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How to Survive Inside China’s Financial System

Uh-oh. This is not how it works. This is not part of the plan. Central banks print money, and then the markets go up. Not this time though…

Late yesterday, the European Central Bank cut its official interest rate by 25 basis points, to 0.75%. The Bank of England announced they would print another £50 billion, while the People’s Bank of China (PBoC) got in on the act as well, cutting interest rates for the second time in a month.

Usually, such co-ordinated action would lead to a share market rally. Instead, markets fell slightly. Perhaps investors have finally realised that falling rates are a sign of economic stagnation? Or perhaps they’re just waiting for the big daddy, the Federal Reserve, to ‘do something’ before embarking on a mindless rally.

The co-ordinated announcement bears thinking about. Was it meant to provide a message of central banking solidarity? Or was it done in the hope of obscuring the ugly realities of the underlying economic activity in each of these regions?

The UK has the LIBOR scandal which threatens to bring down the banking establishment. Europe is back where it finished last week – with bond yields again soaring in Spain and Italy. So much for last week’s rescue…

And what about China’s economy? We discussed the country’s problems in detail this week. Those problems might just be a little worse than expected. The PBoC’s latest official rate cut was completely unexpected. The bank lowered the lending rate 31 basis points to 6%. It lowered the deposit rate by 25 basis points to 3%.

This is an interesting move. It comes ahead of a bunch of economic data releases by the Chinese statisticians. The big one is the economic growth data, due for release in world record time next week. China somehow comes up with its economic data less than two weeks after the end of the quarter.

The fact that the PBoC eased monetary policy ahead of these conditions suggests the forthcoming data will be poor. Interestingly, the Bank eased policy with conditions attached. It told financial institutions to, “continue to suppress speculative investments in housing”.

The PBoC clearly wants it both ways. It’s still operating under the illusion that it can control the flow of cheap credit. It thinks lower interest rates will stimulate spending but it doesn’t want to reignite the housing bubble.

It needn’t worry. Burst credit bubbles never reinflate, no matter how hard you try. Just ask the Fed. They tried to put air into the burst NASDAQ bubble in 2000. But the credit flowed into housing. Then, when the housing bubble burst, they tried to reinflate that market. That policy didn’t succeed either. It just pushed up the price of financial assets and handed gains to speculators.

So here’s a newsflash China – your attempts to engineer a soft landing for your distorted economy will not work. Your actions will bring unintended consequences and cause other problems. You can’t unleash a credit boom of epic proportions and expect to contain the damage.

Check out the chart below. The last time China embarked on a rate cutting cycle was in 2008/09. That wasn’t exactly a good news story and it won’t be this time either. The market knows it too, which is why it didn’t greet news of the rate cuts with the usual enthusiasm.

PBOC interest rates setting

Source: alsosprachanalyst.com

And as we mentioned yesterday, China’s financial system is different to the West. It doesn’t have a household sector saddled with debt. So the effects of interest rate cuts affect the economy differently.

For example, China’s social infrastructure is non-existent. Its citizens don’t feel financially secure. So they save rather than take on debt. And as we also pointed out yesterday, China’s financial system relies on the savings of its citizens.

So what do lower rates do in this situation? There’s an argument to suggest they could be counterproductive. Lower rates could well encourage China’s citizens to save more, making the transition from investment-led growth to domestic demand-led growth even more difficult.

Or lower rates could encourage savers to pull funds out of the banking system. It would perhaps encourage them to seek out a safer store of value. What would that be?

We’ll chance our arm and suggest gold. Gold is like the elephant in the room when discussing China. China absorbs all of its domestic production (around 350 tonnes in 2011). According to the World Gold Council, total Chinese gold demand in 2011 reached 770 tonnes. And that’s only what we know about.

There’s a very high probability China’s gold hoard is much higher than official estimates. The PBoC last provided an update on its official holdings in 2009.

If you are living and working in China and dealing with a repressed financial system (where interest rates after inflation are actually negative) where would you choose to store your wealth? Would you entrust it to a corrupt system that guarantees profits for the banks and their Communist Party owners? Or would you store your wealth in something outside the system, free from counterparty risk?

We know what we’d do. And given gold’s cultural history with the Chinese people, we’re guessing Chinese citizens know what to do too.

But this isn’t the biggest story when it comes to China and gold. It’s much bigger than that. Think about how Chinese citizens might want to protect themselves from their corrupt government. Then apply the same motivation to China trying to protect itself from a rotting Western banking system that survives purely via the creation of more and more debt.

THAT is the real gold story. If you understand it, you understand where the dangers of the next few years lie… and the opportunities. We’ve spent the last few weeks working on a presentation to show you this ‘real’ gold story. It should arrive in your inbox tomorrow. Keep an eye out for it.

Regards,

Greg Canavan
for The Daily Reckoning Australia

From the Archives…

The Biggest Fraud in Economics
2012-06-29 – Bill Bonner

Why India is Buying Gold
2012-06-28 – Greg Canavan

Is the Silver Price Finally Bottoming Out?
2012-06-27 – Tim Staermose

A Giant Game of Currency Chess
2012-06-26 – Dan Denning

An Open Letter to the Fed: What’s Your Number Ben Bernanke?
2012-06-25 – Keith Fitz-Gerald

9 Comments

  1. Ross says:

    Central banks print money and the AUD pops up on queue. There’s no inflation and little domestic stimulus when the money is used to dress extend and pretend balance sheets and then most of it exported in carry trades. They will be working on a plan, just what it is should be giving us the shivers. BIS’s “rebalancing” doesn’t look like the plan.

  2. Lachlan says:

    “Would you entrust it to a corrupt system that guarantees profits for the banks and their Communist Party owners? Or would you store your wealth in something outside the system, free from counterparty risk?”

    The Chinese government openly encouraging it’s citizenry to purchase gold. Is it not in their interest to see their people wealthier if that process does not threaten their own system?. Would our government encourage us to buy gold instead of houses, in fact to regulate openly against housing investment? I believe markets are more stable as they become freer, no doubt at all. The free will of market participants is a stable default situation. With a powerful state we deviate from that more or less. But is not China as a state holding too many aces to be compared to the west? We have all seen how long a can be kicked by a system that has had no collateral and for decades at that. I don’t think China has a lack of collateral.

    Ross do you think the US might declare a national emergency of some sort and devalue while they are at it? Other nations are finding ways around dollars, Chile just recently.

  3. Lachlan says:

    No doubt Greg that China has a debt based monetary system like everyone else and economic activity will ebb and flow with it ie they will have recessions. Are not the problems of the west much greater though? I cannot see the comparison really. The high expectations of westerners alone are a hurdle more than a match for any more tangible parameter are they not?

  4. Lachlan says:

    “Central banks print money and the AUD pops up on queue”
    It’s OK Ross. The RBA can knock it on the head with an open market operation.

  5. Lachlan says:

    They reckon.

  6. Ross says:

    Lachlan, the London City’s viewpoint rag says the RBA might well listen to Cuba :

    http://www.breakingviews.com/china-grows-faster-but-most-cubans-are-better-off/21028481.article

    But, truth be told, the western regimes have been anyway ever since the Bay of Pigs invasion. Cuban corporatism appears to be at the top of the hit parade with western deficit economy regimes and this too is a good fit for China’s regime which is naturally inclined to be along for the ride.

  7. Lachlan says:

    Morgen!
    I’m not so sure Ross. Our politicians seem squeaky enough…
    eg. Malcolm

    “Turnbull was also chair of a large Australia Internet Service Provider, OzEmail (1994–99), a director of FTR Holdings Ltd (1995–2004), chair and managing director of Goldman Sachs Australia (1997–2001) and a partner with Goldman Sachs and Co (1998–2001). In the 1990s, Turnbull was chairman of Axiom Forest Resources, which conducted logging in the Solomon Islands under the trading name Silvania Forest Products. The latter’s work was described by the Australian International Development Aid Bureau as a “clear-felling operation”, and the then Solomon Islands Prime Minister Solomon Mamaloni reportedly threatened to close it down for “constant breaches of logging practices”,”

    Source, Wikipedia.

    ;)

    The world is built on the principle of monopoly (derivative of human nature) and this happens to be the prevailing model imo Ross. At least the little guy can get in the ring (albeit the heavy club of gov regulation) while socialist ideas may preclude private ownership re: means production…a more zombieish state of existence. I believe that objectives to provide meaningful existence/lives for citizens (within the framework of control) are evident by the way corporatist ideology manifests itself.
    Better get back to my Matrix now then ;)

  8. Lachlan says:

    Of course there are natural and often acute limitations for any system in regards to providing for the people.

  9. Lachlan says:

    Having fun talking to myself here. Here is a Doug Casey quote capturing an aspect of corporate fascism as I see it

    “Most big corporate types today are no more than political hacks. They’re not entrepreneurs. They don’t own any shares in the companies they manage – none they paid for. But they give themselves huge salaries, gigantic bonuses, big option packages, and shameless expense accounts. They’re worthy of contempt. The system is completely corrupt.”

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