NYU Professors Says Chinese Stock Market Not a Bubble

The stock market knows more than any individual investor, and China’s is no exception.

The launch of deposit insurance, announced in November and to be implemented in the new year, will effectively reduce the implicit government guarantee of China’s high-yielding shadow banking wealth-management products.

This prospect makes China’s stocks now look cheap by comparison with those products, and investors are bidding them up accordingly. The combined Shanghai and Shenzhen market was one of the world’s top performing stock markets in 2014, up more than 40 percent, compared to only a 10-percent gain in the S&P 500, and the vast majority of this outperformance has occurred since the beginning of November.

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.

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.

via CNBC

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