Newsweek Dec 10 2007
http://www.highbeam.com/doc/1G1-172027276.html
It’s déjà vu all over again. That’s what the rip-roaring bull market in Chinese stocks looks like to anyone who lived through the late 1980s Japanese bubble.
The similarities are striking. The seemingly unstoppable rise of a new economic super-power. Eye-popping trade surpluses. Oceans of liquidity. 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? In 1990 the five largest banks in the world were Japanese. In the subsequent decade all of them either went bust or had to be recapitalized at the public expense.
Chinese capital is paying top dollar for overseas assets? For the Chinese stake in Blackstone Group, read Mitsubishi Estate’s 1989 purchase of the Rockefeller Centre, sold at a 50% loss six years later.
Sky-rocketing 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 capuccino machine? It’s the same movie with a different cast.
So how does China’s bull market rank against Japan’s 1980s blow-out? The answer is that in many respects the excesses are worse. Since the turn of the century, Chinese stock indices have soared some 800% in dollar terms. That’s already ahead of Japan’s 700% gain in the eight years leading up to its 1990 peak. Valuations tell a similar story. At peak, Japan’s Nikkei Index traded at 5X book value. This autumn the Shanghai market traded at more than 8X book, a level which 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 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 new economic superpowers like China and Japan are geopolitical displacements. The internet was a technological example. The effect is the same; to convince investors that “it’s different this time”; that history has changed course and you need to be on the right side of it.
The other indispensable condition is liquidity, lots of it. As with Japan in the 1980s, Chinese 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 investors, who for the first time have an alternative to value-losing bank deposits. It is hard to imagine a set of policies more likely to kick off a major league bubble..
But doesn’t China’s unpredecented growth justify unprecedentedly high valuations? The problem here 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 earnings ratios were lower than in the rest of the world and dividend yields higher. And there are good reasons why 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 of five or six percent.
Furthermore, many companies fall by the wayside as the economy matures. In 1950s Japan there were more than one hundred motorbike companies So only the biggest and most profitable survived? Not quite. The market leader Tohatsu was put out of business by the cut-throat pricing of Honda. The Chinese equivalent of Honda may not even be listed yet.
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 Nasdaq peaked. If Chinese monetary policy doesn’t change, it is possible that stocks will rise more and new records will be written in the annals of financial excess. If so, the ultimate fall-out 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 over-confidence drive capital investment by companies and government agencies.
The bursting of the Chinese bubble is unlikely to be painless, either for the Chinese economy or for the rest of the world.