China has done an about-face over European debt, writes Ambrose Evans-Pritchard.
China has expressed deep alarm at the escalating crisis in Europe and warned against austerity overkill as Europe's crumbling demand sends shockwaves through Asia.
The Premier, Wen Jiabao, told the German Chancellor, Angela Merkel, that Europe must "strike a balance" between fiscal tightening and measures to promote growth. "Europe's debt crisis has continued to worsen, giving rise to serious concerns in the international community. Frankly, I am also worried," he said.
His comments mark a shift in Chinese policy. Beijing has until now backed austerity across the eurozone but the severity of China's own downturn has begun to rattle policymakers.
Exports of electronic goods to Italy crashed 43 per cent in July from a year earlier, and sales to Germany fell 11 per cent. Caixin reported that processing trade to Europe fell 21 per cent.
The country's two largest shipping groups, COSCO and China Shipping, both reported drastic losses on Thursday. The Shanghai composite index of stocks threatened to break below 2000, the lowest since the Lehman crisis. Mr Wen asked for clarification over whether Italy and Spain would adopt "comprehensive rescue measures" needed to unlock the EU bail-out machinery - and open the door to bond purchases by the European Central Bank.
Dr Merkel said eurozone debt remained a "safe investment". Yet it is far from clear whether China can come to the rescue. Simon Derrick from BNY Mellon said China's foreign reserves peaked at $3.31 trillion in February, and have since fallen by over $100 billion. "China is no longer in the market to buy bonds," he said.
Morgan Stanley said there were signs of incipient capital flight from China. The yuan has fallen almost 1 per cent since April, and offshore markets are pricing-in further falls over the next year. The risk for Europe is that China could become a net seller of European bonds if forced to run down reserves to shore up the yuan.
Germany has reasons of its own for going easy on Club Med austerity. The policy has finally begun to boomerang, with German exports falling by 14 per cent to Spain and 8 per cent to Italy.
David Owen from Jefferies Fixed Income said Germany's IFO business climate index has fallen to levels that normally mean recession. "Germany is not falling off a cliff but the confidence numbers are as bad as the UK. We see a high risk of contraction this quarter and next," he said.
Professor Lars Feld from Freiburg, one of Germany's five "Wise Men", warned that euro break-up had become a "relatively large risk" and rebuked hard-line German politicians for "populist outbursts" over recent days. He said an ejection of Greece from the European Monetary Union would set off a "domino effect" through the EMU periphery, slicing up to 10 per cent off German gross domestic product.
"The markets would promptly ask whether Spain can make it in monetary union," Professor Feld said.
He said it was a mistake to rely on the ECB to save the day by buying bonds. The proper solution is a debt redemption fund that eases the debt burden for struggling states, but only under stringent conditions.
German unemployment has been creeping up for five months. Carsten Brzeski from ING said August job data has been the worst since 1993. "The resilience of the German labour market is cracking up," he said.
The bank said EMU confidence data is back to Great Recession levels. "Sustained fiscal austerity and the 'muddling through' approach to the crisis is taking its toll," it said.
The eurozone picture is not entirely bleak. Data collected by Simon Ward at Henderson Global Investors shows that a crucial gauge of the M1 money supply - real six-month M1 growth - has been rising for three months. The figures are a leading indicator of industrial output six months ahead, pointing to tentative recovery later this year.
Germany's money supply may soon be expanding too fast for comfort. A Bundesbank study shows that Germany's broad M3 money has grown at 11.4 per cent over the past six months. German exporters remain super-competitive. The long-term risk is that any policy designed to nurse southern Europe through the crisis will automatically cause Germany to overheat later.