Most commentators agree on three things about the Chinese stock market - but they are right on only two, says the financial historian Edward Chancellor.

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First, there's a bubble. Second, the bubble is the result of excess liquidity in the Chinese financial system. Third, the madness of crowds in Shanghai and Shenzhen shouldn't particularly concern Western investors. They are correct on the first two points and woefully wrong on the third.
 
The Shanghai stock market has climbed by around a third since early August and more than 300 per cent since January. In a recent talk, Peter Tasker, of Arcus Investment in Tokyo, described the course of the Chinese boom using a multi-stage model developed by the economist Hyman Minsky.
 
The bubble starts with a "displacement" which gives investors something new to reckon with, such as Japan's rise in the 1980s and China's emergence as an economic superpower over recent years. The rise in stock prices, initially slow, gathers momentum. In China, around 5m new brokerage accounts are opening every month. These neophyte speculators overtrade.
 
The huge current trading volumes on the Chinese exchanges are so large that broking and stamp duty charges actually exceed the total profits of listed companies, according to HSBC. The reality is even worse because a growing chunk of profits comes from companies reporting gains from playing the market.
 
As the market enters a euphoric stage, investors lose any vestige of risk aversion. Absurd valuations are rationalised. Shanghai stocks trade on a price-earnings ratio of more than 60 times.
 
Today, three of the world's largest six companies by market capitalisation are Chinese (by way of contrast, five of the six most valuable companies in 1989 were Japanese). Chinese banks and insurers are selling for large multiples of book value. The combined market capitalisation of Chinese companies, listed both at home and abroad, is more than double the country's GDP (at their peak in early 2000, US stocks were capitalised at a mere 183 per cent of GDP). Demand for IPOs is so intense the average first-day "pop" exceeds 200 per cent.
 
As bubbles approach their end, savvy investors are always found heading for the exit. That explains the large number of Chinese initial and secondary offerings this year. Warren Buffett recently unloaded his stake in Petrochina at seven times the price he paid in 2003. The Berkshire Hathaway chairman warned the public against buying Chinese stocks at their currently inflated values.
 
There's a bubble all right. But few seem to care. Goldman Sachs economists recently put out a report entitled "More Focused on Old Bubbles than New Ones". For all the furore, the Chinese stock market is not a major source of funding for corporations. And the listed companies, largely drawn from the service and financial sectors, do not reflect the nation's manufacturing economy. Besides, valuations of Chinese stocks listed in Shanghai and Shenzhen are distorted by their limited availability. The same companies trading in Hong Kong with larger free floats sell for around half the price.
 
Sure, when the bubble bursts, there will be some loss of paper wealth, which would probably lead to a slowdown in consumption. HSBC estimates that this might reduce Chinese economic growth to 8 per cent. But considering the current overheating, that is rather desirable.
 
The real cause for concern is not whether Chinese stocks continue to rise or suddenly collapse. Rather, it's the corrupting effects of excess liquidity which, as Mr Tasker observes, is "the fuel that enables manias to blaze strong and longer than anyone expects".
 
People speculate in stocks in Shanghai and real estate in Shenzhen because money is cheap. As the bubble progresses, they will inevitably take on more debt to finance their speculations. When bubbles end, bad debts invariably appear and the financial system suffers.
 
The excess liquidity is the product of China's attempt to peg its currency to the dollar. As a result, interest rates are kept artificially low, boosting exports, but also leading to overinvestment and misallocation of capital.
 
As China overheats, inflation is picking up. Sooner or later, Beijing will have to grasp the nettle. When excess liquidity is mopped up, Chinese stocks will fall. But the banking system could also suffer problems and the economy find itself plagued with too much manufacturing capacity and falling profits.
 
That's what happened in Japan. Foreign investors may not be directly exposed to Chinese stocks but they are unlikely to escape the aftermath when this bubble bursts.

Edward Chancellor