29 October 2011

Risky Chinese Loans for EFSF

Mr Klaus Regling, the chief executive of the European Financial Stability Facility, met with Chinese government officials to discuss how best to structure the EFSF to attract money from China.

EFSF may consider issuing bonds in yuan if China approves of the arrangement.

Is this a wise move?

What about foreign exchange risk?  Many people in the US and elsewhere believe that the yuan is unfairly undervalued by as much as 40 per cent and have been trying to get China to allow the yuan to appreciate.

Presumably, EFSF bonds are medium- to long-term, so even a gradual appreciation of the yuan will place a very heavy burden on EFSF eventually.

Over the past several decades, many countries had accepted yen-denominated loans at concessionary interest rates from the Japanese government to help them in developing their economies.  However, when the yen appreciated over the term of the loans, these borrowers suffered huge losses if they had not hedged their currency exposure or they did not have a natural currency hedge. In many cases, the loss on exchange more than offset the benefit from the concessionary interest rates.  Fortunately for some of these borrowers, the Japanese government magnanimously absorbed some or much of the exchange loss inasmuch as the loans were meant for economic development of the recipients.

Will EFSF make the same mistake as those borrowers?

Furthermore, if EFSF hopes to attract US$200 billion from China, that's a lot of yuan for EFSF to get its hands on in the future when the bonds mature and the principal amount needs to be repaid.  Will it be available?

Finally, what is the political price that EFSF may have to pay to attract Chinese money?  Will China end up being the de facto central bank for the euro-zone, just as it has become the de facto central bank of the US?

Will China insist that European governments stop insisting that the yuan is undervalued?

Hopefully, EFSF is not so desperate for Chinese funds (in yuan or whatever currency) that it will forgo careful consideration of the risks involved.

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Notes

1. Europe Bailout Fund Chief says Yuan Bonds a Possibility The Business Times (29 Oct 2011).

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