Chinese economy is the world’s fastest growing economy. Its real GDP has grown by a factor of eight since 1991. And, according to IMF, China is now officially the largest economy in the world based on purchasing power parity.

In a recent paper, Franklin Allen, Jun Qian, Susan Shan and Julie Zhu contrast this impressive growth with poor performance of its stock markets. How could the world’s fastest growing economy have such a poorly performing stock market? The question is intriguing and fundamentally important for Chinese policymakers and regulators.

The underperformance of Chinese equities is phenomenal. If you invested $1 in a value-weighted Chinese stock portfolio in year 2000, that dollar would have become $0.62 by the end of 2012. Compare that to investing in a globally diversified world portfolio, where the same dollar would have become $1.67 by the end of 2012. In case you are wondering, Japan is the second worst performing country after China.

Several reasons are offered for such underwhelming performance of Chinese stock markets. The main reason appears to be the listing process that determines which firms get listed. The listed firms are doing poorly, and there is some evidence that unlisted private firms are actually doing quite well. Better firms are listing abroad instead of listing locally. One problem with listing is that firms have to go through an administrative process which works on a quota system. The listing process is also biased towards large firms with a track-record of profitability. These profit requirements distort the businesses of these firms. It is not surprising that many firms manage earnings prior to their listing to appear profitable. Moreover, the listing criteria also distorts the real operating decisions of these firms.

Chinese firms rarely delist because of poor performance. Very few Chinese firms have gone through a bankruptcy process – so the poorly performing firms continue to operate and exhibit further deterioration in performance over time.

Many economists feel that much of the growth of Chinese firms is due to over-investment in fixed assets. So, while there is lots of growth (investment-financed), the profits aren't there. The return on invested capital of Chinese firms is surprisingly low compared to firms in other countries. 

My view is that we are just scratching the surface of the problem. It will take a lot more work to understand what's causing the disconnect between the economy and the stock market. Clearly, regulations play a role, but also the growth oriented policies adopted by Chinese firms may be responsible for poor performance. There is too much speculation into the causes. So, I look forward to reading more research in this area.

What happens to trade credit when banks obtain additional control rights as the borrowing firm defaults on its debt contracts? Zilong Zhang, a PhD student at HKUST is examining conflicts that arise between trade creditors and bank lenders following the violation of debt covenants. Covenants violations grant bank lenders with additional control rights that banks can use to secure their own claims at the expense of suppliers. 

The study uses a clever regression design to exploit the discontinuity created at the point of violation. Firms around the violation threshold are similar and yet those violating covenants experience a significant decline in trade credit.  Further, the reduction in trade credit is much larger when there is a greater probability of banks intervening in corporate decisions that may adversely affect junior creditors. In addition, Zilong  shows that dependent suppliers are more adversely affected.

Zilong is now extending his work to examine whether firms take the possibility of these conflicts into account in structuring their debt contracts. Do firms include fewer covenants in debt contracts when the suppliers are dependent? How are other features of debt contracts affected by these conflicts? His preliminary results on this are fascinating, and they show  that firms do take into account the possibility of conflicts among creditors when they negotiate debt contracts with bank lenders.

Zilong is on the market this year.  You can read more about this research and other exciting work that he is doing here.