Why the real Chinese economy is more important than the stock market

China’s stock market has been on a roller-coaster ride over the past year. It more than doubled in value in the 12 months ending on June 12. Then it took a breathtaking plunge, wiping out a third of its value (more than $3 trillion of wealth) within a few weeks. After an extraordinary government intervention, it stabilized and bounced back 12 percent. No one knows where it will go next. If you do, you should be living on your own private island.

Financial markets everywhere are prone to bubbles, and this may just have been China’s turn. But it is also likely that the boom-bust cycle was exacerbated by real reform lagging financial reform.

Wanted: New engines of growth

For a long time, China’s economy grew well based on exports and investment. Both of these engines of growth are running out of steam. As the largest exporting nation in the world, China cannot expect its exports to grow much faster than world trade. Export growth of 2.1 percent year-on-year in June is about what China can expect going forward. On the investment side, China’s credit-fueled expansion has led to over-capacity throughout the economy. An estimated one-fifth of apartments are empty. Heavy industries such as steel and cement operate at low capacity. And while infrastructure throughout China is impressive, the most recent construction of highways and airports is poorly utilized.

China needs new sources of dynamism, and an obvious place to look is in the remaining sectors of the economy that are heavily protected. In China’s dualistic economy, manufacturing sectors are relatively open to foreign investment and trade. And these sectors have become highly competitive: China really is the factory of the world. But there is little room for those sectors to expand rapidly because exports are constrained and investment yields diminishing returns.

China has reached a stage of development at which modern services naturally take over as the growth engine—as countries get richer, more and more consumption consists of the output of the service industries. These are exactly the industries that are protected and uncompetitive in China: telecommunications, media, airlines, logistics, financial services, health, and education. Among G20 countries, China is the most closed to foreign investment in these sectors.

Another issue for the modern service sectors is China’s household registration system, which limits labor mobility. The system has allowed large numbers of unskilled rural workers to move to cities to work in factories—typically living in dormitories, unable to bring their families and become urban citizens. Service sectors of course generate some unskilled jobs as well, but they depend very much on high-skilled labor. The lack of a national labor market in which people can easily move to their most productive opportunities holds back productivity growth in general and is particularly harmful to modern services.

Put the real economy first

The new leadership under Xi Jinping announced a series of reforms that include opening up the service sectors and gradually dismantling the registration system. But progress on these reforms of the real economy has been painfully slow.

Meanwhile, financial reform can potentially complement these other changes. For a long time, China’s low, controlled interest rates acted like a tax on household savers and a subsidy to industrial investment. Heavy controls on stock and bond markets ensured that they played a minor role in allocating capital. Reforms of China’s financial markets in the past two years have been quite rapid: Interest rates have been decontrolled; there is some scope for private banking; firms can more easily access capital markets; and margin trading for stocks has been introduced.

These reforms contributed to an environment in which a stock market bubble was possible. However, the financial reforms have not been adequately complemented by real sector reforms that would allow for the expansion of more healthy companies into the economy—both domestic private firms and foreign-invested ones.

In the short run, the connection between the stock market and the real economy is not necessarily tight. Even with thorough reform, China might still have had a bubble. But in the long run, the development of a diversified group of healthy companies is needed both for real growth and for the sustainable expansion of the stock market. As the stock market was plunging over the past few weeks, the government moved away from market-based reforms and relied on direct controls—such as banning major shareholders from selling shares for six month and allowing more than half of listed firms to suspend trading.

The important question now is whether this unsettling experience will make the leadership even more cautious about the real sector reforms that the economy needs, or whether they will recognize that China’s growth needs a new model and accelerate reform. My advice to the leadership is to focus on the real economy. If it grows well, then the market will find its level and take care of itself.