Japan And Then Some

For those who lived through the late-1980s japanese bubble, today's rip-roaring bull market in Chinese stocks is déjà vu all over again. The similarities are striking—the seemingly unstoppable rise of a new economic superpower, eye-popping trade surpluses, oceans of liquidity and a bull-market psychology that is equal parts hubris, greed and gullibility.

A Chinese bank is now the biggest in the world by market value. Back in 1990, the five largest banks in the world were Japanese (all of them went bust or had to be recapitalized). The Chinese today are paying top dollar for overseas assets, evoking memories of Mitsubishi Estate's 1989 purchase of the iconic Rockefeller Center, sold at a 50 percent loss six years later.

The list of parallels goes on. Skyrocketing salaries for young analysts and fund managers? A boom in warrants trading? Corporate profits padded out by stock-market gains? An IPO market frothing like a malfunctioning cappuccino machine? It's the same movie with a different cast.

The difference is that many of China's excesses are worse. Since the turn of the century, Chinese stock indexes have soared some 800 percent in dollar terms. That's already way ahead of Japan's 700 percent gain in the eight years leading up to its 1990 peak. At its peak, Japan's Nikkei index traded at five times book value. This autumn, the Shanghai market traded at more than eight times book, a level that no stock market in history has been able to sustain.

Qualitatively, there is no contest. In 1989 Japanese companies had solid track records built up over decades of success. Many of today's Chinese champions are brand new. Managements and balance sheets have yet to be stress-tested in a serious downturn.

Most investors are mostly rational most of the time. To turn them into bubble riders you need what the great American economist Hyman Minsky called a "displacement," meaning a shock to prevailing assumptions. The emergence of a new economic superpower like China or Japan is a geopolitical displacement. The Internet was a technological example of the same. Both convince investors that history has changed course and you need to be on the right side of it.

The other indispensable condition for the China bubble is liquidity, lots of it. As with Japan in the 1980s, China's monetary policy has become a hostage to its export machine. Interest rates are held far below their natural level in order to restrain the yuan. At the same time, financial liberalization has opened the securities markets to millions of unsophisticated Chinese investors who finally have an alternative to value-losing bank deposits. It is hard to imagine a more bubble-worthy set of circumstances.

But doesn't China's unprecedented growth justify unprecedentedly high valuations? The problem with this line of thinking is that China's emergence is unprecedented in scale, but not speed. In the 1960s, Japanese GDP doubled in seven years, and Taiwan and South Korea followed the same trajectory in the 1970s. In all these cases, price-to-earnings ratios were lower than in the rest of the world, and dividend yields higher.

There are good reasons that this should be so. High-growth economies have high volatility, with intense booms and equally intense busts. Furthermore, thanks to capital-investment binges, bottlenecks and wage inflation, profit margins come under pressure even at GDP growth rates that Western economies can only dream of. China is entering its fourth year of 9 percent-plus growth.

Many companies will undoubtedly fall by the wayside as the economy matures. In 1950s Japan, there were more than 100 motorbike companies. Today there's one major firm (Honda, which put the market leader at the time, Tohatsu, out of business with vicious price cutting). The Chinese equivalent of Honda may not even be listed yet. The Chinese Tohatsu may have been one of the recent IPOs.

But while plenty of experts are now warning on China (Warren Buffett being a recent notable), bubble markets can go on for longer than anyone thinks. Consider that Alan Greenspan delivered his warning about "irrational exuberance" in 1997, three years before the NASDAQ peaked. If Chinese monetary policy doesn't change, it is possible that stocks will rise even further. If so, the ultimate fallout will be all the more severe.

After Japan's bubble burst in 1990, there was little concern at first. As in China today, it was widely believed that the gyrations of the markets were irrelevant; households owned few stocks and the economy was largely bank-financed. This proved to be wishful thinking. World-class financial bubbles are usually symptomatic of deeper problems; the same forces of lax monetary policy and euphoric overconfidence drive capital investment by companies and government agencies. We don't know when the pop will come, but there's no chance that the bursting of the Chinese bubble will be painless, for the Middle Kingdom or the rest of the world.

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