Some warn of deflating asset bubble in China

— -- A month-long plunge in the main Chinese stock market is raising questions about the outlook for China's economy. The Shanghai composite index sank 6.7% Monday, worrying global investors and capping an August bear market that has stripped more than 23% from share prices.

The nerve-jarring drop prompted some — including the head of China's $298 billion state-run investment fund and a former top Morgan Stanley economist — to warn of a deflating asset bubble. "Some of us were over-optimistic about the ability of China to become the engine of growth for the region and the global economy," said Joshua Aizenman, professor of economics at the University of California-Santa Cruz and a former consultant to the Chinese government.

After doubling in value from their crisis low in early November, Chinese stocks have been whipsawed by signs that the government is tightening the tap on its free-flowing fiscal stimulus. Beijing has battled recession by funneling unprecedented sums through state banks as part of a $586 billion pump-priming. It worked: China has been a rare bright spot on the global horizon, growing in the second quarter at an annual rate of 7.9%.

"The government did a great job of stabilizing the economy. In the process, it created a bit of an asset bubble," said William Overholt, senior research fellow at Harvard University's Kennedy School of Government.

Lou Jiwei, head of China Investment Corp., the government's investment fund, said this weekend that both China and the United States were "creating more bubbles" in trying to combat the global crisis. And Andy Xie, a prominent, former Morgan Stanley economist, told Bloomberg News that the Shanghai exchange is in "deep bubble territory."

Shanghai remains a speculative market, often buffeted by government whims. Investors spend as much time interpreting officials' signals as they do scrutinizing company balance sheets. Now, with lending from state-dominated banks shrinking from a monthly average of about 1,230 billion yuan over the first half of 2009 to as little as 300 billion yuan in August, investors sense the government is pulling back.