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Popular ringtone in Shanghai at the height of the bubble, a parody of China’s national anthem
Irrational Exuberance with Chinese Characteristics: Origins of the 2007 A-Share Bubble
“Arise! Ye who have not opened an account! Pour your gold and silver in the hot market! The Chinesenation faces its most crucial time. The passionate roar of our people will be heard!” “Money, again, has often been a cause of the delusion of the multitudes. Sober nations have all at oncebecome desperate gamblers, and risked almost their existence upon the turn of a piece of paper.” 
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Charles Mackay, “Extraordinary Popular Delusions and the Madness of Crowds” 
Introduction
In the fall of 2007, Chinese stock markets were roaring upward at what seemed to be an everaccelerating pace. The exchanges, based in Shenzhen and Shanghai, had seen valuations grow by amind-numbing 140% in 2006 and a further 120% in 2007. All in all, over the course of about 22 months,the value of Chinese stocks had grown almost five-fold. While it had been true that the profitability of listed Chinese companies was indeed on the rise (growing by 70% over two years)
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The stock market euphoria at the time was palpable. There was word of millions of new brokerageaccounts being created at China’s securities companies as savers began seeking alternatives to lowyielding bank deposits. The rise in asset values was particularly prominent in China’s red-hot IPOmarket, which in September of 2007 registered the two largest IPOs in the mainland’s history with thelisting of China Construction Bank and Shenhua Energy, the valuations hadbeen virtually detached from economic fundamentals – at the height of the bull market, the averageChinese company was trading at a ratio of fifty times earnings at a time when American companies weretrading at around sixteen times earnings. Due to the skyrocketing stock market, by late 2007 five of theten largest corporations (in terms of market capitalization) in the world were mainland Chinesecompanies listed in Shanghai or Shenzhen.
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And yet the mania to invest in Chinese equities was not solely limited to those in mainland China –international investors were similarly bullish. Baidu, regarded by many as “China’s Google”, was tradingon NASDAQ at a price of $409, or at an unbelievable 250 times earnings. Jim Rogers, a renowned hedge. The IPO market proved to be a quick andprofitable way for China’s state owned enterprises to use their large cash reserves, who invested heavilyin newly listed companies. In particular in Shanghai and Shenzhen, financial news became ubiquitous asXinhua created China’s first televised financial news network in 2006.
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PINR. "Economic Brief: China's Stock Market Bubble ." Power and Interest News Report 19 Februrary 2007.
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Dyer, Geoff. "Worries Surface about a Potential Bubble." Financial Times 9 October 2007.
 
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fund manager and author of 
 A Bull in China
(a pop-investing book directing American retail investorshow to buy Chinese stocks) in 2007 advised
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 :Of course, not all analysts were similarly bullish. RateFinancials, a private accounting firm whichanalyzes and rates financial statements for publically listed companies, investigated the SEC filings forthe ten largest Chinese firms listed on the New York Stock Exchange. They found that the Chinese firmsall had “low quality earnings, aggressive accounting, low bad debt allowance, and insufficient cashflow…”
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. The vice-chairman of the China Securities and Regulatory Commission (China’s primaryregulatory body overseeing securities markets, hereafter CSRC) warned Chinese investors of the “risksinvesting in the stock market”, urging that “[Chinese Investors] should think carefully before entering”
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To this end, the stock market in China has often been characterized as a “policy driven stockmarket”. While it is difficult to make an authoritative definition of what exactly a policy-driven stockmarket is, Professor Sebastian Heilmann characterizes such a market as “a market in which politicalcalculations, policy missions, and administrative interference are more important than the dynamics of market competition for determining price fluctuations”.Almost predictably, in late 2007 the soaring equity markets came back down to earth - the ShanghaiStock Exchange Composite Index lost almost two thirds of its value since the top in October. And whilespeculative euphoria is certainly not unique to China, the rapid rise and subsequent crash exposed manyof the misperceptions that foreign investors have concerning China’s bourses. This paper will argue thatthe Chinese stock market has entirely different fundamentals than much of the world’s equity markets.In most countries (even those with similarly underdeveloped capital markets), investing in stocks givesthe investor adequate exposure to the locality’s economic growth. In China, however, the value of equities can be and often are fundamentally detached from the underlying economic reality. To thecasual observer, it appears that many investors rushed to participate in China’s stock market boomwithout a firm understanding of exactly what the assets they purchased actually represented.
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 . It is precisely this political dimension that wasthe origin of China’s rapid and precipitous rise in stock prices as well as the basis for the subsequent fall.
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Rogers, Jim. Jim Rogers Continues to View China as the World’s Best Long-Term Profit Play Keith Fitzgerald. 20August 2007.
 
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RateFinancials. Government Controlled Entities Masquerading as Independent Public Companies. FinancialSurvey. New York: RateFinancials, 2007.
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Dong, Zhixin. "Regulator Warns on Stock Market Risk." China Daily 29 April 2007.
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Heilmann, Sebastian. "The Chinese Stock Market: Pitfalls of a Policy-driven Market." China Analysis (2002)
I'm not selling my Chinese shares. As I said, I bought more of them last week. [I would sell only if] themarket tripled again in 2008. The Renminbi is going to be one of the strongest currencies in years tocome … if you invest in equities, think about China.
 
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3The dual facets of the Chinese economic system
 In analyzing the Chinese economy, it becomes apparent that China is segmented into two sectorswith entirely disparate fundamentals, which I describe as the “institutional economy” and the “privateeconomy”. The institutional economy comprises of the enterprises in China that are either derivative of China’s work units from the Mao era or those that have been incorporated and financed in Hong Kong.Because of their relative size and political prominence, institutional economy is able to utilize themainland Chinese banking system and thus such enterprises have the ability to rapidly grow their assetbase. Without a doubt, the dominant actors in the institutional economy are China’s state-ownedenterprises (comprising of 98% of the sector)
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The “private economy” in China consists of mostly small to medium size enterprises (comprising asimilar 98% of the sector). These companies, due to their small size and lack of political connections, arelargely left out of the formal banking sector. In total, loans to the private sector make up only .66% of allbank loans issued in China. Research from the CICC estimates that 26% of private sector capital comesfrom paid-in capital, 30% from retained earnings, 37% from informal financial channels, and only 7%from formal channelsand their interactions with the central government inBeijing.
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At first glance, it may appear as though the institutional sector should be the primary driver of China’s growth, given the significant financial and political disadvantages piled on the actors in theprivate economy. However, precisely the opposite is true: the private sector grew from a negligibleamount on the onset of reform to in excess of 60% of GDP in 2005. This reliance on self-financing and the curb market means that the privatesector is largely immune from government-directed changes in the money supply or economic policy,reducing the control that the Chinese government has over its private sector in comparison to theirOECD counterparts.
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. This means that a significantportion of China growth has been by way of consumption and investment coming from privateenterprise; indeed, it is estimated that 65% of China’s economic growth comes from its SMEs. Inaddition, the private sector has been the primary driver of China’s much lauded manufacturing industry,creating 75% of China’s industrial output since 1990 and 69% of the nation’s exports
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Liu, Chen Xiang. "SME Financing in China." Economics Working Papers, University of Paris (2007).
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Tsai, Kellee S. "Congressional Testimony on China's Financial System." US-China Economic and Security ReviewCommission. Washington D.C.: USCC, 2006.
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Liu, Chen Xiang. "SME Financing in China." Economics Working Papers, University of Paris (2007).
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Jia, Chen. "Development of Chinese Small to Medium-sized enterprises." Journal of Small Business andEnterprise Development (2006).
. Perhaps mostimportantly, the private sector is much more efficient than the institutional sector; the profitability
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