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China’s Stock Bubble Passes Acid Test

CHINA’S stock-market boom is as clear a bubble as you will find, the conventional wisdom says. When might it burst? Nobody knows if it will. The Shanghai Composite Index has surged 45% this year. Just because China has deep pockets in this time of global crisis doesn’t mean its economic health supports this rally. In a sense, buyers are betting on China’s socialist tendencies rather than its success in fostering free markets. Rather than boding well for China’s long-term outlook, this rally serves as a reminder of risks facing the world’s third-biggest economy.

The strength of China’s fiscal position got a headline- grabbing endorsement this week from Nobel Prize-winning economist Joseph Stiglitz. In the same address, though, Stiglitz undermined that argument in the long run. “We are at the end of the beginning, rather than the beginning of the end,” Stiglitz said. “The global economy may be declining at a slower rate and we may see a bottom soon, but it doesn’t mean a full recovery.” Global Downshifting: The rapid growth rates of the mid-2000s are a thing of the past. The downshifting of global expectaions is taking place from New York to Shanghai. Even with the trillions of dollars of stimulus the U.S. is pumping into markets, American households face a multiyear process of saving more and spending less. The $4.4 trillion Japanese economy isn’t much better off. Gross domestic product contracted an annualized 16% in the first quarter, following a fourth-quarter drop of 12%, according to the median estimate of economists surveyed by Bloomberg News.

With the U.K., Germany and much of the euro area in recessions, feel free to engage in the fiction that China’s $3.2 trillion economy will save the world. Stiglitz isn’t wrong to think China will have a better 2009 than other major economies. Its 4 trillion yuan ($585 billion) stimulus plan and record bank lending are helping to fill the void left by plunging exports. The trouble is, that’s a void too far, even for an economy that’s as top-down as China’s. Flawed Assumptions: Be afraid when just about every economist agrees on something. Everyone seems to think China can pull this off that it can artfully influence a vast, underdeveloped economy of 1.3 billion people.

The flaw in this assumption is that it takes for granted that all those stimulus yuan will be spent wisely on worthy projects and companies. It assumes that those investments, much of them funded with debt, will morph into well-paying jobs that generate wealth for China’s people.

It’s hard to know how China can avoid vast amounts of public money being siphoned off by local government officials to speculate on stocks or property. At What Cost: Even if China ekes out healthy growth this year, the question is what it will cost. China may be setting the stage for a Japan-like bad-loan crisis a few years from now. One also has to wonder if China is moving fast enough to rebalance its economy away from exports toward domestic demand.

China’s public-relations machine is working overtime to spin this story. Its success in getting the global media to play along explains why investors are rushing into Chinese shares. Just because China has built a more sustainable bubble, supported by the promise of ever more government largess, doesn’t explain away the challenges facing the fastest-growing major economy. Officials in Beijing will be hard-pressed to replace the role of the U.S. consumer. China’s stimulus efforts are no substitute for demand from American households, which are entering into a rare period of thrift. If you are sitting on big paper profits in China, it may be time to take them.