Banks, stock markets, and China's 'great leap forward'

Using quarterly data for 1995-2005, we examine the role of financial factors in China's recent increases in real sector activity. After describing the institutional challenges that China faces in building a well-functioning equity market to complement its banking system, a series of cointegrated vector autoregressive models and the associated variance decompositions and impulse response functions show that banking sector development was central to these successes. At the same time, we find that stock market development, as measured by market size and trading volume, did not contribute significantly to them. We suspect that lingering questions regarding the quality of China's stock markets are largely responsible for the latter result, though it also may reflect the smaller size of the “stock market economy” relative to the broader economy in which we measure outcomes.