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(Nicky Loh/Reuters)
(Nicky Loh/Reuters)

The Buy Side

China mania: A wired bus that must keep speeding Add to ...

After a bubble pops, everyone knows a mania has occurred - but what about while it is taking place? I wrote before about the Chinese bubble - and have not been the only one to point it out - but China bears are still too few. Now, one more serious voice has joined the choir: GMO.

GMO is a large, prestigious fund management firm in Boston, known for the pithy comments of its co-founder, Jeremy Grantham. Now another GMO maven, Edward Chancellor, in a superb recent research paper, says China is a huge mania which will have a severe aftermath.

Why am I mentioning it? For two reasons: First, whereas to make my call I used cost accounting criteria (as well as data by Chinese informers), Mr. Chancellor identifies 10 signs for large manias, all of which are present in China (and to which I'll add one more). But second and equally important, as the U.S.-China political face-off escalates, the perils to China's economy and the market are rising, too.

Let's take them in order.

First, here are Mr. Chancellor's 10 criteria for mania:

1. A compelling growth story; 2. Faith in the competence of the authorities; 3. Huge increase in investment; 4. Surge in corruption; 5. Easy money; 6. Fixed currency regime; 7. Rampant credit growth; 8. Moral hazard (a belief that authorities won't let the bubble pop - and have the power to keep it going - so risk is ignored); 9. Financial structures turn precarious; 10. Rapidly rising property prices fuelled by money made in the bubble, which is plowed right back into the bubble. All these conditions are present in China - in spades.

And I'd add one more criterion, a reverse indicator, which emerges at the end of a trend: For example, a book telling us that our own economic system cannot compete with the new autocratic order. In the 1960s it was Russia that would bury us. In the 1980s it was Japan. And now it's China. A "scholar" named Martin Jacques just wrote a book titled, When China Rules the World: The End of the Western World and the Birth of the New Global Order . Yeah, right.

By whichever criteria you use, China is a classic mania. Still, you may ask, why should it pop now?

Good question. The answer, of course, is that no one knows when a mania will pop. But this one may have gotten a step closer, through a risky U.S.-China tit-for-tat. In fact, it has gotten so hot that Chinese President Hu Jintao decided to come to Washington - ostensibly to the Nuclear Summit - to cool down the situation.

You already know my view that market analysis is incomplete if it considers only global financial data, since large state players have political and military interests also. Take the U.S. and China. The U.S. is the established empire, while China is the rising empire. So it is natural for the two to compete - there's nothing sinister in it. But smart empires compete via surrogates, and never face to face.

China has been using North Korea as a surrogate against the United States. Yet when the U.S. asked China to help convince North Korea to give up its nukes, China instead gave North Korea $10-billion in aid, removing North Korea's incentive to talk. The U.S., miffed, immediately sold billions of dollars worth of weapons to Taiwan. The Chinese, mad at the U.S., became even more obstructionist on Iran. The U.S. got madder still and arranged to meet the Dalai Lama. So China, which considers Tibet Chinese, sold Iran missile parts (as the Wall Street Journal recently reported). Perhaps in response, the U.S. administration allowed Congress to put forward legislation to label China a currency manipulator, which would allow higher tariffs and other measures that could impact Chinese exports.

This last move is particularly worrisome, because it takes direct aim at China's employment, which relates to internal social peace. So it got China's rulers' immediate attention and the Chinese President will fly over to Washington to help cool the tiff. We should all hope that he and U.S. President Barack Obama can do it, because for China, this tit-for-tat comes at a particularly tricky time.

As GMO's Mr. Chancellor puts it, quoting another commentator, China is now like the bus in the Hollywood thriller Speed , which has been wired with a bomb set to explode if the bus slows down below 50 miles per hour. China, whose political drivers may have allowed themselves to disregard some international traffic rules, might suffer some internal detonations if the U.S. acts to slow its economic bus. The "currency manipulator" legislation may do just that - unless Presidents Obama and Hu Jintao manage to compromise. If they don't, the consequences to China's resource usage, real estate prices and stock market level may be stark.

Thus my conclusion is similar to GMO's: I'd be very cautious of companies tied to China, and would watch for rising U.S.-China conflict as a warning signal for global markets.

Addendum:

Following the column about my lecture at Columbia University, many asked if my talk has been videotaped. It was. Here it is Columbia U talk.

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