This optimism should be taken seriously. This run-up is not a bubble, and so investors should not fear another crash. Our research shows that after a rocky first decade, which earned China's stock market a reputation as a casino, stock prices in China predict future profits as well as they do in the U.S. Moreover, this predictive power is highly correlated with China's corporate investment efficiency, suggesting that stock prices are teaching corporate managers important lessons as well. However, capital in China is still allocated almost entirely by its massive banking sector. It is time to untie the hand of the stock market, reform listing standards, streamline the IPO approval process now holding up over 600 firms seeking equity capital, and let the stock market allocate capital, too.
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China's financial system is dominated by its banking sector by design. This sector is the key instrument of its centrally planned investment policy. Similarly, the post-crisis expansion of its interconnected shadow component was also by design. To implement its massive economic stimulus, China needed to channel capital quickly to spaces previously unspanned by the traditional banking sector. Chinese shadow banking leverages the power of Chinese guanxi — the reputation and relationship-based enforcement mechanisms that underlie some of China's most effective financing channels — and has helped to sustain China's spectacular growth. But the increasingly obvious lag in investment efficiency shows that even the most well-informed shadow bankers and central planners have lessons to learn from the diffuse investor information aggregated by securities markets.
China's post-crisis shadow banking expansion brought with it an explosion in the market for wealth-management products, particularly high-yielding money-market products. But without an explicit boundary around the guaranteed sector, such as that defined by deposit insurance, China was essentially forced to insure virtually all of its interconnected banking and shadow banking liabilities, or else risk a run on the whole system. Therefore, after decades of restriction to 3-percent administered deposit rates, Chinese investors began to enjoy a rich new menu of money-market products earning 5 percent to 7 percent or more, many of which investors perceived to be risk-free. This effective hike in China's risk-free rate increased competition for investor capital, pulled capital away from the stock market, and rationally dragged China's stock prices down. This, together with the bubble in real estate prices and the prospect of slowing economic growth, explains the lag in the market's post-crisis recovery.
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Though counterintuitive to those who study other financial systems, the prospect of deposit insurance is actually news that China is now prepared to let banks and shadow banks default on some of their liabilities. This therefore reverses the post-crisis drag on the stock market, which now looks relatively more attractive, and stock prices have rationally jumped up. The shrinkage of the government's safety net will also lead to more market-disciplined bank lending, and China's stock market knows this augurs well for corporate profits, too. In addition, China's stock market may become even smarter with reforms that broaden the investor base, such as the opening of the Shanghai-Hong Kong Stock Connect program.
But harnessing the full power of the market means allowing it not only to attract capital, but also to allocate it to the capital-starved small and medium enterprises that are underserved by China's banking sector, where lending is more relationship-driven and politically-driven than credit-driven. While deposit insurance, default risk, and interest rate liberalization should create incentives for more credit analysis, monitoring, and market-determined bank lending, China's stock market has an equally important, complementary role to play. Because stocks are publically tradable, stock markets create incentives for investors to generate information about future firm profits, and aggregate information across individuals into signals that have incremental value to managers, bankers, and central planners.
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Our research shows that China's stock market is already performing these functions well. After more than two decades on the sidelines, China's stock market has finally made to the head of the class. Let China's stock market pick winners, too.
