An official from the Japanese central bank once described to me how to judge whether there are bubbles in a stock market or a property market.

When economists and analysts of institutional investors hold numerous meetings to discuss if a certain market has bubbles, and when most of them deny it, then you can be sure that market is loaded with bubbles, he said.

Another practical way for judging bubbles comes from Peter Lynch, manager of the Magellan Fund and a legendary icon on Wall Street.

At cocktail parties, after a mutual fund manager introduces himself, and if everybody just nods and resumes discussions on the weather or soccer game or should one of them seek the dentist to talk about plaque. Then the stock market is sound.

If someone should approach the fund manager and engage him conversation for about two minutes, and then turn to the dentist, there must be a bull market.

If the stock market keeps rising, almost every guest at the cocktail party, including the dentist, will surround the manager eagerly seeking his opinion on stock investments.

The fund manager must be vigilant against bubbles if everyone recommends to him stocks that are worth investing, even the dentist has an opinion.

With the above two examples, it is not difficult to see why the Chinese stock market has seen plenty of bubbles.

The current disagreement about market bubbles among experts here originates from the fact that they draw conclusions of the Chinese stock market using different factors.

The optimists say the stock market is fine at present because they think China has a unique economy different from others. The pessimists say China might have to pay a high price should the market fall, as has happened in other countries.

Being a pessimist myself, I believe people tend to make similar mistakes without realizing it.

Admittedly, the soaring stock price is propped up by economic fundamentals. The reform of liquidizing untradable shares in State-owned enterprises has helped shareholders and investors.

Listed companies are no longer used as a tool to funnel money from the stock market. Managerial and controlling shareholders are strongly motivated to improve the company and boost its market value.

But the blind pursuit to growth could sometimes be at the expense of sound, strategic development.

The continuous economic boom improves the profitability of businesses and the rise in the stock market is a result of this. But the question is: does the stock market mirror the real economic situation. A large number of businesses that are doing well are not listed on the stock exchange.

Some mature foreign invested enterprises cannot be listed here. And, private local businesses that are fundamentally strong, do not have an opportunity to go public.

Given these factors, the Chinese stock market has become one for speculators, instead of investors.

According to the definition of Charles P. Kindleberger in the New Palgrave Dictionary of Economics, an asset price bubble takes shape when an asset or several assets are on a continuous price hike, which, at an early stage, gives people the impression there will be further increases and attracts more purchasers. If this proves to be false, prices slump, causing a financial crisis.

Bubbles are all alike, resulting in huge losses when they burst.

Investors see a substantial reduction in their wealth and businesses a cost rise in getting adequate finance. Investors cut back their consumption and businesses stop making investments. The consequence is an economic contraction.

Judging from the current situation in China, the market value of stocks does not have a considerable share in the GDP and therefore the impact on the economy would be moderate if the stock market crashes.

However, this does not mean the current stock frenzy should be allowed to go on.

A decreased flow of deposits to banks is a potential threat to the financial sector.

Businesses and individuals tend to invest more in a bull market for quicker and better gains than through bank deposits. But this is risky and short-term.

The stock market fever has affected a number of people, and most are not prepared for the risks involved.

The present situation calls for cool-headedness and a cushion to absorb or reduce losses.

It could become a tragedy for the economy if we continue to turn a blind eye to the threatening dangers.

The author is a researcher with the Institute of World Economics and Politics under the Chinese Academy of Social Sciences

(China Daily 07/13/2007 page10)