China Finally Pays Off; The market has caught up to the booming economy, but will it last? Very likely.

Byline: Ruchir Sharma (Sharma is head of global emerging markets at Morgan Stanley Investment Management.)

Almost as if to make the point that the Chinese growth miracle won't be complete until every skeptic stands converted, policymakers are on a reform blitzkrieg that has the stock market rolling. For the first time, China in 2006 had both the fastest-growing economy in the world and (finally) the fastest-growing stock market, too, according to the Morgan Stanley Capital International database. The MSCI China Index was up 78 percent, compared with the 32 percent average return for emerging markets, and the Shanghai-based A Share Index was up 138 percent. The way Chinese are buying stocks, more strong years could follow.

There's certainly much scope for catch-up. China's economy and stock market spent much of this decade running in different directions. While China has been emerging as a leading manufacturing power faster than anyone expected, the mainland market based in Shanghai has been stagnant, even as rivals from Moscow to Mumbai boomed. Today, while China constitutes 5 percent of the world economy, it accounts for a mere 1 percent of global equity-market investment. For cynics, the lagging stocks symbolized all that's wrong with China's development model: its companies, largely state-owned, showed little care for profitability and got away it, thanks to generous funding by huge, inefficient state banks. The result: low productivity growth, narrow profit margins and opaque bookkeeping. For years, many investors have been resigned to the notion that in China, the growth you see in the economy is not what you get from China stocks.

That's still the prevailing view of the global financial commentariat, which is why many of its members have pronounced the current China bull market a bubble. That word has been put to rather liberal use since the tech bubble burst in 2000. However, it has more often than not turned out to be just a lazy way of dismissing a new fundamental shift. This could well be the case with China today.

Many investors still picture the Chinese market the way it was in 2000, when it was truly in a bubble. The average price-to-earnings ratio on the Shanghai exchange was above 50, and the rising prices of its star companies had no clear relationship to the growing economy. In fact, the only companies that even came to the market for capital were those denied it by the otherwise liberal banking system. Foreign investors dubbed most of the 1,300 listed entities "zombie companies," given their morbid growth and financial statements that amounted to a vacant stare.

But that view is out of date. Today the Shanghai Stock Exchange is a much more accurate reflection of the real economy, following a wave of reforms. The most important development has been the listing of China's largest banks, which had been the Achilles' heel of the country's development model. Policymakers are bringing in strategic foreign partners, cleaning up balance sheets and then listing the banks in the hope that market discipline will force them not to return to their old, reckless lending ways. It's hard to say political interference will cease in a banking system ultimately controlled by the state. But at least the slate has been wiped clean and these banks can make a new start.

That is not the only critical change. The authorities embarked on a plan to reform the domestic market in ...