It may suit China to opt to put its eggs in the US basket, but that would be unwise

Just a few hours after a euro zone summit on Oct 27 the French President, Nicolas Sarkozy, reached out to his Chinese counterpart Hu Jintao to seek support for an enlarged rescue fund designed to solve the region's sovereign-debt crisis. Not long time before, the US Secretary of State, Hillary Clinton, also asked China to continue investing in the US to support President Barack Obama's economic recovery plan.

There is little surprise that the world's economic powers sought China's support. With 30 years of rapid economic growth and high savings, China has accumulated a veritable fortune. Its foreign exchange reserve reached $3.2 trillion (2.4 trillion euros) in June, the highest in the world. Many world leaders have recognized that the way China invests its foreign exchange reserve will affect the global economy.

Given that US debt and European debt are two important components, and that China received pleas from both sides of the Atlantic, it is worth comparing the investment option.

1. Which economy is recovering fastest?

Analyzing economic fundamentals is always the first step in making a right investment decision. Strong fundamentals include continued GDP and employment growth. In a recent report the Organization for Economic Cooperation and Development updated its estimates for US GDP growth next year to 1.8 percent but greatly lowered its GDP growth forecast in the euro area to 0.3 percent.

Also, in the US, moderate job growth is forecast to continue, and the unemployment rate is forecast to fall from its current 9 percent to about 8.5 percent next year. The euro area's unemployment rate was 10.7 percent in September, compared with 10.1 percent in August and 10.1 percent in September last year. There is no sign that the rate will improve next year. Unemployment rates for Spain and Greece were 22.6 percent and 17.6 percent respectively in September.

2. Which economic authorityis quicker in policy responses to crises?

The causes and strengths of financial crises often vary for each particular economy. However, one key issue in controlling crises is authorities' speed of policy response. If the response is too slow, a small crisis may become a disaster. In April 2007 New Century Financial, the largest US subprime lender, filed for Chapter 11 bankruptcy. A subprime mortgage crisis began. In the next few months the Federal Reserve and the US Treasury quickly took action to ease the crisis. Just four months later president George W. Bush announced a bailout of US homeowners unable to pay the rising costs of their debt. In the next few months the US Congress passed a historic bailout bill and President Barack Obama signed the Emergency Economic Stabilization Act, creating a $700 billion Troubled Assets Relief Program to buy failing bank assets.

The policy responses to the crisis by euro zone authorities were significantly slower. That slow reaction resulted in the crisis widening and increased the costs of containing the damage.

3. Which one is more capable of handling a crisis?

Modern market economies always run with uncertainty and crises. The real problem is not whether a crisis comes or how severe it is, but how capable the authorities are in dealing with it. The US, with its financial influence in the world economy and its dollar's dominant role, has a higher degree of tolerance of its own debts and stronger ability to control a crisis than does the euro zone. In the case of a financial disaster like the subprime mortgage crisis, the US can directly use federal fiscal spending to support its rescue package, and the central bank, the Federal Reserve, is well capable of digesting national debts.

The US has a unified financial system to ensure its national debts are manageable. A so-called US sovereign debt crisis is virtual rather than tangible. Even if serious political differences exist in the US, the parties are there to serve one nation and are willing to make concessions, rather than cashing in on debt problems for political ends.

However, to resolve the debt crisis in Europe, in the short term every country, in its national interest, must make sacrifices. In the long term, Europe must establish a unified treasury that prepares the euro zone's budget. The difficulty is that this change will directly affect national sovereignty.

The euro zone debt crisis has deep roots in its structure, in which there is a single central bank with a unified monetary policy but many treasury departments with diversified fiscal policies and soft budget constraints. The EU's Stability and Growth Pact requires that in each euro zone member state the deficit must not exceed 3 percent of GDP and its public debt must not exceed 60 percent of GDP. However, among the EU's 27 member states 20 have violated this provision. Many larger members have consistently run deficits substantially in excess of 3 percent, and the euro zone as a whole has a debt percentage exceeding 60 percent deficits.

Greece's deficit and public debt to GDP ratios are 13.6 percent and 130 percent, respectively. Europe is not that large, but the situation for each country is very different. Germany has an energetic economy, France has a strong middle class, Greece has for long time lacked international competitiveness, with a large, inefficient government work force, Spain faces its most serious real estate crisis ever, Italy's ageing population is growing and growth is weak, and Sweden has the highest welfare spending in Europe. Because there is a single central bank, once they run into financial trouble, the only available tools are fiscal instruments. Decentralized and unbalanced budgets have limited the euro-zone's ability to cope with the euro zone crisis as a whole.

In summary, as an investment choice the US gets the nod over Europe, at least before a unified euro area financial system is established. So it seems that China ought to continue investing its foreign exchange reserves in the US.

However, the above analysis is based on a pure investment consideration. That is, China's investment decision sticks closely to so-called basic principles concerning portfolio management (i.e. safety, liquidity and value appreciation) with an emphasis on safety.

Moreover, it is assumed that China is an exogenous variable (or independent variable). Under this assumption, China is outside the world economic system: China's investment decision will affect the world economy, and the world economy will not affect China. In fact, China is no longer an exogamous variable but an endogenous variable in the world economic system after more than 30 years of reform and opening up.

The question is not where the better investment place is for China but whether China will be hurt economically if it does not invest or continue to invest in the euro zone and the US in this integrated global economy.

The author is an associate professor at the University of Maryland. The views expressed in the article do not necessarily reflect those of China Daily.

(China Daily 12/16/2011 page8)