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China should prepare for worst outcome in Europe
By Sun Lijian |
June 8, 2012, Friday
|
Print Edition
Print Edition
MASS protests against austerity have erupted in debt-laden euro nations like Spain, casting a pall over the worsening sovereign debt crisis.
Under these conditions, European Central Bank officials have mentioned the possibility of a Greek exit from the euro.
Why could troubles in a few nations have grown to the extent of triggering a full-blown, region-wide crisis that has severely impaired global recovery and cast into doubt the euro's future?
In effect, economists including Robert Mundell, often known as "the father of euro," and Nobel Prize laureate Paul Krugman, envisioned long ago a scenario in which a supranational currency would succumb to three combined factors and fail.
They argued that if a country keeps overprinting its currency to fill budget deficit, and meanwhile struggles to maintain a stable exchange rate, a currency debacle is inevitable when that country opens up its capital account to foreign investors.
The debt crisis that has swept Europe is akin in nature to the scenario prophesied by Mundell and Krugman in three respects.
First, there's an inherent flaw in the euro's exchange rate policy. Since the eurozone is a single currency bloc, depreciation is not a viable option regardless of whether the economic fundamentals of Greece, Italy and Spain are in dire straits.
Even if the ECB devalues the euro to boost the export advantage of indebted eurozone members, that will do little to improve Greece's fortunes, for exports represent a tiny proportion of its national economy.
Its pillar industry of tourism, however, is seriously hobbled by a sluggish Western economy.
Germany: the locomotive
But if we look at the eurozone's overall economic well-being, we'll see that a steep depreciation should not be in the cards.
Germany, the eurozone's locomotive, is still full speed ahead, thanks to its export strengths.
Germany's spectacular performance indicates that a depreciation, though highly unlikely, will be short-lived, for German growth will soon make the euro strong again.
Another consequence is that a vast number of hedge funds will rush to speculate on the interest rate differences, and with the complicity of the ratings agencies in their countries of origin, they will buy euro assets at rock bottom prices, adding to the euro's miseries.
Second, the eurozone is naturally deficient in macroeconomic control.
Although a single monetary policy greatly contributes to the euro's global creditability and status, the region's inability to bail out members in trouble the same way the Fed saved tottering banks is its Achilles heel.
In the absence of fiscal discipline, indebted euro nations had expanded their expenditures on social welfare well before the crisis, something encouraged by a credit market once awash in liquidity.
But now with the crisis in full swing, Greece, unable to get fiscal help from the EU, can expect no monetary policy to work magic either.
Moreover, the lack of coordination within the EU has widened the gap of distrust between member nations whose taxpayers are against bailout of their neighbors and debt-ridden nations whose citizens oppose austerity.
As that gap widens, the market is gripped by mounting fears of a Greek, Italian or Spanish default. Those fears have prompted a cascade of fire sales of euro assets.
Finally, the lack of effective financial oversight has created room for speculators to short-sell euros.
European financial markets, wary of a credit crunch, will be even more reluctant to lend to Greece to service its debt.
A vicious cycle emerges that compounds the euro's woes.
If Western nations or the International Monetary Fund can join hands in regulating the financial market and curtailing the short-selling of euros, the vicious cycle may relent a little.
In short, if the above-mentioned three factors come together, stock market crashes and the euro's plummet will occur now and then as a result of negative developments such as an escalating Spanish or Italian debt fiasco.
As a matter of fact, the root cause for the moral risks still high in debt-ridden euro nations is that the euro lacks an exit mechanism.
China: be prepared
Whatever the outcome in Europe, China should prepare for the worst of its fallout.
We ought to realize that China's macroeconomic outlook will be clouded by challenges stemming from the euro's worsening problems.
The challenges are as follows.
First, the challenge of wild exchange rate fluctuation. A soaring dollar and a plunging euro will hike exchange rate risks and costs.
Second, the challenge of capital flight. When hot money is scouring the globe for its next target after the euro, it tends to increase its holdings in premium assets of emerging markets.
Its operation could considerably raise the price volatility in the foreign exchange, capital, property and even commodities markets.
Third, the challenge of shrinking wealth. Amid the uncertainty hanging over Western economies, the portfolio and safety of China's foreign exchange reserves will surely be affected.
The best protection for China's economy is to channel financial capital to the non-virtual economy, and do it decisively and smartly.
At the same time, the leadership in Beijing must deepen market reform and give the private sector a louder voice, in order to ensure the Chinese economy will grow stably yet remarkably differently during a global downturn.
The author is executive vice dean of the School of Economics at Fudan University. Shanghai Daily staff writer Ni Tao translated his article from Chinese.
Under these conditions, European Central Bank officials have mentioned the possibility of a Greek exit from the euro.
Why could troubles in a few nations have grown to the extent of triggering a full-blown, region-wide crisis that has severely impaired global recovery and cast into doubt the euro's future?
In effect, economists including Robert Mundell, often known as "the father of euro," and Nobel Prize laureate Paul Krugman, envisioned long ago a scenario in which a supranational currency would succumb to three combined factors and fail.
They argued that if a country keeps overprinting its currency to fill budget deficit, and meanwhile struggles to maintain a stable exchange rate, a currency debacle is inevitable when that country opens up its capital account to foreign investors.
The debt crisis that has swept Europe is akin in nature to the scenario prophesied by Mundell and Krugman in three respects.
First, there's an inherent flaw in the euro's exchange rate policy. Since the eurozone is a single currency bloc, depreciation is not a viable option regardless of whether the economic fundamentals of Greece, Italy and Spain are in dire straits.
Even if the ECB devalues the euro to boost the export advantage of indebted eurozone members, that will do little to improve Greece's fortunes, for exports represent a tiny proportion of its national economy.
Its pillar industry of tourism, however, is seriously hobbled by a sluggish Western economy.
Germany: the locomotive
But if we look at the eurozone's overall economic well-being, we'll see that a steep depreciation should not be in the cards.
Germany, the eurozone's locomotive, is still full speed ahead, thanks to its export strengths.
Germany's spectacular performance indicates that a depreciation, though highly unlikely, will be short-lived, for German growth will soon make the euro strong again.
Another consequence is that a vast number of hedge funds will rush to speculate on the interest rate differences, and with the complicity of the ratings agencies in their countries of origin, they will buy euro assets at rock bottom prices, adding to the euro's miseries.
Second, the eurozone is naturally deficient in macroeconomic control.
Although a single monetary policy greatly contributes to the euro's global creditability and status, the region's inability to bail out members in trouble the same way the Fed saved tottering banks is its Achilles heel.
In the absence of fiscal discipline, indebted euro nations had expanded their expenditures on social welfare well before the crisis, something encouraged by a credit market once awash in liquidity.
But now with the crisis in full swing, Greece, unable to get fiscal help from the EU, can expect no monetary policy to work magic either.
Moreover, the lack of coordination within the EU has widened the gap of distrust between member nations whose taxpayers are against bailout of their neighbors and debt-ridden nations whose citizens oppose austerity.
As that gap widens, the market is gripped by mounting fears of a Greek, Italian or Spanish default. Those fears have prompted a cascade of fire sales of euro assets.
Finally, the lack of effective financial oversight has created room for speculators to short-sell euros.
European financial markets, wary of a credit crunch, will be even more reluctant to lend to Greece to service its debt.
A vicious cycle emerges that compounds the euro's woes.
If Western nations or the International Monetary Fund can join hands in regulating the financial market and curtailing the short-selling of euros, the vicious cycle may relent a little.
In short, if the above-mentioned three factors come together, stock market crashes and the euro's plummet will occur now and then as a result of negative developments such as an escalating Spanish or Italian debt fiasco.
As a matter of fact, the root cause for the moral risks still high in debt-ridden euro nations is that the euro lacks an exit mechanism.
China: be prepared
Whatever the outcome in Europe, China should prepare for the worst of its fallout.
We ought to realize that China's macroeconomic outlook will be clouded by challenges stemming from the euro's worsening problems.
The challenges are as follows.
First, the challenge of wild exchange rate fluctuation. A soaring dollar and a plunging euro will hike exchange rate risks and costs.
Second, the challenge of capital flight. When hot money is scouring the globe for its next target after the euro, it tends to increase its holdings in premium assets of emerging markets.
Its operation could considerably raise the price volatility in the foreign exchange, capital, property and even commodities markets.
Third, the challenge of shrinking wealth. Amid the uncertainty hanging over Western economies, the portfolio and safety of China's foreign exchange reserves will surely be affected.
The best protection for China's economy is to channel financial capital to the non-virtual economy, and do it decisively and smartly.
At the same time, the leadership in Beijing must deepen market reform and give the private sector a louder voice, in order to ensure the Chinese economy will grow stably yet remarkably differently during a global downturn.
The author is executive vice dean of the School of Economics at Fudan University. Shanghai Daily staff writer Ni Tao translated his article from Chinese.
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