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China’s stock market tremors this year have shaken investors across the world. But there is some consolation from January’s 23 per cent fall in the Shanghai Composite index: the panic has little direct effect on the country’s economy.

A drop in stock prices can lead to lower demand: people consume less when they become poorer. But this so-called wealth effect is small in China. “Domestic wealth invested in stock markets is insignificant as a proportion of Chinese household wealth,” says Chen Long of Gavekal Dragonomics, an investment research firm, who estimates that households hold about 5 per cent of their total assets in the stock market.

China’s stock market plays only a small role in financing the real economy. In 2015, China’s domestic stock market supplied Rmb760bn in funding to non-financial firms, through initial public offerings and follow-on offerings. This represents only 5 per cent of total financing flows to the real economy.

Credit in the Chinese economy has boomed since the 2008 credit stimulus. Since then, the stock of total social financing (the government’s chosen metric for credit) as a proportion of gross domestic product has increased by 88 percentage points. Meanwhile, equity financing as a proportion of GDP has increased by only 3 percentage points.

Banks still run the show . . .

Instead of stock markets, banks run the financial system. Bank loans made up 69 per cent of new financing in 2015. The sector is dominated by the Big Four state-owned banks, which loosen their purse-strings when the economy needs stimulus. Because of this, there is no threat of China’s finances drying up.

Yet this model is itself a problem. Policymakers know the economy needs other sources of finance. Ideally, companies would draw more from stock markets and bond markets, and rely less on bank lending.

In the long run, the recent stock market panics will make it more difficult to achieve China’s goal of a more balanced financial system. The government has already delayed new IPOs, and the launch of an improved IPO system, in response to the turmoil.

“The recent rout is frustrating efforts to deleverage the economy and increase the role of equity financing”, says Louis Kuijs of Oxford Economics, a consultancy. “It is essential for the government to build confidence in the stock market and its regulation in order for equity to play a larger role.”

. . . but banks can lend badly

Currently, private firms suffer because capital does not go where it is most needed. State-owned enterprises get the lion’s share of bank lending. A study by Wenlang Zhang and colleagues at the Hong Kong Institute for Monetary Research found that SOEs have increased their leverage, which they define as loans relative to assets, by 10 per cent since 2008. In particular, SOEs in the construction sector increased their loan-to-assets ratio by almost 50 per cent. Over the same period, the private sector deleveraged.

SOEs get their hands on credit because of their relationships with bankers at the Big Four. Despite President Xi Jinping’s crackdowns on corruption, such relationships naturally develop in a political system that places officials on a merry-go-round between business, banks and government.

Such credit misallocation leads to lower growth. When capital goes into unprofitable projects, this slows the rebalancing of China’s economy away from industries with spare capacity.

“Whenever there is credit misallocation, someone has to pay for the bad debt,” says Michael Pettis, a professor at Beijing University. “The question now is who will take the hit.”

Beyond the big banks

The hope among China’s reformists is that moving away from the bank-dependent lending model could lead to better capital allocation and a more resilient financial system.

Because the Big Four banks form the foundation of the financial system, risk is concentrated. The failure of any single Big Four bank would be catastrophic, as the collapse of Guangdong International Trust & Investment Company showed in 1998.

Such a Lehman-style collapse is unlikely as the government implicitly guarantees the banks. But this leaves a lack of discipline in the sector because banks expect their bad loans to be rescued. If funding came from a wider range of sources, the effect of any one failure would be lessened and some funds would be allowed to fail.

Moving from debt-funded growth to equity-funded growth could put China’s economy on more stable ground. Equity investors accept that share prices change, whereas bond investors or bankers making loans systematically overestimate how safe their assets are. This leads to economies shouldering too much debt because creditors underestimate risk. China, with debt totalling more than 240 per cent of its GDP, is no exception.

yuan.yang@ft.com

Twitter: @yuanfenyang

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