HONG KONG (REUTERS)- Shortly after China unveiled its new leadership last November, the country's main stock market delivered a downbeat verdict on the world's second-largest economy.

For a few days, the Shanghai Composite index dipped below the psychologically important 2,000 mark-where it was 12 years earlier.

The drop was puzzling to many. How could an economy that more than quadrupled in size in a decade, bringing prosperity to many of China's citizens in the process, have produced such poor returns for investors?

Resolving this paradox is central to explaining the country's extraordinary economic development- and to understanding whether it can continue.

On one level, the poor stock market returns can be explained quite easily: Share prices reflect expectations of future growth, and these projections are often wrong, so the performance of markets does not necessarily track the underlying economy.

This is particularly true of the Shanghai index, which is dominated by domestic investors. Over the past 12 years, it has slumped as low as 1,000 and peaked at 6,000 before reaching its current, relatively subdued level.

But a different benchmark and a different timespan tell a very different story. Take the MSCI China index, a more broad-based measure that includes Chinese companies listed in Hong Kong and the United States: An investor who bought the stocks in the index on the day MR Hu Jintao was announced as China's new leader in Nov 2002 and sold on the day Mr Xi Jinping took the stage a decade later would have earned a return of 392 per cent-a reasonable reflection of China's economic expansion over that period.

Stock market returns are a poor way to measure China's economic performance. Even after two decades of reform and liberalisation, the portion of the economy financed by equity investors remains small.

According to figures published by the People's Bank of China, equities accounted for less than 2 per cent of China's "total social financing" in the first nine months of 2012. The main source of financing was bank loans, which still account for 57 per cent of the total. China's still-fledgling bond market contributed 13 per cent. China's economic growth, it seems, depends mostly on debt.

Other evidence points to a bigger concern about growth. Take the performance of China's state-owned enterprises (SOEs), which still dominate the economic landscape.

A recent report by the State-owned Assets Supervision and Administration Commission, which oversees China's largest SOEs, suggests their returns remain poor.

The report, presented at last November's Communist Party Congress, trumpeted the increase in profitability in the Hu era: Between 2003 and 2011, the combined net profit of SOEs increased by roughly four-and-a-half times, to 914 billion yuan (S$181 billion).

But this is less impressive when considering that the same companies had more than three times as many assets at the end of that period as they did at the beginning.

In other words, most of the expansion in the earnings of those SOEs came from expanding their balance sheets; the combined return on assets improved only slightly, to 3.26 per cent.

That's less than half the average for a member of the S&P 500 index, and even these mediocre figures are puffed up-compared to private-sector rivals, most state-owned companies get preferential pricing for raw materials, energy and credit.

In this sense, China's SOEs are a proxy for the country's investment-heavy growth in recent years, particularly after the 2008 financial crisis dulled global demand for Chinese exports.

By most estimates, gross fixed capital formation accounted for around 45 per cent of China's economic GDP between 2008 and 2011 - much higher than in other developing nations. In a nutshell, China has been investing ever-increasing amounts to generate additional economic growth, and the returns on this investment have been poor.

This analysis has prompted many to predict an imminent end to China's economic miracle. As returns dwindle, flows of new capital dry up, and growth stalls. Yet this logic assumes a market-based system of capital allocation that is largely absent from China's financial system.

In fact, much capital is distributed by the country's state-owned banks and guided by the Party's political priorities. The banks, meanwhile, are financed with deposits that pay an interest rate capped at levels that for much of the past decade were below the rate of inflation.

In other words, Chinese banks are cheating their millions of depositors so that they can make too-cheap loans to SOEs.

There is no chance this state of affairs will change in the next few years. Consumers have tried to move their money elsewhere, buying up property and, most recently, pouring their cash into wealth management products that are held off a bank's balance sheet and promise a better return.

But as long as the system is essentially underwritten by state-owned banks - and by the government-China is a long way from a market-based system of allocating credit.

But before you dismiss the Chinese economy, recall that unsustainable investment booms are not necessarily all bad.

In both the American railway boom in the 1800s and the telecom bubble in the late 1990s most investors lost their shirts, yet helped finance valuable infrastructure that fueled monumental economic growth.

China may yet prove to be a similar case, but the country's economic model brings substantial risks: rising inequality, rampant corruption and capital flight are all threats to popular support for the Party.

And shifting from investment- and export-led growth toward domestic consumption - and private enterprise will have to go hand-in-hand with a more efficient way of doling out capital.

Until that happens, the Shanghai index will not be a reliable gauge of China's economic progress.