Analysis - China's support for euro a necessity, not a virtue

An employee counts Euro notes at the Bank of Taiwan head office in Taipei May 10, 2010.

BEIJING (Reuters) - A record surge in Chinese currency reserves serves as a timely reminder that its pledge to buy bonds from indebted European states makes a virtue out of a necessity.

So much has been made of Chinese promises to buy Spanish and Greek debt that somewhere along the way it was forgotten that euro investments are nothing new for Beijing.

A $199 billion (£126 billion) jump in China's foreign exchange reserves in the final three months last year, the most ever for a quarter, dictates that it would need to put upwards of $15 billion a month into European assets just to maintain its current portfolio allocation.

China has been working for years to diversify its official currency reserves, which now sit at a record $2.85 trillion, and the euro has been the primary alternative to the dollar, taking an estimated 25 percent, or about $710 billion.

"We will over the medium term continue to diversify our FX reserves, but as reserves increase, U.S. assets will still form the principal direction for our investments," said Zhang Ming, an economist at the Chinese Academy of Social Sciences, a top government think-tank in Beijing.

"This is the only feasible option," he said. "There are

still too many risks in Europe."

Europe is hardly alone. Other countries have also seen a marked rise in Chinese cash inflows over the past year as Beijing scours the earth to find a home for its bulging reserves.

It has bought record amounts of Japanese and South Korean debt, and has also reportedly dipped its toes into Brazilian, Canadian and Australian issues.

Given a 25 percent allocation in euros, the overall rise in China's reserves last year implies that it parked some $100 billion in European assets during that time, with the pace of investment increasing sharply in recent months.

SAFETY FIRST

Insofar as China looks to prop up indebted European countries, a former adviser to the central bank said that it should buy jointly guaranteed euro zone debt rather than bonds issued by troubled member states such as Spain and Portugal.

"In principle we support the euro, but we also need to ensure that our investment is safe and generates returns," Yu Yongding, an influential economist, told Reuters.

"I think it's much safer if we buy the fund as it has a triple-A rating," he added.

While great globs of Chinese cash will likely end up in German Bunds, the riskier fare will receive only small dollops.

The 6 billion euros of Spanish debt that China has promised to buy, according to Spanish daily El Pais, would amount to a mere 0.27 percent of China's total reserves.

Beijing is extremely reluctant to disclose details of any specific investments, wary of the domestic anger that has flared up at times over the wisdom of storing so much wealth in dollars.

Unsurprisingly, official Chinese media has pedalled a message of restraint at home about the move into European bonds.

"It is good to invest in Europe, but the reality for our country is that we cannot go and solve the problems of the Europeans," said a commentary in the overseas edition of the People's Daily, the newspaper of the ruling Communist Party.

POLITICAL ECONOMY

Unofficial estimates described by a senior EU official as credible suggest that China already holds more than 7 percent of the 8.8 trillion euros in outstanding euro zone public debt.

Some of that has no doubt seeped into the more fragile corners of the single-currency zone. And to what effect?

"China was presumably already buying a significant amount of peripheral government bonds last year and yet this has not prevented their yields from rising sharply, let alone done anything to tackle the much deeper structural problems in the euro-zone," Julian Jessop and Mark Williams of Capital Economics wrote in a note last week.

When Vice Premier Li Keqiang toured Spain last week, as when Premier Wen Jiabao visited Greece last year, China calculated that it could use its euro investments to garner at least some political goodwill.

Beijing is probably not looking for anything specific in exchange, but hopes these friendly gestures will nudge the European Union in the direction of granting it "market status," toning down criticism of its exchange rate regime and cancelling a ban on weapons sale.

"Don't think for a moment that China would not use the bonds to achieve political aims if the need arose," said one China-based European diplomat. "At the very least we are a step closer towards the EU lifting its arms embargo."

But the crux of China's strategic ambition is far simpler than that.

"We don't want to see the euro disappear," Xia Bin, an academic adviser to the central bank, told Reuters.

(Additional reporting by Zhou Xin, Kevin Yao and Ben Blanchard; Editing by Ken Wills & Kim Coghill)