China's equity and fixed income markets face major upheaval as a result of the government's planned reforms, and market observers are voicing hopes that the outcome will be positive, starting with 2014.

For one thing, certain sectors in China will come under pressure next year as mainland authorities begin implementing reforms. But these reforms – which include price liberalisation measures for energy, resources and financial markets; opening up to private and foreign competition; and state-owned enterprise and fiscal reforms – will have a positive impact on stock markets next year.

Shen Minggao, head of China research at Citi, argues the MSCI China A shares index has 20% upside potential in 2014. “As long as the upcoming policies can push forward the reforms and help lower the risk of a hard landing, investor sentiment will recover and can lead to a valuation restoration,” he says.

HSBC Global Asset Management also forecasts an equity boom next year.

In the past, valuations in China were affected by a lack of liquidity, which allowed companies and their bankers to determine prices. This is why bad companies sometimes traded at 40x or 50x forward earnings, argues HSBC Global AM's Michael Chiu, equities investment director for Asia Pacific.

However, the new framework being deployed by the mainland securities regulator will hopefully mean proper practices and market risk for participants, he notes. This could lead to divergence between the value level of the A-share index and the value of the market cap closing.

Citi's Shen argues that Chinese stock valuations have been suppressed by worries over the country's growth model for much of 2013, and that the reforms, some of which will be implemented next year, will help restore investor confidence.

He expects banks' share prices to “normalise” first, noting that the average valuation for Chinese banks is 5.6x forward price to earnings, compared with the emerging market average of 10-12x. This leaves plenty of room for growth, says Shen. He is also overweight electronic appliances, food & beverage, automotive and healthcare stocks.

But it won’t be a smooth ride for China, argues Pu Yonghao, UBS’s Asia-Pacific chief investment officer. “The economic rebalance won’t come without pain,” he says. “There will be some industries affected.”

This could include non-traditional energy companies, such as solar, which will likely receive government support as officials seek to improve living standards and cut pollution. But whether they make large profits remains to be seen, economists argue, and some could go bankrupt.

“Clearly when there are huge concerns over the quality of life because of pollution, some of these reforms will be driven towards a cleaner life,” says Binay Chandgothia, portfolio manager of Multi-Asset Advisors, an investment boutique that is part of US-based Principal Global Investors.

“Whether the companies make money or not depends on the supply/demand situation. If there’s too much supply, then there’s consolidation, and the supply/demand gets into a more balanced stage. In sectors that currently are burdened with oversupply, there will be consolidation until the supply/demand equation gets into a more balanced state.”

Some solar companies have significant debt as well, says UBS’s Pu. He cites Suntech Power, a photovoltaic product manufacturer, which has to restructure an estimated 70% of its debt.

China’s credit issues are another big concern. Fixed income giant Pimco predicts the mainland’s economic performance will next year be “dominated by the dialling back and forth of credit conditions by policy makers”.

Paul Smith, the CFA Institute’s managing director for Asia Pacific, agrees that mainland credit markets represent a “huge” problem that must be addressed in 2014. Many argue that the country’s mounting credit woes are partially due to the shadow banking sector.

“Obviously the credit for small- to medium-sized enterprises [SMEs] is a huge issue. It’s not being supplied by mainland institutions,” Smith tells AsianInvestor. “If you have assets, you can get credit, but if you want credit for your business and you have no security to put up, you won’t find it.”

That's where shadow banks – unregulated institutions that provide loans to SMEs – come in. Although they are a “potentially problematic area”, they serve a much needed function, Smith argues.

Anthony Yau, vice president at State Street Global Advisors, agrees that shadow banking “supports ongoing economic growth”.

But there is little information on the types of loans these institutions are offering. And it’s not just the shadow banking sector that’s spiralling out of control. In the past five years, Chinese banks have added assets that exceed the size of the entire US banking system.

It's doubtful these are all good loans, says Stephen Cannon, head of China at Redbridge Group. This could represent the beginnings of a credit crisis in China that would create the “mother of all restructuring and distressed opportunities”, he adds.

Economists expect further detail from China’s officials next year on how it plans to bring the shadow banking system under control, as well as more information on what the country aims to do about its non-performing loans sector and bad-quality credit issues.

“There are some solutions emerging, but it’s still very early days,” says the CFA Institute's Smith. “Credit remains tight. If you are absolutely in need of it, you’re paying through the nose for it. There’s still a long way to go before the system sorts itself out and provides good financing to smaller businesses.”