Blazing Days at the Shanghai Exchange

Hong Kong - Shanghai's stock exchange has long been a roller-coaster ride, so after watching the benchmark index rise 90% this year, Wang Yaodong decided it was time to pull the emergency brake. "I'm really afraid the whole market will go down," says the property salesman, who sold all his stocks on Aug. 3.

He's right to worry. Stock prices are being fueled by easy money in China, and many experts say that has to end soon. As part of Beijing's effort to goose the economy, banks made $1.08 trillion in loans in the first half, triple the year-earlier level. While most of that was intended for new roads, bridges, and factories, some was put into stocks by managers seeking quick profits. Problem is, when credit tightens again—as it inevitably will—shares may crash. "Chinese asset markets have become a giant Ponzi scheme," says independent economist Andy Xie. "This sort of bubble ends when there isn't enough liquidity to feed the beast."

China bulls counter that the beast can continue to feast for some time. Shanghai shares are just half their October 2007 high, and with the economy recovering, corporate profits will start to grow. The average price-earnings ratio is 26, still well below the average of 60 at the market's peak. "This rally is leading the recovery, so it's fine," says Frank Gong, chief economist for China at JPMorgan Chase (JPM). "Equity markets are supposed to do that."

Gong and others say it's unlikely the government will choke off credit. For starters, no one wants to be blamed for slowing China's recovery. And officials across the mainland have ample incentive to keep the loans flowing. The money helps companies hire and economies grow—key metrics in assessing the job performance of municipal and provincial bigwigs. Local governments also benefit when state-owned enterprises on their turf list on the exchange, which is much easier when prices are rising. On July 27, the government of Sichuan Province benefited mightily when highway operator Sichuan Expressway saw its shares triple on its first day of trading.

Nonetheless, many investors are keeping their fingers close to the sell button. On July 29, Shanghai shares plunged by 5% as rumors spread that Beijing was clamping down on lending. But prices quickly resumed their climb, worrying economists. "The way asset prices are moving in China is not healthy," says David Cui, Shanghai-based equity strategist for Bank of America Merrill Lynch. "The government has to balance its desire for growth with the integrity of the financial system."

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