What’s going on in China now? David Webb, a major figure in Hong Kong investment circles, has a wonderful analysis of the stock market bubble there:

The vast majority of individual investors in China today have never experienced a serious market correction, and have only the simplest understanding of the market. All that they know is that almost everyone they know has made gains on their stocks, so they jump on the bandwagon. What they don’t know is that the bandwagon is heading for the edge of a cliff. Like a giant Ponzi scheme, when everyone has bought in, there will be nobody left to pay them a profit.

By definition, bubbles are markets whose valuations are unsupported by fundamentals. There is nothing to fall back on. Bubbles never just plateau and go sideways - because that would not satisfy investors who bought in expectation of continued rapid gains. As soon as the momentum runs out, those investors head for the exit, and with nobody willing to take their place, the market crashes, usually overshooting fundamental value on the downside. Just a return to the index level of 20 months ago, when valuations of some stocks were beginning to look reasonable, would be a drop of 78%.

Like avalanches and other non-linear phenomena, nobody can exactly predict when a bubble will burst. All they can do is look at the accumulating snow on the mountain, and decide that it is not a good time to go skiing. By staying indoors, they might miss out on some great skiing, but they can be certain of avoiding burial in an avalanche.

Webb points out that this Bubble reminds him of the Taiwan market bubble in 1990, whose peak at over 12,000 has not been approached since. Investors then were similarly naive, had never known a market that fell, and were similarly engaging in irrational exuberance. The Economist noted recently:

However, Paul Cavey, a China economist at Macquarie Securities, suggests that China may have more in common with Taiwan in the 1980s than with Japan. Taiwan’s bubble was even bigger, with share prices rocketing by 1,800% between 1985 and 1990. In Japan, reserve accumulation did not play a big role in the bubble. By contrast, the foreign-exchange inflows into Taiwan were greater in relation to its GDP than those seen recently in China. Taiwan, like Japan, saw a big rise in its exchange rate, by 60% in the four years to 1989.

What might happen when that Bubble goes ka-boom! is anyone’s guess. It’s larger than the Japanese Bubble whose pricking sent the economy into an eternity in the Slough of Despond. Webb optimistically predicts that it might lead to greater media freedom — as Webb astutely observes, the government’s grip on the media is feeding false hopes with reassurances that everything is under control, while at the same time preventing investors from learning the truth. My own feeling is that history is not exactly replete with instances of economic collapse leading to greater freedom for all — at least not without a long interregnum of chaos. In addition to the swath of misery and destruction it will cut through Chinese society, the politico-economic fallout might be profound. For example, consider this tidbit from Newsweek last week:

The quantitative similarities between the two countries are alarming. Fixed- asset investment (construction of ports, factories, condos, etc.) now accounts for about 45 percent of China’s GDP. Its trade surplus has grown from almost nothing in the late 1990s to 9 percent of GDP today. Meanwhile, private consumption has shrunk from half of total economic activity in the late 1990s to just 35 percent this year. By comparison, Japan’s investment component averaged 30 percent of GDP during its peak growth years, its trade surplus topped out at 4.5 percent of GDP and its consumption levels never dipped below 58 percent of GDP. Conclusion: China’s economy is currently more out of kilter than Japan’s ever was.

Katz has coined a term for the problem: economic anorexia. He defines it as a nation’s chronic inability to consume all that it produces—a malady that leads to bloated trade surpluses, asset bubbles and ultimately collapse.

If private consumption in China — already comparatively nothing to write home about — nosedives in the wake of a Bubble going boom!, the effect on Taiwan — and its elections — and its security — might well be profound. Many Taiwanese are investors in that market one way or another. Taiwanese businesses do well in China and the island runs a trade surplus with China. But if that Bubble bursts in December — how will it affect the elections in January and March? The Taiwan economy will take a staggering blow. And if the resultant political fallout challenges the legitimacy of the Communist government, what foreign adventures might it be willing to engage in?

Oh, and what happens to the dollar when the Bubble blows and China can’t soak up all those dollars the Bush Administration printed for its madness in the Middle East?