Until very recently, China was a clear favorite over India for foreign investors. But as far as stocks go, India has been a much better bet.
The Nifty 50, an index of India's National Stock Exchange, has risen sixfold since Dec. 31, 1999. Over the same period, the Shanghai Composite Index has only doubled.
There have been some tremendous rallies on China's markets but these have usually been followed by equally impressive busts. This year, for example, the Shanghai Composite Index is down 21%, among the biggest declines in the world.
Indexes also are, of course, averages and there are many outstanding individual Chinese companies that have grown manifold over recent decades, with their stock prices also multiplying. But how can its markets have been so lackluster overall even as China has come ever more to the fore of global politics and economics? Even the ChiNext index, which tracks the best and the brightest private companies listed in Shenzhen, is up only around 30% since the index launched in June 2010. The Nifty has doubled over the same period.
What has India done right, or at least done better than China, to correlate its stock market performance with economic prowess, as has been true in most developed and emerging markets of note?
China has built impressive market infrastructure, with excellent settlement and clearing processes, but it has failed on two counts. The first is that it has failed to ensure the quality of listed companies despite forcing them to take a lengthy path to market. Second, China has made too little headway on developing an institutional investor base and on encouraging stock players to move away from short-term speculation.
The first problem to some extent forms the basis for the second. Listing rules in China and the reasons some companies float are reflective of politics, not economics.
From early on, it was state-owned enterprises in need of capital by and large which got the nod to list. The private sector and joint ventures with foreign companies were simply excluded.
Together with the painstakingly slow approval processes and the political connections required to list, many companies simply went overseas to hold initial public offerings. Indeed, the entire first and second generation of Chinese internet companies, including Sina, Sohu and NetEase, listed in New York, not Shenzhen or Shanghai.
Startups and high-growth companies that do not yet make a profit simply cannot meet the listing rules of China's main markets as they still stand. There is growing talk of reform, especially as Hong Kong relaxes its rules on profitability, but little action so far.
Because many of the companies that listed in China were of relatively poor quality, as well as state-owned or in sectors favored by Beijing, investors have focused on short-term policy news and not the stocks' long-term prospects. Speculation has been rife since few investors had confidence in the long-term outlook of the listed companies. When connections and subsidies are the factors driving companies, it is no surprise that speculation is commonplace.
Chinese policymakers must understand that there is no quick fix to getting the country's markets aligned with the growth of its economy. The process will take some time but the benefits would be substantial.
First, the authorities should change the listing rules to open the way for all kinds of companies -- private companies yet to turn a profit, joint ventures and foreign companies included. China must move from a process where each IPO has to be reviewed and approved by regulators to a system where companies merely register to list, as has long been discussed.
In this way, initial stock prices would be decided by investors with access to relevant company information and earnings forecasts rather than bureaucrats. At the same time, Chinese exchanges should get more serious about weeding out companies that breach rules on disclosure or other matters.
A change in listing rules won't cause market panic or chaos. Meaningful reforms that are well-flagged would bring more certainty.
Worries of chaos have dogged every proposed major market reform in China. The most prominent example came over a decade ago when regulators began offering ideas to address the issue of converting the then-untradeable stock held by the parent companies of state enterprises into normal shares. Now at best a footnote in China's market development, the non-tradable shares seemed an insurmountable problem for years.
The continual widening of channels for foreign investors to access domestic stocks should be prioritized. The authorities must reduce entry barriers for the Qualified Foreign Institutional Investor program and offer participants the same treatment and market access as local investors, including the ability to borrow stock and trade futures.
The expanded presence of foreign institutions in China's markets will help the development of domestic institutional investors too. This will contribute to shifting the balance of investment toward stocks' long-term outlook, away from short-term speculation.
China can open up without losing control of what is happening. Recent announcements by index compilers MSCI and FTSE Russell that they plan to add to the weight of domestic Chinese shares in their wider indexes should encourage Beijing to keep moving forward.
Volatility may increase in the short term, but that is far from certain. There is no reason to think that currently listed companies should be significantly affected by rules for future listings.
But reform is never free or easy. From President Xi Jinping downward, the authorities in Beijing have a strong aversion to change, particularly when the results are uncertain. They especially fear possible chaos resulting from tumbling asset prices. Any shift in the balance between decision-making by the state and that by the market is contentious, especially given the risk of short-term shocks in a worsening global environment.
Sustained higher volatility is unlikely, but ups and downs are part of normal market operations. Chinese markets are no stranger to boom-and-bust cycles and rampant manipulation.
The existing market framework seems to capture all the downside but only part of the upside. This year started with big promises of market reform but most ideas -- remember Chinese depository receipts? -- failed to translate into action. A renewed focus on lifting the quality of listed companies is long overdue but this would put decisions in the hands of the market rather than the Communist Party. That is always a difficult choice in China.
Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." He has worked in China's capital markets since 1992.