With China's banks seemingly once again risking a crash by an enormous expansion of credit, it is now time for the government to give the capital markets the attention they deserve, said Fang Xinghai, deputy CEO of the Shanghai Stock Exchange at a conference on financial markets in Beijing last week.
The comments followed a speech by China banking expert Nick Lardy from the Institute of International Economics in which he warned that China's banks had recklessly been expanding credit growth since last year. That situation could lead to new non-performing loans, he warned.
"The government has been deeply concerned with the banking system, but it's now time to realize that if the stock markets take off - as they should - it will provide the banks with some competition," says Fang.
The Shanghai composite index hit a 12 month low of 1307 points in November this year, but has since recovered strongly to 1452 as of Friday, Dec 6. Although that is well down on its five year high of 2245 in 2001, the market's decline may have found a bottom, says Fang.
Still, many problems remain before the stock markets become a genuine competitor to the banks.
The stock market forms only 15% of China's GDP by market cap compared to 150% in the UK. Contributing only 4% of total funds raised, its capital raising function is is dwarfed by bank lending. If this is rectified, says Fang, a stronger stock market would force domestic banks to widen the scope of their borrowers and improve their credit allocation decisions and internal risk management systems.
Although China's stock market has been through an unprecedented bear market in the past three years, many observers believes this is actually a healthy development.
"The stocks showed rampant abuses and stocks were clearly overvalued at their previous valuations. The decline, while tremendously painful for investors and brokerage houses is a necessary for the stock market to take on their proper role," says Stephen Green, head of the Asian Programme at the British think tank the Royal Institute of International Affairs.
Fang adds out that many investors misperceive the Chinese stock market by looking at the popular Shanghai composite index which includes A and B shares, and which includes loss-making companies.
"It's more standard and makes more sense by international measures to look at the Shanghai 180 index which doesn't include loss-making companies. If you include loss-making companies, then the nature of the ratio means average price earnings ratio goes through the roof," he points out.
Many investors have pointed out that the P/E ratio in China is absurdly high, and based more on a lack of investment instruments than fundamentals.
Fang says the 180 index is similar to the Standard and Poors 500 index which also only tolerate loss making companies for a limited time, and is thus a better indicator of P/E values.
"The 180 index is reviewed every six month and companies that have taken big losses are thrown out," he says.
Average P/E earnings ratios in the composite index are around 33, compared to 22 for H-shares, even taking into account the huge run up in H-shares since the beginning of this year.
But Fang says that that P/E ratio in the Shanghai 180 index is 22, much closer to an acceptable level and a more realistic reflection of the economy.
"There are plenty of companies in infrastructure making good profits, and taking into account macro growth I think the time is ripe for these conditions to be translated into a healthier the stock markets," he says.
It now just remains for the government to recognize this and put the same commitment into stock market reform as it has in the banking sector.
