market. A Chinese boycott would trigger a collapse in the dollar,
> and send US interest rates sky high.

Feb 25 09:53 AM

[James Bibbings:]

Dave Said: "You seem to overlook the fact that the West is quite capable of screwing up on its own without any help from the Chinese who already have emissaries going from the USA begging for handouts.

The Chinese will be concerned about the security of their US dollar holdings, but getting in even deeper is probably not their preferred option. They could always make the Americans borrow in Euros or Yuan"

The West is indeed quite capable of creating it's own problems, however it does have a unified debt market and Europe does not. Hence I think forcing the US to borrow in Euro's makes little sense. Until the debt issue is fixed (either by law or by market force) Europe doesn't even have the approriate "tools" to handle it's multi-nation currency.

(On this point I personally would argue that central bank intervention and the idea of "tools" is unsound and needs to be re-thought (ie the Federal Reserve/Fractional Model), however, under our current Keynesian dominated global economic paradigm this thought is not mainstream and will probably not be implemented in the near term. I digress, read my blog economicbibb.blogspot.... if you'd like to learn more; I digress)

So if I were to support the notion of a Central Bank "needing" those "tools" I would have serious doubts about the validity of the Euro Currency in the current economic crisis and would never want to hold reserves in that denomination if I was in charge.

However, that being said, I do see the point about not wanting more Dollars, yet fail to agree. If the world is collapsing you want your money with your biggest trade partners and need to find economic allies. China, regardless of whether it likes it or not, made this choice long ago and is now fighting with the US to retain economic viability. If you consider the GDP of all nations, China by pulling out of the US, would decimate both North America and ultimately the world.

The idea of borrowing in Yuan is more interesting, I'll have to consider that further. My initial thought would be that if the US were to do so China couldn't artificially manage it's exchange rate any longer and would become significantly less competitive. Also by doing this Demand for Yuan would no doubt sky rocket.

Feb 25 10:43 AM

[HaavBline:]

So currency speculation can buy China political clout? Fortunately the Chinese are not that stupid. They care far more about their credibility than a few hundred billion quick yuan.

The Euro zone is China's biggest trading partner, surpassing the US a couple of years ago. This is a fact most people do not realize.

Feb 25 11:33 AM

[sundrenched:]

HaavBline, you beat me too it. Why would China want to jeopardize exports to its biggest customer?

Feb 25 12:14 PM

[Monkey Man:]

Interesting idea but not going to happen. A collapse in the Euro would be a major problem for China's exports to the region. Furthermore, China is in close dialogues with the EU (ex-France) regarding working together to combat the crisis; a collapse of the Euro and weaker member nations would exacerbate the global economic crisis.

Feb 25 07:20 PM

[TERN:]

Rather than economic warfare against its customer the Eurozone, China might benefit far more from using a part of its cash pile to take long positions in the precious metals markets.
This would be politically more neutral and financially more profitable.

Feb 25 11:30 PM

[James Bibbings:]

Also a valid point regarding Europe being the largest trade partner to China; I do realize this. Note that I didn't say the US was largest here, just that it was very critical to China. The gap between the EU and America with regard to trade partners is next to zero in relative terms; this is why China choosing in a time of chaos makes sense based on the "tools" ideal from above and the current state of China's reserves.

Again, it is in fact true that the "Euro Zone" is the largest purchaser of Chinese goods at this time. However, if you look at it on a per country basis the stronger EU members make up the lions share of the purchases. The dismantling of the Euro as a currency would not destroy the larger members, and would further validate China's dollar holdings. There is even evidence to me that some of the EU members aren't entirely confident in the Euro currency to this day. If you have traveled to Europe recently (as I have) you'll note that all of the "strong" member countries still allow for the use of and acccounting for (there is a local exchange rate) of their home currencies. I believe they are doing this so that going back to them would be possible if required.

Although I feel the break up of the EU is unlikely, the debt markets undoubtedly must be fixed; if George Soros among others see this it has to be a near certainty. Regarding France; If I was China I would not be wasting my time working with them right now. I'd be more concerned about the trouble brewing within my neighbor to the North and it's now seperate "affiliate" countries. If the Russian old world collapses, as many anticipate, it will make little difference what China wants to do regarding the Euro because the choice will have been made for them before they have a chance to pick sides. Europes exposure to the old Soviet Block is so large it will take a miracle for the European Central bank to hold it together if those countries come unglued.

Lastly, keep in mind that I am speaking from the perspective that governments should be pro-active rather than re-active. China must choose lest it be chosen for; to me the US seems to be a better choice, hence the theory.

Feb 26 10:30 AM

[Sinclair:]

Interesting article.

My view is that the last thing that China needs is a weak euro. If anything it may seek to strengthen the euro to allow it's export dominated growth to continue. What mattters is what China really thinks of future US growth, and whether it thinks Obama is an isolationist/protectio...

As for that comment that George Soros is full of $hit, well, maybe. What Soros is capable of doing, though, is waking up in the morning, realising he was wrong and acting accordingly. That's what makes him successful.

Mar 08 06:46 AM

[Random Capital:]

Sell Euro buy Eastern European Currencies

Oct 18 02:50 PM

[Random Capital:]

China buys High Tech Machinery in Europe for Euros (Siemens,GanzTrans etc), . High Euro means high costs for high tech. Weak Euro would speed up and strengthen China's march towards progress and advance.

Oct 18 02:56 PM