Ten years ago I wrote that, whatever China buys, the price would go up and, whatever China sells, the price will go down. I recently modified the second half to that, whatever China sells, the price will go up too, because I expect China’s factory wage to quadruple over the next decade.

The slogan is a play on China’s size. In economics most observations are based on small perturbations to a large system. For example, when a small country joins the international trading system, economists conclude the impact on its economy based on its prices converging to international prices. When a large country like China joins the global trading system, the impact is both ways. In some areas like natural resources, for example, China’s impact would dominate, hence, changing relative prices for everybody.

In one area that I thought China would have a great impact was luxury market. I noticed the strong preference for ‘famous brands’ in Hong Kong and Taiwan and thought that the same force would apply to the Mainland when it become rich. That force has even surprised me in its strength. When one treks through luxury shops selling watches and bags in Europe, almost all have mandarin speaking salespersons.

There are clearly different degrees of preferences for luxuries among different nationalities, even when one controls for all economic variables like income, age, or family size. One important factor is what economists call discount rate. It measures how much one wants to be paid for postponing consumption. Long-term interest rate is supposed to measure this factor. But, with a global capital market, money flows around the world to arbitrage the interest rate differences. Also, central banks keep inflating money supplies to stimulate economy. Interest rates can on longer reflect the differences in consumption patience.

The discount rate can partly explain the global imbalance. President Obama was putting pressure on China to appreciate its currency. The purpose was to decrease the US’s trade deficit with China. I seriously doubt that this would be effective. You just need to look at the differences in spending behavior between Americans and Chinese in Paris. Apart from Europeans these two nationalities probably dominate the tourist market in Paris. Americans cut their travel in 2008 and 09. Now they are back in Paris with a vengeance. The explanation I heard was that Americans heard about euro devaluation and rushed for a bargain in visiting Paris.

The problem is that Americans are deep in debt. Why should they bother if visiting France becomes a bit cheaper? They should save money to pay off their debts. But, Americans are in Paris for a good time again. They stay at nice hotels, drink good wine, and eat expensive French food.

On the other hand, Chinese tourists go in groups, stay in cheap hotel, eat instant noodle, and then spend ten thousand euro on an LV bag. I disagree with the choice. LV bags are sold almost exclusively to Chinese and Japanese. And they think it’s a global and prestigious luxury brand. In fact, the product is to exploit oriental people’s misunderstanding of western luxury.

My view on LV bag is beside the point. The main point is that Chinese leave with something that will last, while Americans have everything in the stomach. This fundamental difference in behavior won’t change with Rmb going up or not. If Rmb goes up, it will benefit LV sales, not American exports.

Luxuries like bags and watches are in theory consumption goods. But they last for a long time. Hence they are kind of half way between consumption and investment goods. Hence, a country with a lower discount rate or interest rate should have a higher preference for luxury goods. This force is extremely potent when a poor country becomes rich and its inherent preference for luxuries is strong. When this country is as big as China, its impact would be felt in every corner of the market.

When a new factor like China comes into the global market and when the supply quantities are constrained, the luxury prices will rise relative to other goods like necessities. Diamonds, especially the hard-to-find big ones, are in this category. (If your guy can afford one, put the pressure on, ladies. Say it’s a good investment!) When the supplier can increase production but want to fix price, the supply goes up just enough to accommodate China’s demand. Mercedes-Benz cars and LV bags fall into this category.

I discussed in an article the economics and China’s impact on luxuries two years ago. In this article I want to discuss luxury French wines. China’s impact on the market is enormous. No many asset classes have made new highs above the levels in mid 2008. Gold is one. French fine wine is another. China residential property made a new high in October 2009. I can’t recall anything else. Among the three French fine wines seem to have performed best. The French fine wine index (Liv-100 index) is roughly up by 37% from one year ago and 24% year to date. Its upward momentum remains strong.

There is little doubt that the force behind the current upward momentum is Chinese buyers, not Wall Street traders. Bordeaux wine producers are all talking about China. Chinese buyers seem to dominate the en premieur (酒花) for 2009 vintage that will be available in another year. In the first growth wines Mainland Chinese buyers are increasingly pricing out others like Japanese, Taiwanese or Hong Kong people.

French wine is different from LV bag. When it is drunk, it’s gone. Of course, you can store it as investment. But the process is complicated and costly. In terms of Chinese demand, investment is still a secondary consideration. Drinking now is a bigger factor.

Drinking expensive wine is probably the ultimate consumption. One could swallow a lot of money and quickly. It seems inconsistent with the dominant Chinese preference for accumulation. Why is so much demand from China?

An important factor seems to be the need to lubricate business relationships. Like Japan in the 1980s drinking is an all important component in developing business relationships. For some reason this phenomenon recurs during rapid economic development across the world. A little intoxication may be necessary for successful economic development. When one sinks a lot of money into an underdeveloped economy, it needs courage. When many do the same, it then becomes a self-fulfilling virtuous cycle.

Lubricating relationships with government officials may play a more important role in China’s fine wine demand. In the East Asian investment and export-led development model, government usually plays an important role. In China this role is increased greatly due to the government ownership of most assets and the deal specific approval system. When befriending government officials, private businessmen obviously pay for the best.

The business drinking culture has been changing in China. Like elsewhere the liquor consumption has been declining out of health concerns. Obviously, liquor is more effective at loosening people up and advancing business relationships. But, its bad health effect is deterring the consumption. But, when wine is not effective, the liquor is still needed. That is why China’s liquor consumption is declining but still at a high level.

The role of alcohol consumption in business entertainment has produced a unique Chinese phenomenon-the massive demand for Chateau Lafite wine. Lafite is one of the five first growth wines in Bordeaux. France classified Bordeaux wines into first to fifth growth and unclassified in 1855 for its World Expo. At the time four chateaus-Lafite, Latour, Haut Brion, and Margaux classified as first growth. In 1975 Mouton also qualified. Chateaus in some of the Bordeaux’s areas like Pomerol and St Emilion didn’t participate in the classification. They have started their own classification. Some of their wines are more expensive than the five first growth wines. Nevertheless, the first growth label travels well, especially to a new market like China.

Among the first growth wines Lafite has taken a life of its own, rising much quicker than the fine wine market as a whole and other first growth wines in particular. For example, Lafite of 2000 vintage has appreciated by about 550% in pound sterling since 2005, compared to 180% for the market as a whole. The most comparable wine to Lafite is Latour. The latter’s price of the same vintage has risen roughly in line with the overall market. The price differentials between Lafite and other first growth wines for other vintages are not as dramatic as for the 2000 one but are still large. Something special has happened to Lafite in the past few years. That something is China.

China has been experiencing a Lafite phenomenon in the past five years. It has become almost the official Chinese wine for business entertainment. There are many sayings on why so. The most popular one is that the Chinese translation is easy to say and sounds nice. I am not sure this is the best explanation. Drinking at business entertainment in China isn’t really sophisticated. It is all about getting tipsy quickly. Providing expensive wine is really for its own sake; the high price, not necessary the taste, is meant to impress. Hence, when some wine becomes expensive, it can take on momentum of its own. If not Lafite, another wine will probably take its place. The factor that its name sounds nice in Chinese gives it an advantage.

Is the Lafite Phenomenon a bubble? As Greenspan says, one can never be sure until it bursts. It is possible that Chinese drinkers appreciate something in Lafite that other drinkers never did. Hence, as Chinese become richer and spend more on wines, Lafite benefits from this source of demand more than others. So the Lafite phenomenon is price revaluation, not bubble.

An alternative scenario could be that other first growth wines would get the Lafite treatment overtime. Chinese demand is focusing on Lafite due to lack of knowledge on others. When Chinese drinkers become more sophisticated, the demand for other first growth wines will increase. This could be a rising tide that will gradually carry up other fine wines.

The second scenario is possible. It has something to do with the French system for wine production. The laws make the great wine chateaus in Bordeaux impossible to increase production. The most important restriction is that they cannot irrigate. Hence, they have to cut out half of the grape buds to improve the quality of the other half. Wine producers in Australia and the US use irrigation and can produce four times as much wine from the same acreage of land. Bordeaux wine producers have to go for quality and high price rather than quantity. Hence, when a new source of demand comes, the prices will go up.

Indeed, the Lafite price is so high that it has led to a large fake industry. Some analysts estimate that 70% of China’s Lafite consumption is fakes. I personally experienced a few occasions. The people who served me fake Lafite didn’t know it, because they paid high prices for it just like for the real thing. I could tell that the fake was good wine too, probably some good second growth poured into a Lafite bottle, just not the real thing. The forgers have targeted the legendary 1982 vintage in particular. Many rich Chinese have bought large stocks of 1982 Lafite. The odds are that they are all fakes. There are very few bottles of the vintage left. It is highly unlikely that one can get several cases of the real thing.

When the Chinese economy matures in ten or fifteen years, the prices may come under pressure, as business entertainment declines. The final demand would become mostly for self enjoyment and, hence, more price sensitive. Japan has already gone through such a cycle.

While I am not sure that the Lafite phenomenon is a bubble, I am quite sure that Chateau Lafite’s second label, Carruades de Lafite or little Lafite in Chinese, is a bubble. The production of fine wine requires the vine age to average 30-40 years. Vines older than 80 years must be replaced. Hence, a chateau is always taking out old vines and planting young vines. But the grapes from young vines cannot produce high quality wine. Great chateaus like Lafite and Latour use the grapes from young vines to produce second label wine to recover some costs. These second labels are usually quite cheap. They are usually much cheaper than second growth wines.

For example, Lafite’s second label, Carruades de Lafite, sold for about £200/case until five years ago. Since 2005 the price of Carruades de Lafite has increased roughly ten times. Its price sometimes rivals the prices of non-Lafite first growth wines and is usually higher than great second growth wines. Little Lafite is not a bad table wine. But it is definitely not a grand wine worth paying so much money. Its meteoric rise is really due to an identity mistake.

As Lafite’s price becomes a small fortune, the search for a substitute is a natural market response. In China the substitute is little Lafite. The choice is way off the mark. If one shifts from Lafite to Latour, Haut Brion, or Margaux, it would be rational. Their qualities are similar. When Lafite’s price is so much higher than that for others, they should become the next choices. But, in Chinese, little Lafite has the connotation of Lafite’s junior brother, probably similar but a bit less good. Hence, it becomes the substitute for Lafite. Moreover, as its price has risen, it seems to confirm its worth. At least the choice doesn’t look cheap to whom one wants to entertain.

The magnitude of the mispricing of Carruades de Lafite is probably similar to that of internet stocks in 2000. Of course, overtime, the bubble would burst. So why should we be upset about it? The problem is that it has become an insult to other great winemakers. I’m really ashamed of the enormous Chinese demand that has created this phenomenon. I saw Chinese tourists buying cases of little Lafite at enormous prices in Bordeaux for shipping to China.

French wine chateaus maintain traditional methods for making wine. It is arduous, costly, and often unrewarding. The top chateaus could afford a lot of labor and fine equipment to maintain quality and sustain high prices. Most chateaus in Bordeaux are not so lucky. They suffer low prices and low quantities. I visited one unclassified chateau about two kilometers from Chateau Petrus the maker of the most expensive wine in Bordeaux. Its wine is quite good. For some good vintages, it is comparable to the second labels of the first growth chateaus. But it sells for one fiftieth of what Carruades de Lafite does.

A market is efficient when consumers are informed and make rational choices. An efficient market motivates producers to improve quality and control cost. The virtuous cycle leads to great brands that last. The French wine market was like that. I am afraid that Chinese demand is decreasing the market efficiency and may bring down great brands over time. When winemakers see the price a result of propaganda, not quality, they will focus on marketing and decreasing investment for improving quality. It would be a tragedy if Chinese demand, by bringing easy money, brings down a French legacy that has lasted for five centuries.

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