Since the end of September 2024, China has implemented a series of unprecedented monetary policy relaxations that have exceeded market expectations, subsequently leading to a notable surge in market confidence. Over a span of just five trading days, starting on September 24, the Shanghai Composite Index witnessed an impressive increase from 2,770.75 points to 3,336.50 points, marking a staggering rise of 20.4%. However, opinions regarding the sustainability of this rally in the capital market are quite polarized across various sectors of society. Despite these diverse viewpoints, the underlying fundamentals of China’s economy continue to showcase long-term positive signs, emphasizing the strategic importance of boosting the capital markets as a means of propelling economic growth. Many experts argue that the Chinese stock market possesses a solid foundation for long-term upward momentum.

Strategic Importance of Boosting Capital Markets

In the current environment, China stands at a crucial juncture where the economy is in need of new growth engines as it undergoes a pivotal transformation. In this context, invigorating the capital market is of paramount significance for stimulating economic advancement. Capital markets serve as vital machinery for accelerating technological progress and fostering new forms of productivity. To shift from being a “manufacturing powerhouse” to becoming an “innovation powerhouse,” China must prioritize high-tech research and development. The capital market, comprising various financial instruments such as stocks and bonds, can channel societal funds into emerging industries that are critical, facilitating technological innovation and providing financial backing for pivotal projects. As a result, this initiative can optimize and upgrade industrial structures and help China achieve significant advancements in both technology innovation and industrial chain upgrades while expediting the development of new productivity forms.

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The capital market also plays a key role in enabling China to gain pricing power. Within the global value chain, the nation that boasts a robust capital market holds sway over pricing authority. Pricing power typically refers to the influence that market participants wield over asset prices, encompassing stocks, bonds, and commodities among other financial instruments. The relationship between capital markets and pricing power is closely interconnected as pricing mechanisms within capital markets serve as essential tools in the effective allocation of global capital, driven by market supply and demand dynamics. By building influential indices, such as the Shanghai Composite Index and the CSI 300 Index, China is striving to enhance its pricing authority within the global financial landscape. Furthermore, Chinese enterprises are utilizing capital markets to integrate more closely into the process of economic globalization, thereby bolstering their standing in the global value chain.

Moreover, a mature capital market is crucial for optimizing the financial structure. Developing the capital market enhances the proportion of direct financing, mitigates the risks faced by the overall economic system, and ensures a more sensible allocation of financial resources. Having initiated reforms on the stock issuance registration system, the direct financing process has been streamlined. As the multi-tiered capital market system continues to evolve, the proportion of direct financing is expected to rise, aiding in the restructuring of the economy and the transformation of enterprises. Additionally, a well-developed capital market serves to attract foreign investors to hold renminbi assets, thus promoting the internationalization of the Chinese currency.

Capital markets can also have a direct impact on wealth effects, manifesting as the considerable returns on equity market investments influencing household consumption tendencies. Higher returns lead to increased disposable income, enhancing consumption patterns and subsequently fueling economic growth. The vibrancy of capital markets is pivotal in shaping wealth distribution; a flourishing capital market offers diverse investment pathways that ensure a fairer allocation of wealth. Furthermore, the capital held by listed companies and institutional investors benefits the real economy, generating renewed enthusiasm for entrepreneurial ventures and investments, leading to a cycle where more quality companies engage in financing through public offerings.

It is noteworthy to mention that the efforts to bolster the capital market reflect an innovative approach to current macroeconomic governance. Recently, China has rolled out a series of incremental policies aimed at revitalizing asset prices, aiming to fuel confidence, invigorate the economy, and enhance wealth effects to promote consumption and investment. On one hand, the stock market responds rapidly to favorable policy changes, making it easier to entice added capital—from household savings, banking wealth management products, to foreign funds—into the market, thereby quickly restoring market confidence. On the other hand, the package of incremental policies emits positive signals while leveraging the herd effect in financial markets to cultivate favorable expectations among participants. This presents a beneficial experimentation in implementing macro asset-liability management and signifies a shift in macroeconomic governance from merely managing increments to balancing stock management with incremental adaptations.

Fundamental Basis for the Chinese Stock Market’s Sustained Growth

Firstly, the current valuation levels in the stock market are relatively low, indicating robust long-term investment potential. Historical data shows that between January 4, 2002, and September 30, 2024, the average price-to-earnings (P/E) ratio for Shanghai A-shares was 20.5; however, as of September 30, 2024, it stands at only 13.4, significantly lower than the historical average. In comparison, the P/E ratios on September 30, 2024, for the Dow Jones Industrial Average, S&P 500, and NASDAQ Composite Index are 28.8, 28.2, and 43.9 respectively, while Japan’s Nikkei 225 stands at 21.1. As opposed to the high valuation levels present in the US and Japan which carry inherent adjustment risks, the Chinese stock market emerges as a more viable option for long-term investments. As a sound valuation framework is established and P/E ratios improve, the wealth effects stemming from the capital market could potentially experience exponential growth.

Secondly, the recent pivot in macroeconomic policies will likely lead to a rebound in nominal GDP growth rates, subsequently enhancing the profitability of listed companies. Recently, China has shifted its macroeconomic policies, encompassing fiscal policies, monetary regulations, and real estate market controls; measures such as reducing reserve requirements, interest rate cuts, and lowering the rates on existing housing loans have been introduced quickly. As these more lenient macro policies are enacted, inflation rates are expected to revert to historical averages of 2%-3%, and the persistent negative growth of the Producer Price Index may turn positive, with nominal GDP growth anticipated to see significant uplift. This trajectory not only aims to improve corporate profitability but also serves to fortify investor confidence.

Thirdly, foreign equity investments are increasingly being drawn to China, enhancing the underlying momentum in the stock market. The “northbound capital” entering from Hong Kong exhibits tendencies for profit-seeking behavior alongside volatility; whereas previous outflows were considerable, shifts in foreign short-term capital flows tend to reflect movements in the Chinese stock market rather than the root causes behind them. Currently, the stabilization and rebound of the Chinese stock market, combined with the commencement of a dollar interest rate cut cycle, are likely to introduce a concentrated influx of external capital, further supporting the upward trajectory of the stock market.

Fourthly, preliminary efforts to avert and address financial risks in areas such as real estate, small financial institutions, and local government debts are yielding positive results. There have been positive developments in the Chinese real estate market, while risks pertaining to the operations and governance mechanisms of small financial institutions have been effectively mitigated. The governance of local debt risks is also being steadily advanced. These measures not only help prevent potential systemic financial risks but also create a stable environment conducive to the growth of the Chinese stock market.

Fifthly, ongoing reforms in the capital market are continuously enhancing the prospects for the stock market's mid- to long-term sustainable development. Since 2024, the China Securities Regulatory Commission has rolled out numerous initiatives to regulate stock market operations effectively, such as abolishing the transfer and refinancing business, tightening restrictions on major shareholders’ stock reductions, intensifying penalties for financial fraud and insider trading, limiting fund managers’ compensation structures, promoting M&A activities, and strengthening market value management guidelines. These policies facilitate the refinement of governance structures within the stock market and promote sustainable market growth. Concurrently, the government has focused on optimizing the investor profile, encouraging mid- to long-term capital influx into the market, while the People’s Bank of China has introduced new liquidity tools to support the development of the stock market, thereby enhancing market liquidity.

Multi-faceted Approaches to Energize China’s Capital Market

During this critical phase of economic transformation, China must wield the power of capital markets to steer the economy towards high-quality development. This entails allowing the capital markets to grow and evolve continuously as they serve the real economy, thereby propelling the nation towards becoming a modern socialist power.

To achieve these objectives, several measures must be expedited. Firstly, a more expansionary fiscal policy should be immediately enacted. Given the prevalent positive market sentiments, it is essential to incrementally issue special national bonds to rectify the balance sheets of households and businesses, support infrastructure spending, stabilize the real estate market, and promote development in other strategic sectors.

Secondly, an unwavering effort must be made to stave off systemic financial risks in key areas. This might involve increasing the robustness of local government debt restructuring and substitution efforts, allowing the central government to take on more responsibilities. Furthermore, addressing the reasonable financing needs of real estate companies and homebuyers in an equitable manner irrespective of ownership structures will be crucial. Progress in reforming and mitigating risks related to small financial institutions should be methodical, including expanding capital tenures for small banks and optimizing their equity structures.

Thirdly, relevant initiatives to revitalize the stock market must be launched.

This includes further optimizing the initial public offering (IPO) mechanism in the A-share market. With market demand rising significantly, reinstating normalized IPO procedures to increase stock supply is vital for rejuvenating the financing functions of equity markets and broadening exit pathways for equity investments, fostering the development of venture capital and private equity investments.

Additionally, the processes surrounding short-selling in the stock market should be optimized. Short-selling mechanisms can help circumvent rapid price surges that may lead to serious market bubbles; relevant authorities should consider lifting certain restrictions on institutional investors to allow for more flexible risk management and asset allocation strategies, provided they align with existing regulatory frameworks.

Moreover, it would be prudent to consider an increase in the proportion of capital from local social security funds and insurance companies entering the capital markets.

Furthermore, efforts must be intensified around educating individual investors on the associated risks. Utilizing both online and offline platforms to enhance awareness regarding the risks inherent in investing in stocks and funds is essential.

Lastly, given the current volumetric size of the capital markets, the government could generate funds through the issuance of special national bonds to establish a market stabilization fund aimed at enhancing overall capital market stability.