ASIA boosters at the international investment houses have called the stockmarket wrong before. “Maximum bullish”, said Barton Biggs in 1993 about China and Hong Kong, weeks before a prolonged slump. “Back up your truck” and load up on Asian shares, was a notable miscall a few years later. Those equity strategists that remain in the region—a diminished tribe, because many second- and third-tier investment banks have shut up shop—are no doe-eyed ingenues. They understand Asia's challenges. Yet they point out that over the past three years Asian equities (as measured by the MSCI Asia Free ex-Japan index) have fallen by nearly half, even as returns on equity have risen and corporate indebtedness has fallen. They think insufficient attention is being given to more positive factors—not least that, for all its shortcomings, Asia is and will continue to be the world's most dynamic region by far.

Timothy Moe, Asian equity strategist at Goldman Sachs, sets his case for a sustained period of outperformance on three pillars. First, cyclically, and despite a rally from 2001 to early 2002, emerging-Asian equities are currently at the bottom end of historical valuations, both in absolute terms (measured by price/earnings ratios and implied equity-risk premiums) and relative to developed markets (measured by price/earnings ratios and by market capitalisation to GDP). Moreover, because of Asian economies' and stockmarkets' sensitivity to the global economic cycle, any world recovery in 2003-04 would be magnified in the performance of Asian shares—but then so would any slump.

Second, says Mr Moe, many beneficial structural changes have taken place in Asia since the crisis. Macroeconomic stability has been much improved, this time with the advantage of flexible currencies leading to more stable growth. People are also changing their behaviour, with profound and exciting consequences.

The growth of consumer credit in South Korea, which this survey has highlighted, is one example. Mr Moe mentions others. One is the growth in Chinese domestic demand, and the possibilities that this raises for China to act as an engine of growth for the region rather than an economic threat. Over the past two years, imports for domestic use (as distinct from imports for use in China's vast export industries) have shot up, with China now running a trade deficit on such goods. Another striking change is the growth across the region in tourism from mainland China. Mainland visitors to Hong Kong, for example, now spend more per head (over $5,000 a visit) than do Japanese visitors, once famous for queuing outside the Louis Vuitton store in Central district.

Third, Mr Moe predicts fresh flows of money into Asian equities. Overseas shares, for instance, are now heavily under-represented in the portfolios of American equity mutual funds, at only 13% of the total, compared with 19% in 1994. After three years in a row of awful returns on American shares, some money might now be expected to be placed elsewhere. If American mutual funds were to bring their international shareholdings up to the levels of 1994, $210 billion of liquidity would be sent around the world, a good amount of which would find a home in Asia. Add to that pool another, local one: in the medium term, there is huge potential for the development of Asia's nascent pension-fund industry (see chart 7).

It is the old wall-of-money theory, and it is all very plausible, but there are two important caveats. One is a near-term caution about the degree of political risk that has suddenly re-entered the region in the past few months. The bloody terrorist bombing in Bali last November, and a wider understanding of the extent of Islamic fundamentalist operations in Indonesia, look certain to undermine that country's important tourist sector and knock general economic confidence for the next couple of years at least. The Philippines, too, has a terrorist problem, in the form of extortionist gangsters masquerading as Islamists, operating mainly in southern Mindanao province; and personal safety is an issue throughout the country, with knock-on effects upon economic confidence.

More alarming by far is the nuclear brinkmanship of North Korea's leader, Kim Jong-Il. Many of the supporters of South Korea's new president, Roh Moo-hyun, are inclined to blame America's hawkish stance for North Korea's nuclear re-armament. A nuclear threat alongside strained relations with an ally makes for deep uncertainty, which could easily spill over into financial markets.

The other caveat is about a conceptual issue. If Asian stockmarkets do rise on a wall of money, it will be partly because there are still precious few options available to international investors. South-East Asian economies are generally too small to support more than a handful of companies large enough for the biggest institutional investors to bother with. Hong Kong, Taiwan and South Korea have bigger economies and a longer list of sizeable companies. But even there, the shares are relatively illiquid; a majority of companies are family-controlled, with a fairly small “free float” of tradable shares. International investors dislike illiquid shares because they are more expensive to buy and sell, and during periods of market stress may be impossible to sell at all. Moreover, minority shareholders are all too often taken for a ride, even in Hong Kong, which has the region's highest standards of regulation and corporate governance.

And China? Foreign investors are denied access to the domestic stockmarket. Many of the country's biggest companies, admittedly, are listed in Hong Kong, and at the height of the China craze overseas investors raced to buy every new issue. Yet many of these companies are government-owned former monopolies—and for the most part act like it, even though competition is eroding their franchise. Now that the shares of several of these mainland listings trade below their issue price, foreign investors are becoming disillusioned. It is telling that the world's greatest story of economic success has produced the worst share performance: in the ten years to the end of 2002, Chinese shares in which foreigners may invest recorded an average annual loss of 16%.

The inadequacies of Asia's capital markets, where corporate-bond markets are even less developed than stockmarkets, are the flipside of a dominant banking sector that intermediates four-fifths of the region's investment, compared with just a quarter in America. The crisis has indeed spurred some changes for the better in the way that banks in the region assess credit risk, and their new approach to lending is more cautious and disciplined. That caution, in turn, has led to better corporate governance among borrowers. Kookmin Bank in South Korea tries to encourage such efforts by charging a lower rate of interest for borrowers that meet certain corporate-governance criteria, such as having independent board directors. Yet the crisis has not broken the banking sector's dominance in mobilising savings and monitoring company performance. Why not?

Mario Francescotti, a senior manager at Morgan Stanley in Hong Kong, argues that the infrastructure for deep, well-functioning capital markets cannot be built without the participation of the dominant banks. That, he says, is the lesson of the development of Europe's capital markets over the past three decades, specifically the vast Eurobond market, where European banks such as Credit Suisse, Deutsche Bank and Paribas all played a big part. In developing Asia, the dominant banks fear losing their loan book to disintermediation, and governments have failed to prod the banks to develop capital-market alternatives, except in Hong Kong and Singapore. To do so would risk a fresh credit crunch, as banks called in their more doubtful loans and market discipline penalised undeserving companies. Lack of progress on capital markets, in other words, is part of the price of governments' tacit support for forbearance towards doubtful borrowers.

An overwhelming body of economic opinion concludes that not only do banking systems and capital markets complement and strengthen each other; together, they also drive economic growth. Asia does not even have a regional forum for the development of capital markets, though Andrew Sheng, chairman of Hong Kong's Securities and Futures Commission and an acute observer of the region's shortcomings, proposes an Asian Financial Institute to get the discussion going. Still, it will be a long time before the region has meaningful markets that do a good job of mobilising savings and pricing risk.

Might China be different? Some observers think so. Admittedly, China's financial markets are more behind than most: of all China's markets—labour, goods, services, capital—the last is the only one still monopolised by the state. Yet that is changing. On the banking side, the big four banks are slowly being restructured, quasi-private banks are being encouraged, and foreign banks are making inroads and will make more, given China's WTO commitments. When the domestic banks are in better shape, interest rates will be liberalised, probably within the next five years.

Crucially, a new generation of reformist leaders takes over the government's reins next month. It is already considering the merits of getting a functioning capital market to sit alongside the banking system. Some who believe that capital markets are a necessity, not a luxury, are moving into positions of authority. Zhou Xiaochuan is moving from the securities regulator to run the People's Bank of China. Wen Jiabo, who currently oversees financial matters as a vice-premier, is expected to become prime minister.

Morgan Stanley's Mr Francescotti, for one, believes the seeds for proper capital markets in China have been sown. Citizens are already being given a greater choice of savings vehicles. Foreign insurers are entering the country, ready to offer new savings products, with AIG of America the first to get a full licence. Foreign fund managers are being allowed to set up joint ventures with local firms to sell mutual funds to the Chinese. A prodigious amount of work remains to be done, but there will be ways to check for progress as time goes on. For instance, unless a meaningful bankruptcy law, already delayed for years, gets on to the statute books within the next year or so, people should start worrying.

It is just conceivable, then, that China can make the running in regional financial matters, just as it is making the regional economic running now. Either way, if the Asian miracle is to revive, the whole region will need to show a great deal more political imagination, leadership and courage than it has done to date.