Debt crisis hits beyond Europe

The European Union is troubled by its debt problem. This may have negative effects on EU-China relations.

Shrinking of domestic demand and a rise of protectionism in Europe, along with high unemployment and calls for more flexibility in the renminbi exchange rate will likely put a strain on China's exports to the EU.

They can work to build international rating agencies together and encourage more direct investment in Europe from China, which will benefit both sides.

The EU and China are important economic partners, and economic issues are central to EU-China relations. The EU is China's biggest trade partner and export market, and China's second largest source of foreign direct investment. China is the EU's second biggest trade partner after the United States.

The debt crisis in Europe has had a big impact on Sino-European relations. High unemployment and tightening measures are reducing domestic demand, which means a fall in imports from China.

Apart from diminishing demand, the European debt crisis has also put pressure on the euro. A weak euro comes as some comfort for EU countries, but it will also add pressure on China's exports. A weaker euro means a comparatively stronger renminbi, which will dent the competitive advantages of China's goods in the European market.

A pessimistic economic outlook and high levels of unemployment may foster protectionism in Europe, which is already beginning to become apparent because of the financial crisis. All of these factors will put a strain on bilateral economic relations.

EU-China relations had been expected to recover after the turbulence from Nicolas Sarkozy's meeting with the Dalai Lama during the Beijing Olympics in 2008. But during the EU-China summit held in Brussels in 2010, the EU put more pressure than ever on China about the trade deficit, market access and the renminbi exchange rate.

Both Europe and China are victims of the US financial crisis in 2008. To fix the debt issue and avoid similar crises in the future, closer cooperation between the EU and China would make sense. The current difficulties present an opportunity to enhance the EU-China comprehensive strategic partnership.

One possibility is to build a new international rating agency together. The rating agencies have played a major role in the debt crisis. Since the US dominates the ratings market, other major powers, including Europe and China, have little influence.

One of the lessons of the European debt crisis is that the US dominance of the ratings market can expose other countries to risk. After the European debt crisis, both Europe and China have been seeking to establish or strengthen their own rating agencies. So far they have been doing so separately and with difficulty.

The debt ratio as a percentage of GDP in the US is much higher than the average European level, but there is no debt crisis in US. Moreover, treasury bond yields are much lower than in Europe, so the US is able to raise money more cheaply. This is partly because US credit is under the protection of the rating agencies. Without help from rating agencies, the credit of the US government might be downgraded because of its high debt level. If the US credit rating was downgraded, the yield rate of treasury bonds would have to increase.

Since US debt is more than $14 trillion, the extra interest payments could be enormous. The US government, therefore, will not give up the rating hegemony easily. Furthermore, the US rating agencies have a long history and enjoy a dominant position in the international market. It is hard for other rating agencies to enter this market.

Another opportunity for increased EU-China cooperation is China's direct investment in Europe. As its economy continues to grow and its foreign reserves accumulate, China has become a capital-surplus economy and its overseas investment is growing fast. However, Chinese investment in Europe is still relatively insignificant. China accounted for only 1.2 percent of foreign investment in Europe in the period 2004-2006, similar to South Korea but behind India.

European suspicion of Chinese investment was the main reason for this. In Europe, it was believed that Chinese investments were made by State-owned enterprises, which have a close relationship with the government. Many people in Europe were concerned that China sovereign funds and SOEs were vehicles that could allow China to gain control of valuable financial and industrial assets in the West. European governments have therefore laid down strict conditions for investment from China.

European's concerns over Chinese investment have been exaggerated. Research suggests that large SOEs play only a limited role in China's outward investment in Europe. The decision to invest rather than export is sometimes precipitated by actual or threatened protectionism in major markets.

Liu Mingli, Wang Li and Zhang Zhixin are scholars of China Institutes of Contemporary International Relations, respectively working at Institute of European Studies, Institute of World Economics Studies and Institute of American Studies.