updated 5/30/2007 1:38:13 PM ET 2007-05-30T17:38:13

How do you say irrational exuberance in Chinese?

Major Market Indices

Alan Greenspan, the former Federal Reserve chairman, may not know how to say it, but — as he proved in 1996 when he coined the term in reference to the U.S. tech boom — he knows it when he sees it. Last week, he pronounced the meteoric rise of China’s stock market unsustainable.

But China’s leaders may have found a way to control it, at least for now.

Effective Wednesday, they tripled the “stamp tax” on stock trades from 0.1 percent to 0.3 percent. In response, the main Shanghai Composite Index tumbled 6.5 percent to 4,071.27 Wednesday after hitting a record high on Tuesday. The Shenzhen Composite Index for China’s smaller second market fell even more, closing down 7.2 percent at 1,199.45.

The decline in Chinese shares hit other markets, too, although not as dramatically as on Feb. 27, when investors around the world flinched from a nearly 9 percent slide in the Shanghai index.

Despite the drop Wednesday, Shanghai’s benchmark index is still up 52 percent for the year, following a 130 percent jump in 2006.

“This policy change reveals the government’s concern about a possible stock market bubble,” said Citigroup economist Minggao Shen, describing the tax hike as Beijing’s first formal move to cool the boom. “The market didn’t know what the government was thinking until now.”

The gains have been fueled by strong corporate profits and a flood of fresh money from millions of new investors sinking their savings into the stock market amid a scarcity of other investment options. Chinese banks pay just 3 percent interest on deposits.

The number of Chinese stock trading accounts has risen to about 100 million, with tens of thousands being opened every day. The press has reported on first-time investors mortgaging their homes or dipping into retirement savings to play the market.

Government officials and financial analysts have expressed concern that some novices are making risky investments, creating a possible bubble in prices.

Wednesday’s drop modestly affected regional stock markets, with Tokyo’s benchmark index slipping 0.5 percent and Hong Kong’s market closing down 0.9 percent. South Korean shares inched up to a new record.

In Europe, stocks ended modestly lower after initially being off about 1 percent following the retrenchment in China. European stocks gained strength after the U.S. markets opened down only moderately, easing concerns of a sharp global pullback. Britain’s FTSE 100 slipped 0.07 percent, Germany’s DAX index fell 0.21 percent, and France’s CAC-40 gave up 0.24 percent.

In early afternoon trading, the Dow Jones industrial average moved back into positive territory after dropping about 60 points at the open. The blue chip index advanced 22.76, or 0.17 percent, to 13,544.10.

Broader stock indicators also turned positive. The Standard & Poor’s 500 index rose 2.96, or 0.19 percent, to 1,521.07, and the Nasdaq composite index rose 0.85, or 0.03 percent, to 2,572.91.

The effects of the pullback in China’s markets are somewhat limited to domestic investors as the country limits foreign investment in certain areas. While it has eased restrictions, the government still controls how many foreigners can purchase the mainstream, yuan-denominated stocks. Known as “A shares,” these stocks account for the largest slice of the markets. There are also foreign currency-denominated “B shares.” The benchmark Shanghai Composite Index tracks both A and B shares.

Retail investors in China have recently been moving into the B share market, however, as valuations remained lower than in the A share market.

Chinese investor confidence has been buoyed in part by China’s political calendar.

Many expect communist leaders to do whatever it takes to keep share prices up and avoid a public backlash ahead of a key party meeting in late 2007, when new leadership posts are due to be decided, and the Summer Olympics in Beijing next year.

The stamp tax increase “is an early move, so that even if the markets correct soon, they still have time to stabilize or even improve before the party meeting in the fall,” said Citigroup’s Shen.

Economists say a fall in the markets should have little impact on China’s economy, because growth is driven by exports. Also, households have much more money in savings than in shares.

A fall in prices of even 20 percent is likely to have only a modest economic impact, J.P. Morgan economist Frank Gong said in a report to clients.

Gong noted that during a long bear market in 2001-2005, when the main market index fell from 2,300 to under 1,000 points, China’s economy grew by about 10 percent per year.

The World Bank, in a report Wednesday, raised its forecast of China’s economic growth this year to 10.4 percent, up from 9.6 percent, and said its current account surplus could reach $340 billion.

The stamp tax was set at 0.6 percent when it was introduced in the early 1990s but has been cut repeatedly to encourage the Chinese public to invest in stocks. It fell to 0.1 percent in 2005.

Analysts have been forecasting a possible Chinese correction due to the sharp price rise, reducing the likelihood that markets abroad would be taken by surprise.

Copyright 2007 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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