2015 was a turbulent year for the Chinese stock market. On June 12, the Shanghai Stock Exchange Composite Index reached 5,178. But, within two months, it sunk to 3,748. Nearly 15 trillion yuan of market value evaporated in the plunge.

 

China is facing an economic downturn, with deep-seated structural problems coming to the foreground. The government once stabilized economic growth by relaxing credits and incentivizing investments. Within the context of the “new normal,” such mechanisms are losing ground in practice.

In the past two decades, the economic potential of the real estate industry has been overexploited, and the potential for a real estate bubble remains the major threat to China’s financial stability.
 

Moreover, bank-led indirect financing has hit a dead end in light of the fact that the average debt ratio of state-owned enterprises has reached a record high and financial leverage is no longer a workable solution. Evidently, new strategies are needed to combat the current economic slowdown.
 

In the next five years, decision-makers need to redesign the dynamic structure of domestic economic development in accordance with the characteristics and functions of a modern market economy. In the process, it is essential to streamline and revitalize the multi-layered capital market.

 

Perils of asset shortages
Since the late 1990s, asset shortages, instead of commodity shortages, have been the foremost threat to Chinese economy. Such a predicament has heightened since the beginning of the 21st century. To address commodity shortages, policymakers are supposed to increase investment, augment productivity, safeguard supply and meet public demand. When asset shortages occur, the major tasks facing policymakers are absorbing excess capacity, mitigating debt risk, making financial assets more productive and supplying high-quality assets.

MIT economist Ricardo Caballero pioneered theories of asset shortages. In his view, developed countries, such as the US, possess a wealth of highly productive assets. Even more enviable, they are adept at creating extremely valuable financial assets. Statistics show that financial instruments account for nearly 70 percent of US household wealth. In China, almost 70 percent of household wealth is tied up in the real estate industry because of the country’s poor capacity to generate high-quality financial assets. Such a shocking divergence of wealth structure stems from a series of systemic differences between the US and Chinese economies.
 

For example, in China, an excessive amount of resources has been allocated to real estate development, which is the driving force of economic growth. The real estate bubble is at the heart of the illusive economic boom. Economic hyper-growth has nothing to do with capital market prices. This is evident in the prolonged slump of securities market in which small-cap and junk stocks are customarily overpriced and blue-chip stocks undervalued.

 

Mature capital markets
A functioning capital market is indispensible to a modern economy. The monetary market is crucial but not sufficient on its own. In China, financing is carried out through a monetary market that revolves around the debtor-creditor relationship rather than a capital market built upon rights and interests. Consequently, the bond between the finance industry and real economy in China has been deteriorating. Revitalizing the capital market and equity trading is the primary cure for China’s economic status quo.
 

A vibrant capital market can solve the housing bubble and pave the way to innovation-driven growth. Well-off households have to purchase needless properties simply because no better investment channels and instruments are available. Quality financial assets and investment opportunities could help to overcome such a dilemma.

Likewise, capital market growth can fuel innovation. The former British Prime Minster Margaret Thatcher observed that Europe did not have its own Nasdaq, and that was why it lagged behind the US in terms of technological innovation. In this light, China’s innovation economy cannot take off without a dynamic capital market that allows businesses to engage in low-cost financing. Because of the high-risk nature of most strategic industries, financing is conspicuously inadequate. Market-driven investments are crucial to an innovation economy.
 

Capital market growth will mitigate the risk of local government and bank debts. Currently, most government debts are concentrated in commercial banks, meaning that securitizing bank assets can serve to stabilize such a precarious situation. Yet without a mature capital market, efficient securitization is unlikely to happen.
 

Also, the government alone is incapable of effectively reducing excess production capacity. There are two pathways to terminate business operation―administrative order and market withdrawal. The latter includes bankruptcy and merger. A fully functioning capital market is a prerequisite for merger.
 

It is also a requirement for interest rate liberalization. Given that more than 90 percent of Chinese enterprises rely on indirect financing, the real economy might be stifled if the central bank relaxes its control on interest rates. The only solution is to encourage enterprises to undertake direct financing while adopting a gradual approach to interest rate liberalization.
 

The general public wants comprehensive capital market reform. To avoid social unrest, policymakers must submit to the will of the majority. At the moment, a bullish stock market is what most Chinese citizens are calling for. Suffice to say, a rising average property income caters to the public interest.
 

A healthy capital market can help resolve the conundrum surrounding pension and social security funds. Only in a vibrant and prosperous stock market can the monetary sources for the two funds be sustained through reducing state-owned shareholding and increasing return on equity that goes into state treasury and social welfare facilities.

 

Workable solutions
Obviously, an adequate supply of quality financial assets will resolve economic risks besetting China instead of engendering more uncertainties. The domestic economic situation is jeopardized by turning a blind eye to asset shortages that give rise real estate bubbles, restraining financial activities to “balance” the real economy and the financial economy, and allowing the proliferation of low-grade financial assets.

Therefore, to fully realize the notion of “modernizing the financial market system” put forth by top decision-makers at the Third Plenary Session of the 18th CPC Central Committee, we have to truly understand asset shortages and the prerequisites of economic restructuring. Such an understanding is the first step toward a workable solution to China’s economic imbalance.

 

Liu Zhibiao is a professor of economics and deputy dean of the Nanjing University Business School.