Good News From China Is Not All It Seems For Bonds

15 September, 2011

China to the rescue, yet again. News in Tuesday’s Financial Times that Italian officials hope that China will buy government bonds from Rome prompted an outbreak of déjà vu among market participants.

Recurring headlines are rarely good news in the eurozone debt crisis as a spate of denials that a country is in trouble has often been followed by news the country will take a bail-out. Similarly, China’s interest in peripheral eurozone countries has done little to help them.

Both Greece and Portugal received strong public support from China and tried to sell debt to Beijing but subsequently succumbed to the need for international rescues.

Spain is the one country not to need a bail-out after hearing soothing words from Chinese officials. But its descent towards a rescue was only checked by the European Central Bank buying, not Beijing.

“If the Chinese bought as much in euros as words were written about them for Portugal, Greece and Spain then we would all have been better off. But I find it very surprising for China to step into this mess and buy bonds at the moment. Real assets maybe, but I can’t see the point of buying eurozone bonds,” says Gary Jenkins, head of fixed income at Evolution Securities.

Still, the story that the chairman of China Investment Corp led a delegation to Rome last week for talks with the Italian finance minister and other officials does raise some serious issues. One is about the general lack of buyers for many peripheral eurozone government bonds, as shown by a disappointing Italian auction on Tuesday: who is the buyer of last resort?

The market would love it to be China. Its name is certainly bandied about when any international crisis breaks out. CIC was part of a Bank of America consortium that was in discussions to buy Lehman Brothers in the dramatic weekend before the investment bank collapsed in September 2008.

Its role in the eurozone debt crisis has been only slightly more concrete. In January 2010, Greece tried to sell up to €25bn in government debt to the Chinese in a deal that never materialised. Its yields continued to rise until it was forced to accept an international rescue in May 2010.

It was a similar story in Lisbon. At the end of last October, Portuguese and Chinese officials talked of how interested Beijing was in buying Portugal’s bonds. The stance was confirmed during a state visit by Hu Jintao, the Chinese president, the following month to Lisbon.

In a final display of support, China reportedly was the buyer of a €1bn private placement Portugal issued in January 2011, shortly before a crucial bond auction.

But all the moves had little effect, with Portuguese yields rising continually until its bail-out this May.

“The Chinese have turned up on these quite strategic occasions,” says Jens Larsen, European economist at Royal Bank of Canada, pointing to the leak of the Italian story just before a debt auction. “But whether it materially matters is another issue. I don’t think personally it will help Italy. But the context is one where you see China being much more confident in international financial diplomacy.”

The last country China helped out, more openly than the other two, was Spain. It bought bonds from Madrid in the summer of 2010 and announced a slew of investments in Spain in January of this year. The most effusive comments came in April when premier Wen Jiabao called Spain “China’s best friend in Europe”. Yet none of this stopped Spain’s yields tracking higher both at the end of last year and this summer before the ECB stepped in.

The problem for many in the market is that, without China, the buyer of last resort remains the ECB, which is “reluctant and divided”, according to Mr Jenkins. He adds: “Normally you would invest alongside the central bank but you don’t know how long they will be buying for.”

The ECB remains keen for Europe’s temporary bail-out vehicle, the EFSF, to take over bond buying as soon as possible but it can only do so once all 17 eurozone countries have approved the deal.

Some investors have even suggested that the Swiss National Bank could buy Italian debt rather than German or French debt as it does currently with the euros it holds as part of its efforts to weaken the franc. They argue that this would support the euro far more than buying Bunds. But Alan Ruskin of Deutsche Bank dismisses the idea: “They have got an awful lot of exchange rate risk so why introduce credit risk?”

All this explains why markets would lap up big purchases from China: the ECB “is close to being the only buyer of size” in Italy, as Mr Larsen says. Finding other big buyers quickly will be crucial to avoid another eurozone conflagration.

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Good News From China Is Not All It Seems For Bonds

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