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As China's GDP approaches US$11 trillion, its stock markets have finally woken up.

China's stock markets are ready to welcome foreign investors

Guru Ramakrishnan says the growing maturity of the Shanghai and Shenzhen exchanges should hasten their opening up

The time is ripe to rewrite the tale of two stock markets in China: the Shanghai and Shenzhen exchanges. These markets seldom get the respect they deserve. Their relatively nascent existence of 20-plus years is often ridiculed and the two institutions have frequently been dubbed "casinos" where insiders and speculators manipulate prices and meteoric fortunes are made or lost overnight.

The recent sharp rise in stock prices and the ensuing market volatility seem to provide the anecdotal evidence to critics who are constantly trying to make their case for the instability of these markets. A careful examination under the bonnet of China's stock markets, however, tells a very different story.

As China's gross domestic product approaches US$11 trillion, its stock markets have finally woken and are now playing catch-up: stocks have doubled during the past 12 months alone. The transition of China from a smoke-stack manufacturing economy to one based on services and new media seems to be well on its way.

The outperformance of the innovative technology-oriented Shenzhen stocks over their sleepy capital-intensive Shanghai Composite counterparts is a sign of the change of guard that is so desperately needed. Despite the rapid rise in valuations of stocks, China's market capitalisation-to-GDP (70 per cent) still trails many economies that it now dwarfs, including Japan (154 per cent), Canada (130 per cent) and Australia (118 per cent).

As the experiment of moving the economy away from a state-led investment model to a consumer-driven one evolves, the stock market, as a resource allocator, will have to take a lead role in orchestrating this shift. This is why it's most important for China to open its domestic markets to international investors while allowing domestic residents the opportunity to invest freely abroad.

In the past two decades, the Chinese stock markets have matured enormously. The Shanghai and Shenzhen exchanges today are substantially more liquid, offer greater transparency and require higher quality standards for listing, disclosures and auditing of financial statements than many of their global competitors.

These markets are centralised and, unlike the US, treat individuals and institutions trading in these markets alike. All orders are visible to other market participants and the structure of the markets themselves does not provide any trading advantages to either the individuals or the institutions that trade there: no "dark pools" of liquidity exist, for example. Although stories of individual stock disasters abound, the 10 per cent price limit on shares and a few other regulatory measures have helped truncate market volatility.

Despite these clearly differentiated exchange features, the cost of equity capital for Chinese firms continues to be relatively high. Somehow, China's statistically low correlation to global stock markets (which should help international investors diversify their portfolios) has not helped in the reduction of the overall Chinese equity risk premium.

One important indicator of a well-functioning stock market in any country is the information content that stock prices provide - whether about future profits of companies that operate in it or how efficiently the corporate sector invests its financial resources.

Recently, a plethora of academic work on a cross-section of Chinese firms documents that China's stock markets over time have done a good job of incorporating information about future cash flows of companies into the pricing of stocks today. These results challenge the "casino theory" of China's stock market.

As international investors get access to the A-shares through the Hong Kong-Shanghai link, markets there will unquestionably become more complete and will act more efficiently. The second component of a maturing stock market lies in the role stocks play in helping companies make the right resource allocation and investment decisions. Sensible decisions to invest in incremental capital expenditure should be rewarded by the market in the form of higher stock prices. In particular, this should be true of investments that are made by companies over and above the already expected levels of capital expenditure by the market.

The data from analysing the impact of stock prices in China, to changes in investment during the past 15 years, clearly demonstrate that the Chinese stock market does reward firms that deploy incremental capital effectively.

These results must give the Chinese government hope as it embarks on much-needed financial market reforms.

With over US$3.7 trillion of foreign exchange reserves in hand, the time has come for the government to open the stock markets fully. The Chinese should allow international investors access to buy and sell securities on the Shanghai and Shenzhen exchanges, and restrictions on short selling must be eliminated. These acts alone will provide further discipline to curb exuberant behaviour.

Policymakers and regulators need to understand that the low correlation China's stock markets have to those in the rest of the world makes stocks there a valuable part of any global investor's asset portfolio. They should capture this economic rent by allowing China's firms to be a part of the global investable indices.

This decision will help reduce the Chinese equity risk premium, bring in much needed equity capital to the right kind of Chinese companies, make markets there more efficient and lead to the right resource allocation decisions that are always at the core of a well-functioning stock market.

This article appeared in the South China Morning Post print edition as: Ready for change
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