Yesterday, Chinese stocks ignored a rate increase and rose to a record high. It marked the fourth time in a row that Chinese share prices rose on the first day after an interest rate increase. The Chinese authorities are attempting to cool down what is clearly an overheated economy and stock market.

After the 0.27 percentage point increase, a one-year deposit will earn 3.06%, but that interest is taxable, making bank deposits a losing bet in an economy where inflation is reported to be running at 3%. On the other hand, the Shanghai Composite Index has quadrupled in the past two years.

The one-year lending rate was increased by 0.18% to 6.57%, so that the real cost of borrowing is around 3.5%. With the economy expanding at 10% during the last few years there is little wonder why investment activity is so high in China.

China’s fixed exchange rate prevents the government from meaningfully increasing interest rates. Although there are other measures that can be introduced to temper investor enthusiasm such as a capital gains tax, most investors believe that the Chinese government is wary of sparking a crash before the Olympics next year.

Even if the Chinese government does not act to contain the current bubble, a crash could still be triggered by some outside source such as a geopolitical shock. Although I am certain that Chinese stocks are way overvalued, I realize that they can easily become even more overvalued and remain so for a long time. However, the odds of a significant correction or crash are increasing by the day.