Jun 20, 2013 05:31 PM

A Tale of Two Stock Markets

The rivalry between China and India has been making headlines all over the world ever since the concept of the BRIC nations came into widespread use in 2001. Of course, it is quite an intriguing topic as the world's two most populous countries adopt different political and social institutions, but tread the same path toward rapid economic development.

The China-India comparison is a textbook case study on the effect of institutions on economic development, a topic that is the focus of most discussions in academia.

However, few conclusions have emerged thus far. Statistically, China's economic achievement is undoubtedly more impressive, but other scholars argue that the India model is more sustainable given its superior institutions.

However, economic data offer retrospective wisdom but not forecasts. Moreover, approaching the topic by studying institutions cannot deliver any quantitative results.

So, I want to join this discussion from another perspective: by looking at the growth of China's stock market. It might not be a comprehensive approach, but stock indices can arguably reflect more economic information, such as development efficiency, social benefits, future expectations and, more importantly, economic benefits for the middle class. All of these insights are beyond the purview of the GDP growth rate.

I'll start with 1992 when the Chinese stock market was just established. At the time, few people invested in the fledgling stock market. I will divide the comparison into several phases so as to bring more significance to the most recent market performance.

For the sake of comparison, I will list both nominal growth rates of the two countries as measured in domestic currencies and growth rates in terms of U.S. dollars. The former data are not affected by exchange rates and thus better reflect market performance. The latter data are from the World Bank, thus providing a more fair comparison.

By simply looking at the GDP columns, we can clearly see that China's economic growth is much faster than India's, regardless of the yuan's appreciation against the U.S. dollar since 2008.

However, quite the opposite is true in terms of the growth of stock indices in China and India. First, from Econ 101, we should know that the stock market grows hand in hand with the economy, and that successful listed firms tend to outperform the overall economy.

The theory applies generally to India but not to China. China's stock market lags far behind India's, except during the 1990s, when the private sector in China grew remarkably.

This of course can be interpreted as a sign that China's stock market was cooling from the frenzy because the market earnings ratio has dropped from a whopping 48 in 2001 to 11 today, while the earnings ratio in India has remained stable between 14 and 25.

Nevertheless, although China maintained a double-digit economic growth rate after the financial crisis in 2008, the return rates of China's stock market in the following four years averaged around 8 percent, compared with 20 percent in India.

I would pay more attention to the economic data since 2008, which brings to light the performance of various economies as the world economy enters a low growth rate period.


So we can generally conclude that China's blistering economic growth benefited the middle class much less than the Indian economy did for its people. In fact, the A-share market in the past decade was a nightmare for most domestic investors.

The reason was explained by the government more than 20 years ago, when an official said on TV that the central government revived the stock market mainly to "assist the reform of large and medium-sized state-owned enterprises," reform being the official rhetoric for helping them out of capital shortages.

Because the stock market was meant to serve this purpose rather than truthfully reflect asset prices and guide capital allocation as it should in a normal market, it is no surprise that common investors in China's stock market, those who do not understand the central government's intention, have been barking up the wrong tree looking for long-term payoffs in the market.

It is hard to compare financial assets, which account for only a small part of Chinese households' wealth, with real estate assets, which make up the bulk of the wealth, because China's real estate market formed relatively late and the ownership of a house does not necessarily speak to its value until it is sold.

Judging by available data, however, the housing-price-to-income ratios in China's major cities, like Beijing and Shanghai (ranging from 28 to 41), are significantly higher than that of Kochi (21.87), a coastal city with the highest housing prices in India.

Worse still, investment efficiency in terms of economic growth has declined fast in China. According to Charlene Chu, a China banking analyst at Fitch, between 2005 and 2008, every yuan a bank lent out led to a 0.71 yuan increase in GDP. The figure fell to 0.3 in 2009 through 2012.

In my opinion, this indicates a sharp decline in investment efficiency if not a misallocation of capital.

In 2012, China's debt-to-GDP ratio reached 180 percent, an alarming level for the risk management capabilities of the banking system. This high ratio could result in financial instability.

Research by central bank officials estimated that Chinese banks will need at least 1 trillion yuan in net profit to meet the demand on capital adequacy ratio brought about by new loans. This was based on the assumptions that banks would make 8.5 trillion to 9 trillion yuan in new loans this year under the capital adequacy requirement of 12 percent.

More alarming is that this would come just a few years after the big state-owned banks raised funds by going public while money supply grew annually on a double-digit basis.

The gold-buying spree in China earlier in this year should alert the government to the deficiency of investment channels for a huge amount of excess liquidity in the market.

Because the stock market constantly frustrates most investors and the real estate market scares off ordinary people, the gold market becomes the last resort for investment. The problematic financial market may unsettle Chinese society despite the government's immense annual expenditure on social stability.

My point is that economic development should deliver concrete economic benefit to the ordinary Chinese citizen rather than promote the country's GDP ranking. It is possible that the path of further economic growth in China will be more arduous in future decades given the domestic and international environment.

I doubt that the Chinese people will be able to calmly carry on with their lives if China gets mired in lengthy economic stagflation like Japan.

The author is a fund manager with Guggenheim Investments

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