What will happen when the China bubble bursts?

We may bemoan the UK housing bubble, but it's nothing compared to that in Chinese equities. And it won't just be Chinese investors ignoring warnings about the dangers of speculation who end up getting burned.

On Wednesday May 9, for the first time, the value of shares traded on China's stock markets was greater than the rest of Asia combined, and this includes Japan.

Volume on the Shanghai stock exchange was $33.2bn, while the smaller Shenzhen exchange saw $15.8bn worth of shares change hands. The combined total of $49bn was 21% higher than the previous Chinese record daily total and nearly double Japan's turnover on that day and triple the combined volume of Australia, Hong Kong, Thailand, Singapore, Malaysia, Korea, India, Taiwan, Indonesia, New Zealand and Vietnam. Turnover in Chinese listed equities is sky-rocketing. Just six months ago, trading volume on Chinese markets was only $5bn a day. The volume figures are even more astounding if you consider that day trading is not allowed in China.

The huge jump in trading volume has helped push the Shanghai Composite Index above the 4,000 mark for the first time, less than two months after it passed the 3,000 level. By comparison it took four months for the market to rise from 2,000 to 3,000, while the index first broke through the 1,000 barrier way back in 1997.

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The rising market, which has climbed 300% in less than two years, has encouraged a huge revival in retail interest since the start of the year. Chinese people have been opening new stock trading accounts at a rate of 300,000 a day.

What's behind the China bubble?

So how do you explain this phenomenon? Quite simply Chinese people have nothing better to do with their money. Leaving it in a bank offers negative returns after inflation and tax. The property market is already out of reach for many and highly illiquid, while unless you are rich and influential enough to get round the law, you are not allowed to take your money offshore.

More important it offers the ordinary Chinese a chance to gamble. If you have been to race meeting in Macao or Hong Kong, you are under no illusions that the Chinese people love a punt. Although the ruling Chinese communists banned gambling as a "social evil" back in 1949, the current stock frenzy shows that Chinese citizens have not lost their taste for it.

The Chinese are addicted to risk. They have been known to work 60 hours a week in a factory and risk the week's wages on the turn of a card. Cultural fatalism and superstition have long fed the propensity for gambling, but there is also a commonly held belief that in a country with a massive population and few clear rules, luck will be the important ingredient in getting ahead.

Penniless college students, housewives and taxi drivers are flocking to deal in the Shanghai market. So it is not surprising that we are hearing instances of individuals re-mortgaging their property to punt the stock market.

Government officials are worried. China's Securities Regulatory Commission posted this warning on its website:

"Investors should be fully aware that there exists no stock on earth whose prices surge and never slump." At one time public warnings would have been enough to trigger a sharp sell-off in the market, but investors are now ignoring them.

The Chinese stock market trades on a price-to-earnings multiple of about 50. We are at the stage where a Chinese share is not necessarily valued in terms of the sum of the returns it will yield over its life, but more likely what someone else is willing to pay for it.

What happens when the China bubble bursts?

Fundamental valuations are ignored in a bubble, just as they were in the Japanese stock market boom of the 1980's and sky-rocketing Nasdaq market in the run up to the year 2000. In other words we are in the realms of momentum investing, when traders follow and then accelerate an existing trend. And this momentum can be extraordinary when the participants are ordinary Chinese people who spot a chance to make some money. This is a far more virulent and dangerous speculative bubble than say the UK housing market.

Cheng Siwei, a senior member of the National People's Congress, pointed out, only 30% of the more than 1,300 listed companies have investment value. The market may have further, even much further, to rise. Who knows? But the eventual collapse of the Chinese stock market is not a question of if, but when.

When the bubble bursts in China, what are the implications? Much depends on the reaction of the Chinese government. If the government decides to support the market, it has the cash, in the form of US Treasury bills. If it liquidates these assets it will mean firmer US interest rates and a slowdown in the world economy. On the other hand, if the Chinese government does nothing, the fall-out from a crash will harm the domestic economy, bringing down other economies in the region and unsettle a rising Chinese middle class. At the same time the boom in commodity prices would go into reverse. It may be that our future prosperity will in some senses be determined in a Beijing court presided over by some retired Peoples Liberation Army major. Now there's a thought.

By Brian Durrant for The Daily Reckoning. You can read more from Brian and many others at www.dailyreckoning.co.uk

Brian has contributed to MoneyWeek with his expertise in investment strategy, for example how to quadruple your dividend income and how to navigate through the stock market in the 2008 financial crisis. He’s also touched on personal finance such as the housing market and the UK economy.