China’s Policy Response To Its Equity Crash To Be Inflationary And Boost Gold

What do we know about how central banks respond to stock market crashes? Typically they lower interest rates and ease monetary conditions in liberal fashion and worry about the inflationary consequences later.

So now that China is seeing its own version of the 1929 Wall Street Crash, should we not expect the same? In 2009 China greeted the global financial crisis with a stimulus package equivalent to half its GDP.

Policy response

It would be easy enough now to cut interest rates and devalue its currency to ease the pain to follow such a massive stock market event. This is the textbook response to the deflationary impact that such heart attacks have on an economy.

Credit is already seizing up in China and trade is being affected. Commodity prices are in free fall, from oil to iron ore, copper and nickel. Printing money and doing it quickly is the only way to slow this down.

The danger is that pumping money into an economy causes bubbles. Indeed the stock market bubble in China that is bursting now is the direct effect of the policy response to the global economic crisis in 2009, six years ago.

Where will the money go this time? Likely the same place as last time: precious metals. Gold went on a tear from under $800 to $1,923 an ounce between 2009 and 2011, and that was the best performing asset class apart from silver, up from $8 to $49 an ounce.

Domestic inflation

China also created a great deal of domestic price inflation raising local price levels to the point that Western visitors no longer found anything cheap. We can expect more of the same again.

However, after a major stock market crash like the one now happening in China there are usually major aftershocks in the real economy, in the banking sector in particular.

Central banks know this and learnt from the 1929 Wall Street Crash the imperative of keeping the banks functioning. That said bad debts still have to be purged and businesses go bankrupt and people get ruined in the process.

This is called a recession, not something China has suffered for decades. It will mean a major slowdown in demand for everything China has been buying from the rest of the world: industrial commodities, German cars, luxury goods, and even tourism.

Fire sales will depress the price of some goods temporarily but a combination of a destruction of capacity and money printing will prove inflationary, and that is usually the only way to revive an economy from this sort of trauma.

Precious metals

Investors in gold and silver will get very rich – as prices will soar as Chinese inflation takes off – but it will be very hard for anybody else. In truth, over-inflated global stock markets will have to follow Chinese equities into a major downturn in a contagion like the 1930s.

How long this lasts and how deep the damage proves to be will depend on just how good global central banks are at managing macroeconomics. We are about to find out.

But forget about the Fed ever raising rates for years. The pressure will be in the reverse direction. How long to QE4?

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