We'll all be shaken by great fall of China

Although it is still 85%-owned by the state, PetroChina has just floated on the Shanghai Stock Exchange and a couple of others. The shares, which were overpriced to start with, promptly doubled. As a result, it is now the world's largest company by market capitalisation.

But it is by no means alone on these lofty peaks. By the same yardstick of market capitalisation, China can also boast the world's largest insurance company, the world's biggest bank and the world's largest airline. Indeed, five of the 10 largest businesses in the world would appear to be Chinese.

It is nonsense, of course, and it is dangerous nonsense. PetroChina has barely a fraction of Exxon's turnover and profit, China's banks were universally derided as the world's worst just 10 years ago when at least 40% of their balance sheets consisted of loans that were never going to be repaid.

They may easily still turn out to be the world's worst when the Chinese economy cools enough for us to see where they have been lending their money, because in a boom such as theirs bankers are among the first to lose their heads.

Meanwhile, the airline and the insurance business operate without any of the competitive pressures faced by their equivalents in the West, so who knows how they would fare in a market economy? But enough said. Clearly the valuations are crazy.

It is all frighteningly reminiscent of Japan in 1989. The country then boasted the top three companies in the world, and five of the top six. Telephone company NTT was the world's largest corporation. The top financial, and number three, company Nomura was bigger than most of the world's other investment banks put together. That was when Japan Inc appeared to have conquered the globe.

The price-earnings multiple reached 70. Investors rationalised this by saying that the Japanese produced their accounts using different methodology, so Western measures of value were irrelevant. It would have been clearer if they said they made the figures up. They also said Japan was growing so fast that earnings would catch up with the valuations in a year or two. In short, they peddled the same rubbish you now hear used to justify the Shanghai boom. Then, of course, came the financial collapse.

What brought the Japanese market to its knees were its own internal contradictions - the fact that the earnings were largely a fiction, and the share prices the result of an irrational buying frenzy from a population with nowhere else to put their money. That also should sound familiar to those currently playing the Chinese market. The earnings multiple there is "only" 60 at the moment, but given that shares have already doubled this year, they should get to Japanese crash levels of 70 just the other side of Christmas. Then watch out.

There can be no doubt that this will happen - the only issue concerns the timing. The current level of dealing costs already exceeds the total profit of the quoted sector, so investors are already destroying their own capital simply by being in the market. They will realise this at some point and, too late for most of them, they will then try to take to the hills.

Again with a curious indifference to history, people assume that the Chinese economy is so strong it will shrug off a financial crash. But why it should escape a similar fate to that of Japan is not clear. The fact is that so much of what passes for profits in the Chinese financial sector is the fruit of speculation - on shares, on property and on other financial assets - and these will disappear when the markets turn. When the profits plunge, just as they did in Japan, the financial institutions will be crippled.

Recovering from the collapse and consequent deflation took Japan 15 years, and it was a much more sophisticated place then than China is today. China may suffer less because the Japanese prolonged their agonies with policy mistakes, but more to the point its crisis could easily come just when the Western economies are at their most vulnerable as a result of the credit squeeze, continuing problems with the banking system and high oil prices.

Indeed, that is precisely what Murphy's Law dictates should happen. Not only does it say that anything that can go wrong will go wrong, it also suggests that it will all go sour at the worst possible time. So when the Chinese financial crash comes, it will be just at the point when the West is relying on that country to keep the global economy moving. But how could it? These countries live by trade. Japan's problems caused a recession throughout Asia. A similar Chinese problem could do the same across the world.