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China helps take pressure off euro

Spain, Portugal and Greece -- three of the eurozone's most financially shaky members -- in recent months have touted a lifeline thrown to them by China: a promise to buy these countries' embattled bonds.

The pledges from the government in Beijing temporarily took some pressure off European debt markets, but China has been quiet on how much money it will actually invest. What is clear is that China has an immense interest in helping the eurozone, its biggest trading partner, out of its current woes.

On Wednesday, Spain signed more than a dozen business accords with China, two days after Vice Premier Li Keqiang wrote in daily El Pais that his country will keep on buying Spain's public debt as a show of support.

That follows similar deals and promises from China for already bailed-out Greece and Portugal, seen by many as the next weakest link in the 17-country eurozone.

Europe has been fighting a bruising battle to keep its currency union together. But a euro110 billion rescue loan for Greece and the euro67.5 billion bailout of Ireland have failed to erase fears that mounting debts in several member states might be too much for the struggling eurozone and could eventually even endanger the euro.

A deepening crisis in Europe or a meltdown of the euro -- which already appeared to be in a state of free-fall last spring -- would hurt China, now the world's second largest economy and holder of massive foreign currency reserves, most of it in U.S. dollars.

Beijing believes that a stable global economy needs at least two lead currencies, and China has already invested heavily in European government bonds to prop up the euro as a viable alternative to the dollar, says Vanessa Rossi, a senior research fellow at Chatham House in London.

Much of China's clout come from its large trade surplus and the savings that result from it, a sharp contrast to the debt woes of some of Europe's governments. Rossi estimates that of China's massive $2.5 trillion foreign exchange reserves, close to $1 trillion are holdings in Europe. That's still far behind the $1.5 trillion invested in the United States, but would imply that China on average now holds about 10 percent of eurozone government debt, says Rossi.

Any new promises to buy bonds come on top of significant existing investments, and are mostly meant as a "psychological support" for the euro, says Rossi.

Yet psychological support is significant, as more confidence in government bonds means lower interest costs when indebted countries borrow and could help prevent a death spiral in which rising borrowing costs feed default fears and end with the country unable to borrow -- and needing a bailout.

Beijing's interest goes beyond the stability of the euro. A deep or prolonged economic depression in Europe -- a possible consequence of a breakup of the eurozone -- would hurt China, which sells about 25 percent of its exports to the continent.

Greece, Portugal, and Spain are relatively small in terms of trade. But their collapse could hit Germany, which gobbled up some euro29 billion in Chinese exports in the first 6 months of 2010, while supplying the Peoples Republic's elite with luxury cars, industrial investment and technologically advanced goods.

China's recent deals with Europe's weaker members also include investments in key sectors such as ports and telecommunications -- investments that other countries have been reluctant to allow.

Indirectly tying support on debt markets to other business accords presents China with "a dream opportunity to hammer out some lucrative business deals," says Jonathan Holslag, a research fellow at the Institute for Contemporary China Studies at the University of Brussels.

Once a country has advertised Beijing's help with its bonds, it becomes much harder to say no to other investments, says Jean Pisani-Ferry, the director of Brussels-based think tank Bruegel.

Some analysts are worried that financial help might come at a political cost.

"For a lot of smaller member states we have already seen that there was growing pragmatism relating to China," says Holslag.

Portugal and Spain have supported China's demand to be granted market economy status, while Greece, Italy and others have been pushing the EU to drop its arms embargo, which was imposed after the 1989 massacre on Tiananmen Square.

When the EU's High Representative for Foreign Affairs Catherine Ashton prepared a report on the bloc's relations with China, "the member states that had a lot of financial problems took a very kind position on all issues," says Holslag. "It was really the first indication that the growing economic dependency on China is having some impact."

It's not that China is necessarily asserting direct pressure on these governments. "It's more subtle than that," says Holslag. "The deeper the economic cooperation with European member states, the more favorable will China's position be viewed."

Others are not convinced that China is really putting its money where its mouth is and that it's real interest is not in helping out the various Europeans in their battles with the bond vigilantes, but in staving off relentless political pressure from the U.S.

Lutz Karpowitz, a senior foreign exchange strategist at Commerzbank in Frankfurt, says China knows it has to allow its artificially depressed currency -- the yuan -- to rise against the dollar to get lawmakers in the White House and Congress off its back, but would much rather do it in the context of a falling dollar.

If other currencies such as the euro rise, China needn't lose out as the yuan's value would stay more or less the same on a trade-weighted basis.

"This is all a lot of political talk," says Karpowitz. "They don't care about Portugal or Greece and I'm not sure they're particularly interested with the Spanish reforms."

China has increasingly become an easy target for U.S. politicians as the country's unemployment remains stubbornly high. While the U.S. continues to run up a massive trade deficit, China is reaping massive surpluses as its industrial might gets stronger by the day.

Under a free-floating environment, economists say the yuan would rise in value against the dollar in these circumstances. The problem, at least as seen in the U.S., is that it hasn't because the Chinese authorities want to keep their currency depressed to continue its export-led growth.

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