The huge and puzzling gap between China’s great long-term economic growth and the terrible performance of its stock market is significantly explained by politics.

A new study finds a strong link between political connections and initial public offerings in China, one that is doing the average investor no favors.

Hong Zhou and Guoping Li of Beijing’s Central University of Finance and Economics find in a paper that 74 percent of private firms that get to list under Chinese IPO rules are politically connected and more likely to report “significant deterioration” in financial performance after listing.

China has been disappointing equity investors for decades. While Chinese GDP has increased ninefold since 1999, its main stock market index is only up a paltry 160 percent.

One peculiarity of China’s stock market listing process is that firms are evaluated by regulators ahead of an IPO on a “merit-review” basis led by the China Securities Regulatory Commission, China’s version of the SEC. Merit review is both more opaque than a U.S.-style review, which depends on high levels of public disclosure, and also therefore more subject to political suasion. The implication is that the CSRC has and uses greater latitude in determining who gets to list in order to reward and punish.

While it is impossible to prove, it is reasonable to suppose that a more open process would uncover firms that were either falsifying their performance or showing some marked deterioration. Investors in Chinese firms don’t benefit from a process that does this kind of discovery well.

The study also found that politically connected Chinese firms were more likely to engage in “lawbreaking” such as falsifying financial statements. Yet despite breaking regulations more often, they were less likely than others to be punished.

The authors argue that China should move to a more open, disclosure-based review process, as well as freeing stock exchanges from direct political control. Sadly, a look at China’s approach to regulation over the past year gives little hope for a belief that China will be quick to reform. This puts investors in a very difficult position. It is very hard to simply take a pass on the world’s second-largest economy as an investment destination.

Reading this study, and the news, it may be hard for thinking investors to do anything else.

 

James Saft is a Reuters columnist.