Exclusively from Michael Pettis’ newsletter:
There is little chance that any BRIC rescue is likely to happen, and if it does, it would be bad news for Europe, not good.
…My guess is that nothing will happen except a few token gestures aimed mostly at generating positive headlines and boosting confidence. Why? Because if Germany, with its superior understanding of the politics of the EU and greater dependence on European demand, while enjoying the benefits of information asymmetry, is not willing to buy Spanish and Italian bonds, it would be pretty foolish for the BRICs to step into the breach, and the BRICs pretty much know this. Their idea of “helping” Europe, I suspect, consists of buying German bonds, not those of Italy and Spain.
In which case how does it help? Not a lot, and in fact it will make things worse for Europe. This is because more foreign investment will not help Europe. Local governments, it turns out, are suffering from a classic case of skewed incentives, in which actions that benefit individual players like the governments of Spain, Portugal or Italy in the short term may hurt Europe as a whole.
Why won’t BRIC purchases help those countries overall? In the short term it would seem that a country having trouble funding itself at manageable interest rates should welcome any major new investor no matter his provenance. Every large buyer is a valuable resource, especially if it is large enough to restore confidence to the markets and spur other investors.
But we have to remember that foreign investors are not the same as domestic investors. Any net increase in foreign purchases of euro-denominated local government bonds has an impact far beyond the short term funding impact. It also affects the trade environment.
This impact is an automatic consequence of the way the balance of payments works. Today Europe runs a current account surplus. By definition this means that far from being starved of capital, European savings exceed European investment, and it exports the excess to the rest of the world.
In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.
Foreign money does not solve the credibility problem. What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.
How would this happen? There are many ways, but the most obvious is that as foreign central banks sell large amounts of dollars to buy euros, the euro strengthens against the dollar. As this happens, European manufacturers become less competitive globally and their exports drop.
This would cause a rise in European unemployment as those manufacturers are forced to fire workers. It would also cause total European savings to decline as total production drops more quickly than consumption. Remember that savings is simply the difference between production and consumption. In other words as more foreign savings enter Europe, one consequence might simply be less European savings, which is hardly likely to resolve the solvency problem.
Of course there are other ways Europe could adjust. Europe could prevent a rise in unemployment if all of the new foreign funding was used to fund direct investment. Every dollar given to Spain by the BRICs, in other words, would have to be matched by a one-dollar increase in Spanish infrastructure spending. Might this happen? Of course not. Given the need for transfer and welfare payments, it is very unlikely that Spain in this example would transfer the additional money to a new investment project, and anyway if it did it would not solve the original problem of selling bonds to finance its day-to-day needs.
There is a third way. As workers are fired because the European manufacturing sector becomes less competitive, European governments could borrow even more money to cover the transfer payments or otherwise give them jobs. This is really just a variation on the above, but the conclusion is a little different. It suggests that any net increase in foreign purchases of European bonds will be met by a more-or-less equivalent increase in the amount of government bonds issued. This, of course, does not help Europe in the aggregate, although it may temporarily help the governments issuing those bonds.
As the above cases show, the increase in foreign investment would simply be matched either by an equivalent reduction in domestic savings or an equivalent increase in domestic debt to counteract the rise in unemployment. Rather than ease the burden, in other words, foreign investment simply replaces domestic savings, undermines the manufacturing sector, and raises unemployment or debt. The BRICs, in other won’t help Europe by buying Italian bonds. They will simply help the Italian government at the expense of Europe generally.
So is there any way the BRICs can help? Yes, there are two ways, one cynical and the other not so cynical. If it is certain that Spain, Italy, Portugal and so on will default, BRIC purchases can be matched by European purchases of US government bonds. This will eliminate the currency impact and leave unchanged the various capital and current account imbalances – although at the expense of a large negative carry. But, when the issuing government defaults, a portion of the cost of default will be borne by the BRICs. Clever, right? Unfortunately the BRICs are probably fully aware of this risk.
The second way that the BRICs can help is by funding direct investment in infrastructure and manufacturing capacity throughout Europe. If the infrastructure is economically viable, European wealth will grow faster than European obligations to the BRICs and everyone can be better off. Of course this solution eliminates the possibility that the BRICs will simply buy government bonds.
One way or the other I am unable to see any way in which Italy’s great hope of Chinese bond purchases can leave Europe better off. It is easy nonetheless to see why desperate governments welcome official money from the developing world with their trillions in reserves. European savers are increasingly refusing to provide financing, and so any alternative source of funding is seen as a godsend.
But we must remember that although the afflicted European governments will benefit in the very short term from the help of foreign investors, the adverse impact on European manufacturers and on European savings overall more than makes up for it. An increase in foreign funding creates slower growth and, with it, the need to increase fiscal deficits in order to prevent a rise in unemployment.
Turning to foreign sources of capital will only aggravate the problem from which Europe already suffers. Even assuming that developing countries are willing to take on risks that Europeans find prohibitive, their help will not improve prospects for Europe. On the contrary, it will hurt growth prospects and make the ultimate resolution of the debt crisis more difficult than ever. BRICs should be exporting more demand, not more capital.
It is important that the desperate short-term funding needs of certain governments do not lead to an overall worse outcome for Europe. If Europeans do not want to fund credit-impaired European governments, they should not ask foreigners to do so. Slower growth and foreign debt will not help resolve the problem of insolvency.