The good times can't last.

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The Unbearable Exuberance of China's Markets

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Chinese investors are acting as giddy as Americans were on Dec. 5, 1996, the day Alan Greenspan made his infamous "irrational exuberance" dig at markets. Don't take my word for it. Here's what the country's securities regulator said Friday, the day the Shanghai Composite Index rallied to its highest close since May 2008: “Investors should be cautious about market risks,” the China Securities Regulatory Commission said on its microblog. “We shouldn’t be thinking if we don’t buy now, we will miss it.”

Not much ambiguity there, and yet Shanghai stocks rallied Monday, heading to their longest streak of gains since 2007. What gives? Beijing is making the same mistake Washington did 18-plus years ago by not clamping down on a stock-market boom that's based more on leverage than reality.

Then-Federal Reserve Chairman's Greenspan's swipe at Wall Street froth was a halfhearted one -- so cryptic, in fact, that many seasoned Fed reporters missed it. It came in the middle of a mind-numbingly boring speech about Japan's 1980s bubble. For a couple of days, markets quaked at the prospect that the Fed might cut short the ongoing rally, which had assigned astronomical valuations to the dodgiest startups.

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But then Greenspan blew the endgame. Lawmakers were apoplectic over the Fed targeting stocks. Rather than stand his ground, Greenspan shut up and moved on. If the Fed had clamped down more assertively in the late 1990s -- say, with stringent margin requirements -- a Nasdaq crash might've been averted. Chastened investors might've been less inclined to overleverage in the decade that followed. In Beijing, central bank governor Zhou Xiaochuan can't afford to make the same mistake. 

Economic fundamentals aren't driving this rally -- political expedience is. Chinese growth is slowing -- an early indicator of factory activity hit an 11-month low in March -- Beijing is clamping down on credit and a property market that once seemed unstoppable is reeling. That leaves one place for Chinese to satisfy their urge to get rich quick: equities. And recent policy tweaks are helping them. In September, China reduced fees by more than half for individuals and institutions to open share accounts. At the same time, the futures exchange cut margin requirements for equity-index contracts. Last month, it trimmed the amount of cash banks must hold back from lending by 50 basis points to 19.5 percent. 

Not surprisingly, the outstanding value of margin trading, or shares purchased with borrowed money, on the Shanghai Stock Exchange rose to a record $158 billion on March 20. Actually, it's been setting new highs almost daily for weeks now. In the week ended March 6, mainland investors opened 662,000 new stock accounts, the most since December, when the Shanghai gauge jumped 21 percent.

Obviously, a fast-growing number of Chinese are buying for fear of missing out on the boom. With $3.8 trillion of currency reserves, China can always bail out the market if a crash happens. But before long, on top of keeping economic growth near 7 percent, the government will be propping up stocks, companies on the verge defaulting on dollar-denominated loans (property developer Kaisa may be the first) and state-owned enterprises suddenly starved for liquidity. Smart as Zhou and President Xi Jinping are, that's a lot of leaks to plug at a time when they're also switching growth engines from investment and exports to services.

Authorities must clamp down more forcefully on margin lending. The CSRC has already been ignored once. An eerie coincidence, its earlier warning came on Dec. 5, 18 years to the day Greenspan first uttered his signature phrase. China's regulator warned that stock prices for some listed companies were "relatively high" and that "there are about 700 companies in the Shanghai and Shenzhen stock exchanges with a price-earnings ratio of above 100." Three days later, investors pushed the Shanghai Composite up 2.8 percent to surpass 3,000. Today, it's 25 percent higher than it was on Dec. 5.

There are a few plausible explanations why so many investors might leave logic at the door. First, the potential of China's middle class and hopes for more blockbuster initial public offerings like Alibaba's are eclipsing worries about deflation. Second, Beijing had until recently been directing its 1.3 billion to pile savings into equities to support the market. Third, there's some genuine optimism that China is serious about transforming its economy.

But policy makers will regret willingly orchestrating this bubble. Making it easier for tens of thousands of small investors to bet on stocks will backfire terribly if economic fundamentals don't begin to validate the market's exuberance, and fast.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Nisid Hajari at nhajari@bloomberg.net