Shortly after China unveiled its new leadership last November, the country's main stock market delivered a downbeat verdict on the world's second-largest economy. For a few days, the Shanghai Composite index dipped below the psychologically important 2,000 mark-where it was 12 years earlier.
The drop was puzzling to many. How could an economy that more than quadrupled in size in a decade, bringing prosperity to many of China's citizens in the process, have produced such poor returns for investors? Resolving this paradox is central to explaining the country's extraordinary economic development-and to understanding whether it can continue.
On one level, the poor stock market returns can be explained quite easily: Share prices reflect expectations of future growth, and these projections are often wrong, so the performance of markets does not necessarily track the underlying economy. This is particularly true of the Shanghai index, which is dominated by domestic investors. Over the past 12 years, it has slumped as low as 1,000 and peaked at 6,000 before reaching its current, relatively subdued level.
But a different benchmark and a different timespan tell a very different story. Take the MSCI China index, a more broad-based measure that includes Chinese companies listed in Hong Kong and the United States: An investor who bought the stocks in the index on the day Hu Jintao was announced as China's new leader in November 2002 and sold on the day Xi Jinping took the stage a decade later would have earned a return of 392 percent-a reasonable reflection of China's economic expansion over that period.
Stock market returns are a poor way to measure China's economic performance. Even after two decades of reform and liberalization, the portion of the economy financed by equity investors remains small. According to figures published by the People's Bank of China, equities accounted for less than 2 percent of China's "total social financing" in the first nine months of 2012. The main source of financing was bank loans, which still account for 57 percent of the total. China's still-fledgling bond market contributed 13 percent. China's economic growth, it seems, depends mostly on debt.
Other evidence points to a bigger concern about growth. Take the performance of China's state-owned enterprises (SOEs), which still dominate the economic landscape. A recent report by the State-owned Assets Supervision and Administration Commission, which oversees China's largest SOEs, suggests their returns remain poor.
The report, presented at last November's Communist Party Congress, trumpeted