Fasten your seat belts; the ride is about to get choppy.

Chinese policy makers are concerned with the dramatic recent falls in the value of the Chinese Stock Market. They are right to be concerned. Although we can, and should, allow financial markets to allocate capital across sectors, the market as a whole is a creature of sentiment. And U.S. experience suggests that market crashes often precede deep recessions.
Today, the Peoples Bank of China was given the authority to purchase shares in the Chinese Stock Market. This is a bold experiment; but it is not unprecedented. In 1998, in the midst of the Asian Financial Crisis, the Hong Kong Monetary Authority engaged in a similar exercise. That intervention was large and successful and was the beginning of the end of the Asian crisis.

Chinese stocks are not dramatically overvalued and prospects for growth have recently picked up. I have advocated in the past for  the policy that the Peoples Bank is now engaged in. But the devil is in the details.

Stock market intervention could unfold in two ways. A purchase of shares by the central bank might be financed by money creation (Quantitative Easing). Or it might be accomplished by swapping short-term debt for risky securities (Qualitative Easing). Chinese interest rates, at 4.8%, are still in positive territory although inflation is currently at 1.2% and falling if official statistics are to believed. That leaves room for purchase of shares financed by money creation and it is an option that I would not rule out.

Buying stocks through money creation is not the only avenue. The Peoples Bank also has the option to purchases shares without increasing the monetary base through swaps of shares, either for foreign exchange or through domestic government borrowing.

China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.

An alternative strategy would be to issue domestic debt and use it to purchase stocks. That would leave the Bank with liabilities, short-term debt, offset by assets, shares in the Chinese stock market.

It would be a mistake to bet against a Central Bank that is committed to dampening market volatility and a national treasury that is backed by the present value of future tax revenues. But an intervention of the magnitude that China is now contemplating cannot fail to spill over into world financial markets. Fasten your seat belts; the ride is about to get choppy.