Credit: Can Asia support Europe’s debt problems?

Credit magazine, April 2011

In January, headlines began to appear about Asian sovereigns saving the eurozone. They were caused by public comments from officials in China and Japan indicating that the two sovereigns would, in different ways, support debt issues from struggling European Union nations. This convenient mirroring of a shortage of funds in one continent and a surplus in another seemed a tidy way of remedying a potentially crippling problem. As one of those headlines said, reflecting the sense of happy symmetry: “Sovereign crisis, sovereign solution?”

Asia’s involvement in EU debt raises a number of questions, starting with how much commitment of funds actually happened. There are also issues about how much tolerance these sovereigns, and others in Asia, will have for eurozone exposure, and precisely how they are likely to engage.

First, it’s useful to pin down exactly what happened in January. In that regard, it’s much easier to answer the question with respect to Japan, which came in as the lynchpin for the inaugural bond from the European Financial Stability Facility. (The EFSF is a Luxembourg-incorporated entity set up to preserve financial stability in the EU by providing temporary financial assistance to troubled member states, and its bond issues are backed by guarantees from member states of up to Eu440 billion).

The bond, placed on January 25, raised Eu5 billion as part of the EU/IMF financial support package for Ireland. Japan had pledged to be a big part of the deal, and the EFSF has confirmed that it purchased more than 20% of the issue. EFSF also said that “very strong demand came from Asia,” though it has not been more specific on how and where that was represented; one bookrunner said 38% of the deal went to Asian accounts.

Pinning down what China did is trickier to do. When Klaus Regling, who heads EFSF, was asked if China had come in to his bond, he appeared to confirm it indirectly by saying: “None of the major players were missing.” Certainly, media and analyst coverage has spoken widely of China’s pledges to support the eurozone’s debt markets, but it is hard to be certain about any tangible investment. The certainty of China’s involvement all stems from comments made by Li Keqiang, who is China’s Vice-Premier (China actually has several of these, but he is understood to rank highest) and deputy party secretary of the State Council; he’s considered a likely successor to Premier Wen Jiabao, so what he says matters. In January, he wrote a guest article in El Pais, the Spanish national newspaper, that “China is a responsible, long-term investor in the European and particularly Spanish financial markets, and we have confidence in Spain’s financial market” and “It [China] has purchased Spanish Treasury bonds and will buy still more.” The figure Eu6 billion has been mentioned, but not confirmed, in relation to purchases of Spanish Treasuries.

In other remarks on visits around the region that month, he appeared to suggest China would support the debt of the eurozone’s more troubled countries, and it is understood – but again not confirmed by China – that it has bought Greek debt too. Finally, when the European Financial Stability Mechanism, a rescue fund representing the EU and a separate vehicle from EFSF, raised Eu5 billion earlier in the month, China – through the State Administration of Foreign Exchange – is believed to have bought 6% of the bond (we do know, from bankers close to the deal, that Asian investors made up one quarter of demand, and those close to the deal say that SAFE, the Bank of Korea, Bank Negara Malaysia and Hong Kong Monetary Authority all received full orders rather than being scaled back in the four times over-subscribed deal).

Whether or not China did come into these deals, in some sense it hardly matters; the market took enormous comfort from the sense that there was a flood of sovereign wealth waiting and potentially able to solve Europe’s problems. Partly for these reasons, Portugal’s closely-watched bond sale in January – actually earlier than the EFSF, but after China had made positive noises about support and Japanese finance minister Yoshihiko Noda had said it would be sensible for Japan to take 20% of the EFSF deal – sold very well, comfortably oversubscribed in both its five and 10 year tranches. Spain and Italy completely fairly long-term debt the same week, and Belgium, which had also been drifting into scrutiny, completed an FRN issue.

The improvement in sentiment has happened despite the fact that, in Japan’s case at least, there has actually been no new flow of euros involved. Noda said of the ESFS investment that “we’d like to do this within the realm of euro liquidity in the foreign currency reserves,” which is understood to mean that the investment comes from holdings Japan already had in euros, rather than from, say, a sale of US treasuries to convert those funds into the European currency. This news did have an impact on the euro itself – it rallied first, then fell back again when it became clear the investment would come from existing euros – but doesn’t seem to have impacted sentiment about the debt markets themselves.

But what’s in it for these Asian investors? Why does any entity – the state itself, or its designated investment vehicle – invest in troubled EU debt? These aren’t just acts of charity, of course. The spread on the EFSF deal was fixed at mid-swaps plus 6 basis points, implying a borrowing cost of 2.89% for the facility, and that proved remarkably attractive: 500 investors came into a book of Eu44.5 billion. While not a huge payer, the suite of guaranteeing nations makes this unquestionably AAA-rated paper, yielding modestly more than German bunds; the earlier EFSM deal was 12 points over mid-swaps.

But there’s more to it than that, and clearly a political dimension. When Li Keqiang went to Spain, he didn’t just bolster the country’s debt markets with his comments, but sign Eu 6 billion or more of trade agreements that, among other things, give Chinese companies greater access into Spain. It’s not unreasonable to think there might be a quid pro quo in supporting a country’s debt position. Similarly, when Japan’s Noda made his pledge on the EFSF bonds, he couched it not in investment terms but prudence and responsibility. “The euro zone is planning to issue a large amount of bonds in a cooperative manner late this month to raise funds to assist Ireland, and it is appropriate for Japan, as a major economy, to buy some of the EFSF bonds to bolster confidence.”

Economists and strategists see plenty of this latter sentiment in the behaviour of the Asian buyers. “The euro zone is of incredible importance to both China and Japan as trading partners,” says James Woods, chief Asia strategist for Citi Private Bank. “There’s a sense of a need to support these countries, both for what you might call global prudential purposes, but also to underpin some of the demand among trading partners.”

This political element might also explain why almost nobody in Asian banking wants to speak publicly about the trend: seven different economists and strategists declined to be interviewed on the subject.

Diversification is also key. China in particular is felt to be particularly heavily exposed to dollars and sees the need to do something about it. “The diversification aspect is particularly apparent with regards to China’s concentration risk in Treasuries,” Woods says. “Japan has its own challenges at the moment, and investing in the eurozone is not going to be top of its list of priorities. [Woods was speaking shortly after the earthquake in Japan.] But China will be doing much more to diversify its FX holdings, and I suspect this underpinning of support to countries like Greece is having quite a positive effect.”

Does he expect them to continue to invest? “Yes, I absolutely believe that will be the case. I can’t see any reason why not.”

Also, Asian sovereigns do already have exposure in euros, and it is not in their interests to watch the currency decline or even fail. Rachel Ziemba, analyst at Roubini Global Economics, estimates that 25-30% of China’s reserves are in euro denominated assets. If that’s true, it equates to almost US$800 billion-worth of euro-denominated securities. “Recent Chinese rhetoric has oscillated between providing pledges of support for eurozone assets, and calling on European leaders to prove that they can get the debt issues under control, lest the bloc’s woes continue to destabilize the global economy and financial markets,” says Ziemba in a recent study. “The mixture seems designed to protect China’s existing portfolio, stabilize the global economy and perhaps if necessary secure for China some seat at a restructuring table.” The first of those – the portfolio – is clearly of pressing importance if her estimates on the proportion of holdings in euros is correct; she believes that China has invested in both sovereign debt and agency issuance of European countries, and chiefly European bonds in order to ensure liquidity. “The search for yield may have made some of the debt of periphery countries attractive, but such debt may not make up a large part of the portfolio,” she adds.

On top of that, a weak euro creates competitive pressures for exporters in Asia – none bigger than China and Japan. Toyota, for example, most certainly doesn’t benefit from a weak euro as it seeks to sell Japanese cars into Europe.

There is, after all, a track record of Asian and Middle Eastern sovereign entities – and in particular sovereign wealth funds – intervening in support of the western financial system, believing that doing so creates a long-term investment opportunity while also stabilising the global economy to everyone’s benefit. They did so by buying into flagging US and European banks during the Asian financial crisis. It’s well worth remembering that this yielded heavily mixed results, and caused a lot of pain for all of them at least for a while. On the positive side: both the Government of Singapore Investment Corporation and Kuwait Investment Corporation bought stakes in Citi and, after suffering for a while, sold out (at least in part) at a profit. The Qatari state made a fortune with a swift purchase and sale of a stake in Barclays. But Abu Dhabi Investment Authority, the biggest of them all, is suing Citi for money it lost on its investment in the US house, and Temasek in Singapore lost unspecified amounts – but likely billions – by selling out of stakes in Bank of America Merrill Lynch and Barclays Capital at what turned out to be the bottom of the market. Korea Investment Corporation is still sitting on a heavily underwater position in Bank of America Merrill Lynch. They are not all going to pile in blindly again in support of a turnaround story.

Global sovereign wealth is truly vast: common estimates are around the US$4 trillion mark for sovereign wealth funds alone. And that’s not counting overall foreign exchange reserves: Japan’s foreign currency holdings were worth US$1.096 trillion at the end of 2010, second only to China, where they were last logged at $2.85 trillion.

That scale is especially helpful since the existing EU/IMF support package is already too small to bail out Ireland, Portugal and Spain in aggregate, much less Italy or anyone else. Sovereign entities are a good fit with any macro-related debt instrument that is going to require years to come good, since in the main they don’t have to justify quarterly or even annual performance.

For groups like this, a designated facility like the EFSF (or its sister agency, the European Financial Stabilisation Mechanism) make a lot of sense. Though most sovereign entities in Asia and the Middle East don’t really have to justify their decisions to anybody, it is nevertheless an easier sell politically to invest in a broad multilateral European agency than, say, directly into Greece. Additionally, EFSF creates conditionality on fund recipients that an individual sovereign would find it difficult, politically or practically, to impose itself. “I think it makes more sense to go in to support the facility, because essentially it means that the checks and balances and terms of conditions for the facility are protecting their money as well,” Woods says. “It encourages a greater amount of cooperation from the recipient country to the donors than going in with direct bilateral lending. Much better to support the conditionalities which are being imposed by the donors, rather than to circumvent those conditionalities by going directly.”

They will have plenty of further opportunity: according to the EFSF itself, it plans to raise up to Eu16.5 billion this year, and up to Eu10 billion in 2012, while the EU through the EFSM will raise up to Eu17.6 billion this year and Eu4.9 billion in 2012. That’s on top of the sovereign debt issuance from member states themselves.

Will other Asian entities seek to invest in European sovereign debt? “I think that’s largely a call on two factors,” says Woods.” Firstly, the euro itself: whether it will perform well in the coming year or so. Secondly, what the eventual resolution of the peripheral story is – whether it’s a bailout, a restructuring or just more of the same. Once there is clarity as it relates to those two drivers, we will see support as a consequence.” Additionally, he points to an anomaly in European economics at the moment. “One factor I would highlight is the likelihood of higher interest rates in the eurozone, alongside the liquidity support.” That creates an unusual situation: rising interest rates clearly impact bond yields, but liquidity support underpins support for those bonds. “It’s a conundrum Asian sovereign wealth funds will want to understand first before having comfort to start investing.”

The likely outcome is that some Asian money will come, and this will certainly help; but expecting Asia to prop up the eurozone is unrealistic and probably dangerous. And, moreover, Asia can’t fix the eurozone, just apply the band-aids that get sovereigns through to the next redemption deadline. Beyond that, it’s all up to Europe itself.