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"You can observe a lot by watching." (Yogi Berra).

Among the more interesting comments we heard about last week's IRA on the February market meltdown, "A Normal Correction: February 27 Market Break," concerns the true origins of the market sell-off in China. According an old China hand, the sharp drop in the value of China's financial markets was the side effect of a political struggle, not a financial event.

According to this well-placed observer, whose firm provides risk management services throughout the region, the rising powers around the Chinese financial markets sent a message to the political cadres in Beijing. The message behind this not-so-subtle muscle flexing: we have the power to affect the stability of global markets and, indirectly, that of China's political future.

As heirs to the Confucian ethic which puts those who decide matters of state at the top of the social ladder, and those who engage in commerce with foreigners at the bottom, China's communist leaders fear and distrust the power and motivations of the country's rising class of economic princes.

The close association with foreign interests of China's financial and business leaders makes their loyalties subject to question. Chinese Communist Party cadres gladly accept gratuities offered by business leaders and their foreign partners, but all the while they ponder the political equation; they weigh the time when an appeal to the populist dragon which lurks not far beneath the surface in China's rapidly growing urban slums might be useful.

Rarely a day goes by now when some financial observer does not question the gravity-defying climb of the Chinese equity markets, a retail-fueled speculative boom the like of which has not been seen in the supposedly developed world in 80 years. Whereas in past times peasants revolted at rumors of foreign missionaries eating children, perhaps the next cycle will include Chinese financiers (perhaps joined by their foreign investment bankers) being lynched by an angry mob in retribution for market losses. Crucifixion, after all, was the punishment of choice for speculators in ancient China.

An appeal to the populist animal spirits is especially effective just following a financial bust, as Americans learned in the early 1930s and US corporations learned with the passage of Sarbanes-Oxley following the dot-com hiccup. The likely witch hunt in the US following a more general financial market collapse might not rival the thrills and excitement of, say, rioting in Shanghai, but one cannot help but wonder at the social reaction, both in the US and China, when the global financial markets inevitably correct.

To be more specific, a long-time reader tells The IRA that references to the Pecora Commission, the special panel established by the Senate Banking and Currency Committee in March of 1932 to investigate the causes of the Wall Street Crash of 1929, may be appropriate in both societies. In the four years of its operation, the Pecora Commission interrogated hundreds of financial moguls and ultimately led to the creation of the SEC and modern-day market regulation.

Whether or not the February 27 market break was the result of a political contest between China's communist rulers and the rapidly growing power of that county's commercial class, both the US and China face a serious social shock should the worst fears regarding speculative excesses in the financial markets be realized. Measured in terms of spreads and earnings multiples, the magnitude of the risks being taken have never been higher and the rewards offered for taking those risks never lower.

In the US, a sustained financial market sell off might well tilt the balance of political fortune back squarely in the hands of the left for the first time in over a decade, but the repercussions in China of a real Shanghai meltdown could be far more profound. Most observers assume that China cannot reverse its opening process, but such assumptions ignore that country's violent and changeable political history. Should China's political leaders decide one day to play the populist card and attack the "opportunism" of China's business elite, the mass of China's poor will be behind them and then, as they say, all bets are off.

Source: China Market Syndrome: Just Deja Vu All Over Again