How strongly China’s shares have outperformed US stock markets

The debate about China’s economic performance is, for economists, about macro-economic performance and related fundamental questions of economic theory. If they chose to invest in China’s markets that is, for them, secondary. For most people, naturally, the order of priorities is the reverse. It is about making money - economics is relevant only insofar as it indicates how to do this.

Nevertheless the two are evidently related. The theoretical discussion about China’s economy, which has been going on for the three decades since its reform process started, is therefore simultaneously about economic theory and financial returns.

Given this it is  interesting to see how financial markets have judged this debate. Economic theory shows  China's economic performance should succeed. What is the longer term judgement of financial markets? As three decades ago there was, of course, no share market in China Figure 1 shows a comparison over the course of this century of the return in dollars on China’s main share index, the Shanghai Composite, and on the US Dow Jones Industrial Average and NASDAQ.

Figure 1

 

 

The pattern is evident. So far this century, now only a fraction under 10 years old, anybody putting their money into the Dow Jones would, up to 4 December this year,  have lost 6% in dollar terms, have lost 44% on the NASDAQ, and would have gained 186% on the Shanghai Composite. A rather emphatic market judgement. Taking into account inflation the losses on the Dow and the NASDAQ would have been significantly greater. This shows by what a huge margin the share market judges China has outperformed the US. The market  judgement is in line with the findings of economic theory.

These financial facts therefore cast an interesting light on the debate that has been going on regarding the prospects for China’s economy. Leaving aside rather extreme views such as those of Gordon Chang, who for many years has been predicting the imminent collapse of China, or Societe Generale analyst Dylan Grice, who holds that China's is the largest bubble in the entire history of the world, Professor Michael Pettis of Peking University has formulated one side of this discussion with commendable clarity: ‘I continue to stand by my comment… that the US would be the first major economy out of the crisis and China one of the last.’  The author of this blog has argued, both here and elsewhere, the exact opposite: ‘China will be the first major economy out of the crisis and it will emerge from it before the US.’

Behind such conclusions at a macro-economic level lie many questions of economic theory that have been long discussed. The present author wrote a long article on China’s economy 17 years ago, in 1992, entitled ‘Why the Economic Reform Succeeded in China and Will Fail in Russia and Eastern Europe’ the conclusion of which is self-evident. At that time an alternative argument was presented that Russia and Eastern Europe, by following ‘shock therapy’, would be economically successful while China was supposedly only carrying out timid half reforms and would therefore fail.

Seventeen years later the facts have judged these two diametrically opposed analyses. Under the impact of ''shock therapy' Russia, overwhelmingly the dominant economy of Eastern Europe, suffered the greatest decline in production ever suffered in any country in peacetime. Large parts of Eastern Europe had only fairly recently recovered from 'shock therapy' before being hit by the international financial crisis and the performance of even the best of them does not remotely compare to China - which throughout this entire period of almost two decades enjoyed the most rapid sustained growth of any country. It was China which the facts proved to be well judged and successful regarding its economic policy.

The financial consequences of such different analyses were in many cases direct. As the author lived in Moscow in 1992-2000 he was able to see the consequences first hand. George Soros amongst others, misled by talk of 'robber barons' becoming 'legitimate' and of  'reformers' in Russia, by which was meant those who led Russia into this economic disaster, lost $2 billion. Soros put $1 billion into acquiring the mobile telecommunications company Svyazinvest in what he later described as the worst investment of his career - the present author remembers the episode vividly as he wrote a paper during the bidding battle advising what a disastrous investment it would turn out to be in light both of the specific character of Svyazinvest and in particular the overall economic conditions in Russia. Shock therapy was a catastrophe in Russia not only for its economy but for foreign investors compared to the success of China. In Russia, also, correct macro-economic theory and making and loosing money were closely related.

What conclusions, therefore, follow from the stellar performance of Chinese share markets compared to those in the US? First, they throw further light on the question of the 'efficient allocation of capital'. The most important and scientific test of this is, of course, the development of total factor productivity in the economy. As a recent article in The Economist notes, the most up to date analysis of this concludes, confirming many previous studies, that the development of total factor productivity in China is the highest in the world - the latest estimate is that it is four times that of the US.

But 'efficient allocation of capital' might also be used in a more popular sense of 'where is the return on investment in a financial sense'  - where do you get the return on your money. In that sense money put into the US stock market over the last 10 years was entirely misallocated - you lost money on it. Money put into Chinese shares was extremely well allocated - yielding a total return in dollars of 186% or 11.1% a year.

The number of people who wish to go through the macro-economic arguments in relation to China - savings rates, national accounting identities, investment ratios - is strictly limited. But insofar as the financial markets have a vote they cast it only on one side. Those who put money into US shares this century lost money. Those who put their money into China's share's made lots of it.

It is not the most theoretically sophisticated economic argument regarding the relative dynamic of the economies of China and the US.

But to most people it will still be the most convincing.

Comments

[Marc]

Dear John,

my apologies firstly, as I expect this note will be far below the usual level of comments that you receive, but, if I've understood your work correctly, I believe you have said that one (major) aspect of the current recession/ depression, has been the over valuation of assets held in dollars (which seems entirely right to me, as you have said before, as it looks like the US has run the world economy since the the end of wwII, not to mention that it's had the most guns, and until recently the dollar was as-if the world currency [this is isn't coherent!!]), but what I was writing about, was that whilst I agree with you on this (in my limited capacity to understand and comment etc) it's just that another factor seems to have been at work - in addition to, not instead of - which also seems to mek a lot of sense to me, and that is the assertion that the arrival of Peak Oil (and the money flows created by speculation as a result of that, flowing from the middle east to the US, fuelled the speculation and lending which created the crisis of confidence within th bourgeoisie - the only ones - apart from china - with the capital the provide the investment levels you describe, to lift production / the economy out of recession.

Sorry, not very coherent, it's just that, as you say, a major turning point in world history has been reached, but it seems to have been preceeded by another one, just before it - Peak oil:

http://www.taxresearch.org.uk/Blog/2009/12/03/peak-oil-reality/

Now, if I remember correctly, in the History fo the Russian Revolution, it was because the bourgeoisie were both unable and unwilling to carry on, and to my mind, it seems entirely possible that both Peak oil and the changes in climate (whether they are as a result of human activity doesn't seem to matter so much) are a similar point, but this time in world history, as clearly Capitalism cannot answer the question of this magnitude - the Copenhagen summit I believe will result in no change what so ever.

Kind regards
Marc