Euro woes and Chinese inflation are good for gold

"Markets rise on hopes of bail-out."

That headline on the BBC website just about sums up yesterday's rally. Panic's over. Some kind man is going to print lots and lots of money and make everything better.

European Central Bank (ECB) president Jean-Claude Trichet has hinted that investors should not "underestimate" the eurozone's determination to protect itself. So now the assumption is that he'll pull a massive rabbit out of the hat at today's meeting of the ECB.

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There's a lot of pressure on Monsieur Trichet to keep this rally going. We'll find out later this afternoon how he plans to do that. It should make for fascinating viewing, to say the least...

There's no easy fix for the eurozone

Markets are waiting with bated breath to see how the ECB is going to save the eurozone. But there really is no easy solution.

Robert Peston has a good piece on his BBC blog today explaining the problems facing Portugal's banking system. And these rather sum up the difficulties facing the ECB.

To cut a long story short, Portugal's banks have been borrowing large amounts of money from the ECB and from the Portuguese central bank (Banco de Portugal) to keep their heads above water. Just to be clear, you can't keep doing that. Central banks are there to act as lenders of last resort, not a permanent life support drip.

See also:

• A backdoor bail-out for Europe?

But what's even more troubling for the ECB is what the Portuguese banks have been doing with the money. They've been buying Portuguese government bonds. In other words, the ECB has "channelled eurozone taxpayers' money, via Portuguese banks, to the Portuguese government for the funding of a public-sector deficit without ever having sought the permission of eurozone taxpayers."

So one group of ECB members, led by Bundesbank President Axel Weber, wants to pull their 'liquidity support' for the banks as quickly as possible. But of course, doing that right now would just make the sovereign debt crisis worse. Because then no one at all would be lending to these troubled governments.

The ECB may hope to keep propping up the system until the eurozone's politicians can come up with a more permanent solution. That might involve raising enough money to bail out the weaker links in the region. But the problem with that solution is that, even if German taxpayers were willing to stand for it, there may not be enough money to go round.

Unless the ECB starts nakedly printing money to fund these countries' deficits (in much the same way as the US and the UK have done) then it's hard to see the eurozone surviving in its current structure. Even another flurry of 'shock and awe' money-raising won't have a lasting effect. After all, the last big push after the Greek crisis didn't have a lasting impact.

Anyway, more light will be shed on all this later today (for an update, see: A back-door bail-out for Europe?) But I wouldn't necessarily bet on Trichet coming up with the goods. He tried 'jawboning' his way out of the Greek problem with similar veiled threats, without being immediately ready to act. If there's one thing that European authority figures seem to be very bad at, it's learning from their past mistakes.

So what else is going on in the world? Well, another big issue that's been swept under the carpet somewhat by the euro crisis is China's inflation worries.

Why do you need to worry about Chinese inflation?

Well one reason is the potential impact on us over here, as my colleague David Stevenson pointed out last week: Chinese inflation is about to hit Britain. But another reason is because of what the authorities might need to do to control it. Inflation and food inflation in particular is one of the biggest enemies of social stability in China. If it gets out of control, that could result in significantly tighter monetary policy.

One side effect of tighter money is that you get to see who's been swimming without their trunks on, as Warren Buffett would no doubt put it. Or to put it in a less endearingly folksy manner, you get to see which cruddy infrastructure projects and ill-considered loans were only being propped up by ridiculously cheap money. And when those bad loans stand revealed in the cold light of day, that's when people panic as they wonder how solvent the overall system is.

A proper slowdown or even crash in China's economy would be very damaging. It doesn't have to be. Economist Andy Xie of Rosetta Stone Advisors wrote a detailed and very readable piece on how China should handle its inflation problems, which I've highlighted on my Twitter feed this morning. But there's no guarantee that even China's far-sighted central planners (as they've been lauded by various Western pundits) will be able to walk this tightrope.

Gold should still be in your portfolio

What's all this fear of inflation and currency debasement good for? I think you probably know the answer by now. Chinese investors are doing exactly what half of Germany and anyone else who's worried about the value of their savings is doing. They're buying gold. Bloomberg reports this morning that China's gold imports jumped "almost fivefold" in the first ten months of this year, compared to the whole of 2009. According to the Shanghai Gold Exchange, imports rose to 209 tonnes, from 45 tonnes last year.

And this trend seems only likely to continue. For all that gold is a lot more expensive than it once was, and more widely covered in the mainstream press, I still think it's a useful hedge to have in your portfolio.

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