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The headlines driving markets in recent minutes is a rumor about Italian officials talking about bond purchases with China.  The media of course will hold China up as though they are some white knight riding in to save these failing European nations.  But make no mistake – that is not even remotely close to the truth.

On the one hand, China can “help” ease the strains in the Eurozone by buying bonds of various periphery nations.  This helps kick the can in the debt game, but does NOTHING to solve it.  We know this because we’ve already seen this movie once before.  China made waves last year when they announced a firm commitment to buy Greek bonds.  Of course, this announcement soothed markets for a few months and then the underlying trends took hold again and we all know what’s going on in Greece today.

You see, what happens when China commits to buy Eurozone debt is that they are actually targeting the exchange rate.  It’s no coincidence that the easing fears in late 2010 with regards to Greek/China debt buying ultimately led to a sizable rally in the Euro.  Make no mistake, this is an attempt by the Chinese to push the Euro higher and maintain what China views as a favorable exchange rate with EMU nations.  China doesn’t want to see the Euro collapse versus the Yuan and they will do everything in their power to make sure that doesn’t occur.  So, when foreigners accumulate Euro financial assets they are essentially driving import growth to the Eurozone.   This actually reduces Eurozone aggregate demand and adds to the debt deflation we are seeing there.  Buying the bonds helps soothe fears of credit contagion, but it in no way solves the problem of too much aggregate debt.  Instead, it helps kick the can as the austerity measures instituted by the EMU will continue to cause the negative debt trends to deteriorate.  This is exactly what we saw in Greece after China committed to buy their bonds last year.

China is no white knight here.  They are trying to save their own skin.  And who can blame them?  They don’t want to be sucked down the global tubes due to the construction of a flawed monetary system in the EMU….

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