William Pesek: World finance shifts on its axis

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It's official: the world economy is completely upside down.

What else is one to think as Europe goes hat-in-hand to developing China and feeble Japan? You would think China had better things to do with its cash than shore up a sinking euro zone. The same goes for Japan, where deflation and paralysis may soon deliver the sixth prime minister since September 2007.

Japan plans to buy bonds issued by Europe's financial-aid fund, joining China in assisting a region battling a fast-spreading debt crisis. And does Europe ever need the help.

Bailouts of Greece and Ireland just pave the way to even bigger ones of Portugal, Spain and, perhaps, Italy.

It's this last economy that should have officials in Beijing and Tokyo thinking twice about loading up on European debt. Yet here's something even bigger to consider: what the world really needs isn't China's and Japan's excess cash, but more balanced and sustainable growth in Asia's main economies.

Europe's debt woes are just beginning. No matter what the region's policy makers do, they're still stuck with a currency they can't devalue and massive and growing debt loads. Buying Europe's debt may bandage things over, but China and Japan can't stop the inevitable worsening of the euro crisis.

Consider this a "We-Are-the-World" moment. Japan, flush with more than US$1 trillion of reserves, also is thinking as much about diplomacy as economics. Helping Europe in its time of need will score points for a nation losing power and prestige.

Japan's aid seems more of a me-too gesture to match China than a long-term strategy.

It doesn't seem like a huge risk, either. The European Financial Stability Facility will raise as much as €16.5 billion to help bail out Ireland. It plans to issue between 3 billion and €5 billion of AAA-rated bonds this month, of which Japan may buy more than €1 billion. As Europe's debt mess worsens, though, Japan's investment may go bad in a hurry.

Rather than tossing money around, Japan should get busy reviving its economy once and for all. It should act boldly to encourage entrepreneurship, learn to live without huge government borrowings and zero interest rates, increase immigration, raise productivity and boost competitiveness.

Japan is doing none of the above, and that's detrimental to the outlook for world growth. At least Asia's second-biggest economy isn't spreading contagion around the globe in the manner of Europe. A few more years of muddling along and avoiding reform, though, could put Japan in dangerous waters.

The nation's bond market has long been a financial pressure cooker. Even though public debt is twice the size of the economy, 10-year bond yields are less than 1.2 per cent. It makes no fundamental sense, even in an economy facing modest deflation. The risk of a Japanese debt meltdown looms. It's imperative that Japan learns to grow without adding debt.

China, meanwhile, should close the chequebook and instead fix imbalances that destabilise markets. The first step is faster yuan appreciation. China shouldn't do it because the United States is demanding action, but because it's in China's interest.

Surging food and oil prices will exacerbate overheating risks.

A big yuan revaluation would help officials in Beijing regain control, while raising the international purchasing power of 1.3 billion people. It's great that China is voicing support for Europe and backing it up with bond purchases. It would be even better if China restructured on its own.

China's financial might is a product of its US$2.8 trillion of currency reserves. We're long past the late 1990s when the International Monetary Fund's vault contained enough liquidity to save countries from ruin. Should Spain come knocking, bigger benefactors will be needed. Yet Asia's savings won't be enough if a key economy like Italy crashes.

It's no longer debatable whether the global financial system is upside down. The shift began with the realisation that economies such as China, India and Brazil might eclipse the US in the next 30 or 40 years. It got positively tectonic when the savings of developing nations began shoring up economies once viewed as role models.

Things have gone full circle now that China, a nation struggling to eradicate poverty, is being looked upon to act like some massive bond insurer for the euro zone. The same goes for Japan, which has more than its fair share of budding crises and too much debt of its own.

It's not surprising officials in Europe would look to Asia for help. It is, after all, where the money is.

What would help even more is for Japan and China to get their economies in order. Sadly, neither is.

- BLOOMBERG