Dancing with shadows: China and the financial markets.

• Author: Schamotta, Karl
• Position: Financial Markets

More than 20 centuries ago, the favorite mistress of a powerful Chinese emperor fell ill and died. The emperor missed her so terribly that he lost his desire to rule and retreated into seclusion. He was inconsolable until one of his ministers invented a new form of theatre. With the help of an oil lamp, a mulberry screen and a puppet made from donkey hide, his beloved was brought back to life. The emperor wept and rejoiced.

Shadow play, or pi ying xi as it came to be known, became a cultural institution passed down from generation to generation, eventually forming the basis for the modern cinema.

Today, a different form of shadow theatre is being performed on a much larger stage. Now, the Chinese economic dragon plays the central character, and the drama is being projected on the trading screens that span the globe.

For more than a decade, audiences across the Western financial markets have watched in awe as China has defied many of capitalism's rules on its way to becoming one of the world's largest economies.

China's spectacular growth shifted the flow of international trade and breathed new fire into previously moribund areas of the global economy.

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Commodity prices, emerging-market equities and resource-linked currencies all soared to new historical highs as asset managers sought to capitalize on exploding Chinese demand. Businesses adjusted to a new set of investor perceptions and a flood of capital flowed into countries that were poised to benefit from its continued growth.

Few market participants had the capacity--or the desire--to step behind their screens and examine the Chinese miracle more closely.

Traders with little insight into the inner workings of the Chinese economy suspended disbelief in the hope that the dragon's insatiable appetites would put new impetus behind global growth.

The glittering skyline of Shanghai overshadowed the ghost cities of Jiangsu. Thousands of newly minted millionaires rendered hundreds of millions of uprooted, poverty-stricken peasants insignificant. Gleaming new airports outshone the gritty realities of a rapidly industrializing nation.

In an echo of an earlier time, the emperors of global finance became more enamored with their own perceptions of China than with the underlying fundamentals.

China's Long History Leads to Present Strategy

This willingness to dance with Chinese shadows has a long history.

When Marco Polo's tales reached Venice in the 13th...