My bubbles!

We watched quite a few cartoons when we babysat for our friends Ian and Nicole during our third year of law school. Lliam was only about 20 months old at the time, and it was difficult to keep him occupied with a few toys and stuffed animals, not to mention our somewhat suspicious cat. Despite our frequent exposure to all things Nemo during that time, we still laugh at the stoned-out sea turtle Crush, the nebbish clown fish that can't tell a joke, and even the armada of idiot seagulls. But it was the character Bubbles, pictured above, who came to mind as I read the news today.

China's two stock markets are a little overheated right now. For evidence, one need only look at how China's state-owned monolith PetroChina debuted on the Shanghai Stock Exchange today, reaching a $1 trillion market capitalization via an IPO geared towards boosting production capacity here on the mainland. (Their underwriters at UBS and CITIC probably made a mint on the fees) $1 trillion is a lot of money, to be sure, but the figure that's more interesting to me is this one: as measured by market capitalization, China now contains five of the ten largest companies in the world, including the world's largest bank, insurance company, telecommunications carrier and airline. Can you say overvalued? I think I can, particularly when I look at some of the serious problems afflicting PetroChina just a few years ago.

Alan the Oracle called it a bubble back in May and the markets are still reacting. We saw the effects in the classroom when one professor told us about how his 12 year-old son lost 2,000 RMB trading stocks. True, the Chinese government has attempted to cool the irrational exuberance, but the PetroChina deal seems to indicate that bubble still has air in it. But what will truly cause an uproar, in my humble opinion, is when the inevitable correction hits China's low-income traders who have taken to day-trading in droves. Indeed, regardless of how many securities' laws China enacts, there will no doubt be hell to pay if China's poor lose their shirts in Shenzhen.

Here's my prediction: yes, the bubble will burst, but the inevitable big scandal will involve be a state-owned enterprise (SOE) that cooked its books. (I like to call it "Enron with Chinese characteristics") Smart players in international financial markets will only profit modestly, however, because China's market protection mechanisms inhibit truly efficient arbitrage. Within China, people will begin to appreciate how interference with efficient markets (PDF) actually hurts the little guy, but what that realization will lead to is anyone's guess. I'd say its one of two possibilities: the Chinese economic market will either open more or it will shut down. Given the recent trends, however, I'd bet on the former.

I think China is on the right path to smoothing things out. Allowing foreign investment in SOEs is a positive maneuver. But letting foreign institutional investors trade class A shares (which the NYT called for six years ago) would be even better. This is not to say that institutional investors don't have their problems, but only that a slow introduction of institutional capital into the market for class A shares could help drive share prices in a more rational direction.

In other words, it's time for China to stop yelling "我的泡！" ("Wo de pao!" or "My bubbles!") every time the treasure chest gets overinflated.