THE poor performance by China's share markets is well known. Prior to the recent holiday, the Shanghai Composite had fallen by 40 percent in yuan terms since its post-global financial crisis peak and 66 percent from its all-time high.

Using US dollar valuations, to make international comparisons and take into account yuan revaluation, the MSCI China A share index was 52 percent below its all-time high and 33 percent below its post-financial crisis peak.

In contrast, the MSCI World index on the same day, in US dollar terms, was 22 percent below its all-time peak and 6 per cent below its post-crisis high. The MSCI Emerging Markets index was 25 percent below its all-time high and 17 percent below its post-crisis peak.

The performance of China's share market is, therefore, approximately six times worse than world stock markets and twice as bad as emerging ones. On average, anyone investing in China's shares over this period would have lost a great deal of money.

Sharp contrast

This record sharply contrasts with China's economy. Not only has China's been the world's most rapidly growing major economy since its economic reforms began in 1978, but since the commencement of the international financial crisis, it has far outperformed other major economies.

In the five years to the second quarter of 2012, China's economy grew by 54.4 percent, compared with US growth of 2.9 percent and contractions of 0.5 percent in the EU and 0.8 percent in Japan. Given that China's population percentage increase is low compared with many countries because of its one-child policy, China's economic growth in per-capita terms is even more striking.

This contrast between the high growth of China's productive economy and its share market performance has led some to conclude that the decline in Chinese shares must be due to a stock market malfunctioning.

For example, one publication recently contrasted "the mind-boggling divorce between the poor performance of the stock market and the strong growth of the economy." It called for "bold actions to arrest the tailspin of the market" and for "administrative measures to galvanize the stock market." Others have suggested China's pension funds should be invested in the stock market to prevent its decline.

Such ideas are extremely dangerous. They fail to understand the international experience and historical evidence regarding the relationship between economic growth and return on shares. Consequently, these ideas have cost individual investors large sums of money, and if acted on, they could lose the Chinese state billions of dollars or damage its pension funds.

International and historical experience shows clearly that the faster an economy grows, the worse the return on its share market. Put technically, the correlation between increases in per-capita GDP and return on shares is not positive but negative. Therefore, China's share market does not perform badly despite its rapid economic growth; it performs badly because of its rapid economic growth.

It is important to understand that this finding is not the result in one study. It is the conclusion of all major studies on the subject. For that reason, the results may be summarized.

Siegel's standard Stocks for the Long Run noted: "Real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual (developed) countries is associated with lower returns to equity investors. Similarly, (for) the stock returns for the developing countries ... there is a negative relation between the returns in individual countries and the growth rates of their GDP."

Dimson, Marsh and Staunton's Triumph of the Optimists found, regarding total real return on equities and GDP per-capita growth that "statistically, the correlation is -0.27 for 1900-2000 and -0.03 for 1951-2000."

And Ritter's Economic Growth and Equity Returns concluded: "My calculations for … 16 (developed) countries over the 1900-2002 period get a correlation of -0.37."

Jain and Kranson's recent survey The Myth of GDP and Stock Market Returns noted that "the data show clearly that, over long periods and when adjusted for inflation, stock market returns and GDP per capita growth are negatively correlated."

Negative correlation

Goldman Sachs private wealth group, reviewing the studies, noted that the negative correlation between GDP per-capita growth and share price growth even extended to different groups of economies ranked by growth rate.

"If one invested in the slowest growing quintile of countries during this 100-year-plus period," the Goldman group said, "the equity returns would have outperformed the fastest growing quintile by 3 percent a year … Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5 percent a year."

Goldman Sachs specifically noted: "China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns … China's economy has outgrown that of the US by about 8 percent a year since the end of 1992 … Its equity market, however, has lagged that of the US by about 8 percent a year.

"Over the last 15 years, earnings-per-share growth in China has been negative 0.9 percent, while that of the S&P 500 companies has been 5.4 percent a year. Most recently, in 2010, China has outgrown the US by an estimated 7 percent, but the MSCI China Index has returned just 4.8 percent ... On the other hand, US equities have returned 15.1 percent. Since the peak of US and Chinese equities in October 2007, China has outgrown the US by an estimated 10 percent a year, but Chinese equities have lagged the US by 2.7 percent a year."

Goldman Sachs concluded: "Whether it is one year, three years or 18 years, economic growth has not translated into better investment returns in China … The evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies."

The evidence of the negative correlation between per-capita GDP growth and return on shares is overwhelming. The more rapidly GDP per-capita grows, the worse shares perform.

Because China has the most rapid per-capita GDP growth of any major economy, it would be expected to have the worst performing major share market, which is exactly what has occurred. Consequently, China's share market is not "malfunctioning." Rather, it is functioning as would be predicted.

It should, of course, be noted that these are relative growth rates. If all share markets were rising, it would be anticipated that China's rapid economic growth would be manifested in returns on its share markets rising less rapidly than others.

But currently world share markets have fallen below both all-time and post-financial crisis highs. Therefore, China's rapid economic growth manifests itself in declines on share markets that are worse than other countries.

The implications are clear. If China's share market is not "malfunctioning," attempts to reverse the situation by administrative means will fail but could also result in financially damaging losses for China's state or its pension funds.

A situation whereby individual investment decisions and proposed state policy are driven by a wrong understanding of the relation between economic growth and performance by share markets is astonishing and dangerous.

As China's economy grows rapidly, its share market performs badly.

That is the conclusion that follows from all historical and international experience. Therefore, it must be the practical starting point of policy toward China's share markets.