Inside Investment: Tulipmania, Shanghai-style
There’s trouble brewing in the Chinese stock market. But a short, sharp shock could be just what is needed.
"Now, everything is made in China." The gallows humour that bounced around the dealing floors following the mini-correction in worldwide stock markets triggered by an 8.8% sell-off in Shanghai was pretty typical of the genre. Long on wit, but short of substance. However, the events of late February did serve to remind everyone of what should already have been glaringly obvious: the Chinese stock market is a bubble of historic proportions.
When bubbles burst, they do so spectacularly. Everything that has happened since suggests that the Chinese stock market will be no exception. On May 6, Zhou Xiaochuan, the governor of the People’s Bank of China, did what eminently sensible central bankers do. He tried to talk down the market before too many "greater fools" got sucked in and hurt. It was his equivalent of Alan Greenspan’s "irrational exuberance" speech in December 1996.
Zhou’s plea fell on deaf ears. So had Greenspan’s. There is, however, a big difference. In the US, cocking a snook at authority is a national pastime. It has been ever since a bunch of rowdy Bostonians decided to tip tea into their harbour. In China it is virtually unheard of. The authorities succeeded in talking down the markets in 2001. This time they have failed. Every move since Zhou’s speech – increasing interest rates, boosting reserve requirements and tripling stamp duty – has caused a flurry of concern, only to be followed by another record market high.
This bubble is not a by-product of a new sense of economic and political freedom in China, however. It is the direct result of macroeconomic policy. China is pursuing a mercantilist agenda. That is not meant in the disparaging and hysterical way some on the anti-free trade wing of the US Democrats use the term. It is simply a fact that Chinese policymakers favour exports over imports. In support of this policy the yuan is kept weak by accumulating foreign reserves.
This is a perfectly rational way for China to exploit its comparative advantages and, in the process, drag its people out of poverty. However, it comes with some unintended consequences. The huge amount of monetary liquidity this policy creates has to find a home. First it went into the property market, latterly it has gone into the stock market. The result, like Japan’s investment binge in the late 1980s, has been a frenzy of speculation.
China’s dilemma is also reminiscent of Holland in the 17th century. At the time the Dutch were merchants to the world and Amsterdam was the entrepôt of global trade. The mandate of the Dutch East Indies Company, founded in 1602, was to exercise a monopoly over the spice trade, a prototypical mercantilist business model.
After its long war with Spain, the United Provinces was inundated with mutilated and counterfeit coins of many denominations. In response, the world’s first central bank, the Bank of Amsterdam, and the first uniform currency were created in 1609. Uniform coinage and the stability of the Bank of Amsterdam acted as a magnet for precious metal being mined in the Americas. Mint output doubled in just five short years, between 1630 and 1635, to 17 million guilders.
Over a similar period, between 1628 and 1633, house prices more than doubled on the Herengracht. This famous street was then the haunt of the nouveau riche merchant classes and it still houses Amsterdam’s elites. This Dutch "golden age" has been captured for posterity by the genius of Rembrandt. But the flipside of this massive wealth creation was Tulipmania.
At the height of Tulipmania a single Viseroij bulb sold for 3,000 guilders, more than 20 times the annual salary of a skilled craftsman. The price of the common Witte Croonen bulb rose in price 26 times in January 1637, only to fall to a 20th of its value one week later. As a recent paper notes: "The story of Tulipmania is not only about tulips and their price movements, and certainly studying the ‘fundamentals of the tulip market’ does not explain the occurrence of this speculative bubble. The price of tulips only served as a manifestation of government policy that expanded the quantity of money and thus fostered an environment for speculation."*
Sounds familiar? China’s stock market bubble will burst. But the results do not have to be catastrophic. There was increased bankruptcy in Holland after 1637. But the mass of the populace was not affected. The Dutch golden age lasted for many years to come. Increasing consumption in China can take up the slack of lower investment, moderating export growth and an appreciating yuan. Like Tulipmania before it, the bursting of China’s stock market bubble is destined to be but a footnote in the country’s economic history.
*Doug French, "The Dutch monetary environment during Tulipmania", Quarterly Journal of Austrian Economics, 9, 1 (Spring 2006), 3-14
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own