Thursday 11 March 2010
Lowdown on China stock markets
China’s stock market is now bigger than the bourses in London and Tokyo and has become the second largest in the world after the United States. Some of the largest firms in the world are also now listed in China. Yet, not enough is known about the behaviour and reasons for the rapidly rising stock markets in Shanghai and Shenzhen.
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Lowdown on China stock markets
Panellists from NTU’s Nanyang Business School:
# Dr Hwang Chuan Yang, Professor of Finance & Director of Research and PhD Programme
# Dr Zhang Huai, Associate Professor of Accounting
# Dr Luo Jiang, Associate Professor of Banking and Finance
# Dr Xin Chang, Simba, Assistant Professor of Banking and Finance
Moderator and writer: Narendra Aggarwal, Director, Public Affairs, NBS
OVERVIEW
China’s stock market is now bigger than the bourses in London and Tokyo and has become the second largest in the world after the United States. Some of the largest firms in the world are also now listed in China. Yet, not enough is known about the behaviour and reasons for the rapidly rising stock markets in Shanghai and Shenzhen.
In an ongoing Nanyang Business School-Business Times Roundtable discussion series, finance and accounting professors at Nanyang Technological University’s Nanyang Business School (NBS) examine the growth of the mainland’s stock market which is often volatile and sees a lot of speculative trading.
Narendra Aggarwal: Can we start by doing a quick recap of the emergence of China stocks and look at where and how they are traded?
Associate Professor Luo Jiang: Many Chinese companies issue stocks to raise capital. They are mainly traded in China, though some companies are also listed in Hong Kong, the United States and here in Singapore.
There are two stock exchanges in China - the Shanghai Stock Exchange and the Shenzhen Stock Exchange. In these two exchanges, most companies issue shares denominated in Chinese yuan and these shares are referred to as A-shares. Some companies also issue shares denominated in US dollars, which are listed in Shanghai, or Hong Kong dollars, which are listed in Shenzhen, and these shares are referred to as B-shares. The B-share market is much smaller and has lower liquidity than the A-share market. For companies that issue both shares, B-shares are usually traded at a considerable discount to the A-shares.
Foreigners can invest in the A-share market through the Qualified Foreign Institutional Investors (QDII) mechanism.
Quite a few Chinese companies - most insurance companies and commercial banks - issue shares in Hong Kong and are listed in the Hong Kong Stock Exchange. These shares are denominated in Hong Kong dollars and are usually referred to as H-shares.
Assistant Professor Xin Chang, Simba: China’s B-shares typically trade at a discount due to a lack of information between the company and the foreign investors. Also, the pool of B-share investors is smaller as those allowed to hold foreign currency is rather limited.
On the other hand, A-shares generally rule high due to the speculative activity which pushes up their prices rather high. Also, remember that the Chinese like to gamble, and with A-shares being in yuan, these shares are easily available to a very large number of investors and speculators to place bets on.
Professor Hwang Chuan Yang: The growth of China’s stock market really took off after the 2004 share restructuring reform; before that, more than 50 per cent to 60 per cent of the shares of most companies could not be traded as they were mostly government-owned.
With the government holding being gradually reduced over the years, more and more stocks have now become available to the general public to invest in, thus giving a healthy boost to the market. The reform is ongoing and the transition is not over yet as some of the previously non-tradable shares being released to the market have a lock-up period of three to five years, sometimes even longer, before they become fully tradable.
Assistant Professor Xin Chang: As a result of more China shares coming into the market and their value having risen sharply, China has overtaken Japan to become the world’s second largest stock market by market capitalisation. Latest figures from the China Securities Regulatory Commission (CSRC) show that the total market capitalisation is 24.393 trillion yuan as at end-2009, which is equivalent to US$3.578 trillion.
In contrast, according to the Tokyo Stock Exchange, its total market capitalisation is 307.779 trillion yen as at end-2009, which is equivalent to US$3.337 trillion.
The US still has the biggest equity market worth US$13.312 trillion.
However, it needs to be clarified that the total market capitalisation of China stock markets includes both tradable and non-tradable shares. The market value of tradable shares is US$2.218 trillion.
Narendra Aggarwal: No doubt China now has the second largest stock market in the world. But what really causes the huge amount of speculation and volatility in China stocks?
Professor Hwang: The speculation takes place because there are not enough tradable shares to meet the market demand. The float is just not big enough. There is a lot of demand but the supply of tradable shares is not there. If the float is not big enough, everybody tends to bid higher than the fair value of the stocks because they think the next person will bid even higher due to the lack of supply. This kind of unhealthy speculation pushes up the stock prices way beyond their fair value as a result of the gambling attitude.
The increase of the float can in fact reduce the speculation. I have a study that shows that if the stock market reforms had not taken places, the speculation would have been even greater. After the reforms were initiated and more and more tradable shares came into the market, the level of speculation has in fact gone down and the speculative component in share prices has gradually come down. However, float is not the only speculative cause.
Associate Professor Zhang Huai: Evidence from my research with Professor David Hirshleifer, Merage Chair in Business Growth and Professor of Finance at Paul Merage School of Business, University of California at Irvine and Dr Ming Jian, Assistant Professor of Accounting, at NBS, suggests that China’s stock market is not completely rational. We examine how Chinese fascination with lucky numbers affects the stock market. The Chinese have a strong belief in lucky numbers and unlucky numbers. The numbers 6, 8, and 9 are generally believed to be lucky because they sound similar to words that have positive meanings, while the number 4 is generally deemed unlucky because in Chinese it sounds similar to the word ‘death’.
This superstitious belief is influential in China. For example, the opening ceremony of the Beijing 2008 Summer Olympic Games officially started at 8pm on Aug 8, 2008, because 8 is a lucky number. Tens of thousands of Chinese got married on Sept 9, 2009, because nine means ‘for a long time’ and getting married on 09/09/09 would supposedly bring longevity to the marriage and the couple’s lives.
This superstitious belief can potentially affect stock prices because listed stocks are assigned numerical codes and investors typically refer to those stocks by the codes.
For example, Bank of China’s listing code on the Shanghai Exchange is 601988. We focus on the IPO market and test whether this belief in lucky numbers affects pricing of IPOs. Our results suggest that the answer is yes. We find that IPOs with lucky numbers in the listing codes are initially priced at a whopping 23 per cent premium, relative to those with unlucky numbers, although the fundamentals of the two types of the firm are similar.
Our further investigations show that when more information about the firm is revealed and uncertainty diminishes, investors realise their pricing errors and unwind the lucky number premium. As a result, the post-IPO returns of firms with lucky numbers are lower by 6 per cent per year, compared to firms with unlucky numbers. Overall, our results suggest that investors resort to superstitious beliefs when they price newly listed stocks on China’s financial market.
Assistant Professor Xin Chang: While the blame can be placed on excessive demand, for Chinese investors, there are no other better alternatives than investing in the stock market. Also, the Chinese stock market investors are less sophisticated than their counterparts in the United States and are therefore not able to make fair valuation of the stocks they invest in. The prices are often supported by appreciation expectation, rather than fundamentals.
Another important element is their firm belief that the government will never let the stock market fall. As a result of this belief, the stock market bubble is getting bigger and bigger. Excessive liquidity is another driving force because now the interest rate in China is very low and it is easy to get cheap bank loans. It is noteworthy that the stock markets recorded a huge increase of 80 per cent last year.
Associate Professor Zhang Huai: The lack of social protection is responsible for the high savings rate, which tends to be well above 50 per cent. For example, a countrywide adequate medical insurance system is non-existent. If you are sick, you have to pay upfront for your treatment. There have been accounts of people dying in front of hospitals because they do not have enough cash to cover the upfront payment. Therefore, there is a real need to save.
Your savings can be put into either a savings account or the stock market. If you put your money in a bank, your savings actually depreciate due to the combination of the low interest rate and the inflation, leaving the stock market the only sensible place to park your money.
Narendra Aggarwal: Is there any difference in the speculative behaviour of investors with regard to A and B-shares, and the H-shares which are listed in Hong Kong? Why does this happen?
Professor Hwang: I have a study showing that A-shares are more speculative than B-shares, this is part of the reason why the B-shares are traded at a discount.
Furthermore, there is a larger speculation component in the A-share price of stocks that have no B-shares - B-shares are like an anchor that help prevent A-shares from running away with speculation.
Assistant Professor Xin Chang: Currently, over 60 mainland China companies are listed in both China and Hong Kong, with the latter stocks being traded in Hong Kong dollars and dubbed H-shares. Of these, 49 stocks, or 83 per cent, have their A-share prices higher than their H-share prices. Overvaluation of A-shares is severe with 20 stocks having A-share price/H-share price of over 200 per cent.
For Hang Seng China AH Premium Index which has 44 stocks, the average A/H price ratio is 153 per cent, suggesting that A-share price is on average 53 per cent higher. The weighted average is around 20 per cent.
With the Hang Seng China AH Premium Index, investors can track the price gap between shares of companies traded on both the Hong Kong and Shanghai bourses, although opportunities for arbitrage between the two markets will remain limited.
Hong Kong and Shanghai investors have reached different conclusions about the valuation of Chinese companies listed on both stock exchanges. Shanghai’s yuan-denominated A-shares, which can only be bought and sold by domestic investors, trade at an average 53 per cent premium to their Hong Kong counterparts.
Associate Professor Luo Jiang: At this point, it needs to be noted that for the larger Chinese firms, such as the insurance companies and commercial banks, their H-shares prices are quite close to and sometimes higher than their A-share prices. These companies are less affected by speculation and price manipulation.
Narendra Aggarwal: Of late, a lot of new issues have taken place in China. If the stock market is not efficient, what is driving its IPO market?
Assistant Professor Xin Chang: Just last month, 37 IPOs took place in China and their PE ratio was 68 times. To put it in perspective, in the US stock market, the average PE ratio is between 20 and 30. No doubt, there was some backlog due to very few new issues over the past two years.
But what is more important is the market performance of these new issues. The common phenomenon around the world is that the new issues on their first trading day are above their issue price in any market and thus provide compensation for the new investors. But in China now, the new issues have opened below the issue price. This is what happened in the short run, but this is also true of the long run. Now, this China stock market is helping a lot of state-owned enterprises (SOEs) to raise money but unfortunately not helping the investor to make money either in the short or the long run. In fact, I have a research paper pointing out that in China, companies have a severe underperformance after an IPO.
Associate Professor Zhang Huai: The IPO market is heavily controlled by the government in China. In other markets, such as the US, the IPO considerations are driven by purely economic considerations. In China, the IPO process needs governmental approval and the government’s decisions are sometimes politically motivated. This is a key difference.
Assistant Professor Xin Chang: But a new development is that the authorities no longer help to determine the IPO price. Now, the company and the underwriter decide the issue price and that is how they can set it so high as 68 times, and take advantage of the investors’ sentiment because they have the idea that no matter how high the price, people will still invest. Also, often, the investment bank, the domestic banks and institutions may not have good research capabilities, price setting experience and sufficient accountability.
The companies really have the incentive to maximise the issue price so that they can raise as much money as possible. But this is not at all good from the investors’ point of view.
Professor Hwang: Undoubtedly, China’s IPO market is overheated. Buying stocks in an IPO is more like a gamble, as even if the returns are so skewed, chances are that once in a while you could hit the jackpot. Even when the chance to win in a lottery is small, people do buy the lottery in the hope that if I happen to buy into a good IPO, there could be easy money to be made.
Assistant Professor Xin Chang: Even though individual investors are very powerful in China because of their collective huge savings, slowly the more astute investors among them are moving towards mutual funds in the hope of smaller assured returns.
Associate Professor Luo Jiang: The institutional investors in China, including mutual funds and insurance companies, trade more frequently than their foreign peers. Their trading behaviour sometimes leads to significant price fluctuations.
Associate Professor Zhang Huai: Looking ahead, I think the way to go for China to stabilise its stock markets is to go for more investor education which has been lacking so far. At the other end, there has to be more oversight by the China Securities Regulatory Commission to ensure that listed companies develop good corporate governance and are fair to the investing public at large.
Narendra Aggarwal: Chinese New Year is around the corner - it is a good time to buy stocks?
Associate Professor Zhang Huai: There is a good reason to celebrate Chinese New Year. That is, you will be richer. Prior academic literature provides strong evidence that pre-holiday returns are higher. Using 90 years of data from the United States, researchers found that the pre-holiday trading day return is 22 basis points. This compares to the regular daily return of 0.9 of a basis point. So, the pre-holiday return is 23 times larger than the regular daily return. Holidays account for about 50 per cent of the price increase in the Dow Jones Index.
Similar evidence has been found for markets in Singapore and China and this effect is even more pronounced for the Chinese New Year holiday. A recent study found that in China’s stock market, the pre-holiday return for Chinese New Year is more than three times higher than that for other public holidays. Now that the Chinese New Year is coming, if you are an investor, just sit back, relax and enjoy the ride.
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