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China, Bubbles and Gold Bullion

China's attempts to engineer a soft landing will fail...

CHINA'S latest interest rate cut was completely unexpected. The People's Bank of China lowered the lending rate 31 basis points to 6%. It lowered the deposit rate by 25 basis points to 3%, writes Greg Canavan for the Daily Reckoning Australia.

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.


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. 

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Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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