Introduction To Chinese Stock Market

Published Date: 02 Nov 2017

Introduction to Chinese Stock Market

1. The establishment and development of Chinese stock market

In the early 1990s, the China government established two stock exchanges in Shanghai (Dec 1990) and Shenzhen (Jul 1991) to develop the economy, to attract international capital inflows and make change from public ownership to private ownership in economic system.

Unlike western stock markets, the inevitable outcome of the development of market economy, Chinese stock market developed based on socialist market economy and under intense government intervention, which made it a stock market with Chinese characteristics. Looking back in to the past 23 years, we divide the history in to five parts:

1990

1991:Initial stage：

Shanghai and Shenzhen Stock Exchange began business on December 1990 and July 1991, which meant that centralized trading stock market was established officially and the Chinese stock market began to function as resource allocation from then.

1992

1997:Pilot phase

In 1992, former chairman Deng indicated that China should have a try on securities and stock market while still be adhering to socialist society. From then on, China set up the goal of economic reform was to establish "market economy of socialist society". On September 1997, the CPC (Communist Party of China) recognized the "joint-stock system is a special form of public ownership" on the constitutional level on the 15th National Congress of the CPC. At this point, the status of the stock market was established formally.

1998

2001:Specification phase

China began officially to use the means of laws and regulations to regulate the stock market in 1998. At the end of 2001, the financial market legal system was initially formed with the Company Law, Securities Act as the core, departmental rules and regulations of the State Council as the main body and supplemented by provisional administrative regulations.

2002

2004:Transition phase

The government was deepening the understanding of the function of the stock market and began to realize it is not only the financing tools, but also the method of bringing wealth, stimulating consumption growth and improving the corporate governance of enterprises, etc. In January 2004, the State Council issued "Several Opinions on Promoting the Capital Market Reform and Stable Development", indicating that the determination of the government to reform and develop the capital market, in order to facilitate the function of resource allocation.

2005

Now :Remodeling phase

Reform of non-tradable shares [1] began in May 2005, which is a process of remodeling of China's stock market. (When, 这里最好加一个脚注) 98% of the companies in Shanghai and Shenzhen markets completed or had access to fulfilling the share reform program, which meant share structure reform basically completed in these two years. China's stock market entered an era of vigorous development and capital market financing and resource allocation function was improved.

We use the State Economic Development Index of Conditions (SEDIC= Shanghai Composite Index (1+growth rate) × (1+GDP growth rate)). SEDIC indicates that virtual economy is an important part of the national economy, recognizing the country's economy need a strong stock market and the stock market falling may wear out the fruits of development of GDP. We can know from the table (add source) below that in some period China's stock market were consuming the results of the development of China's GDP. A sluggish in the stock market may harm the national economy and increase the economy’s internal friction.

Table

2. Different kinds of stock in China

There is an alphabet soup of different kinds of Chinese shares.

"A" shares are dominated in local currency (RMB). They are available for Chinese nationals and for foreigners who have acquired a QFII (Qualified Foreign Institutional Investor) quota. The A-share market has been essentially closed off to foreign investors and prices are largely determined by the actions of individual Chinese investors. "A" Shares are traded on the Shanghai and Shenzhen stock exchanges.

"B" shares are dominated in US dollars in Shanghai Exchange and in Hong Kong dollars in Shenzhen Exchange. B shares are only available for foreign investors initially. But beginning in early 2001s, B shares are available to domestic investors. B share market is far smaller in terms of capitalization, turnover and number of stocks (Groenewold et al. 2003).

"H" shares are the stocks of Chinese companies that list on the Hong Kong Stock Exchange and their financial statements are presented in accordance with international accounting standards. These shares are available to the international investors.

"N" shares are listed (in New York) on either the New York Stock Exchange or the NASDAQ market.

"L" shares are traded on the London Stock Exchange

"S" shares are traded on the Singapore Stock Exchange, etc.

Chinese stock market is a semi-open stock market since there is only limited opportunity for Chinese nationals to invest in foreign markets and for international investors to invest in Chinese mainland markets. Here we will focus on mainland Chinese market.

3. Stock market efficiency

Generally, Stock market has the following functions:

a. Raising funds and adjusting the flow of funds between capital surplus and scarcity sectors.

b. Allocating capital effectively and efficiently according to the price changes.

c. Stock trading imposes indirect monitoring and evaluation on list companies.

The stock market plays a meaningful role in corporate finance and allocation of capital only if it is efficient. If stock prices can reflect their intrinsic values, we call it efficiency. Stock market efficiency started to have a specific meaning after Fama (1970, 1991). Generally different types of efficiency are distinguished depending upon the information set considered: Weak-form efficient, semi-strong-form and strong-form. These will be studied in detail later. Weak-form efficiency means the prices already reflect all historical information, so investors cannot get excess return based on past information. The semi-strong and strong forms of the efficient market hypothesis include more types of information which should be reflected on the economy and individual companies. Under the semi-strong efficiency hypothesis, the stock price should reflect all the public information, so fundamental analysis based on all public information cannot get consistent excess return. The strong efficiency hypothesis includes broadest type of information, which means in additional to public information it requires that even private information should be reflected in stock price. Therefor insiders cannot get more profit from private information.

Part II. Weak-form efficiency of Chinese Stock Market

So far, there is no unanimous conclusion on the Efficient Market Hypothesis. As for the mature stock markets, the generally accepted view is that the market has reached weak-form efficiency. However, to test whether these mature markets have reached a semi-strong or strong efficiency, further validation is still required. The majority of studies on Chinese stock market efficiency are mainly focused on the extent to which the stock market is weak-form efficient.

Ever since 1980s, scholars from both domestic and abroad have done a substantial number of empirical researches about Chinese stock market efficiency, basically using random walk model or AR model which are in the form of linear serial correlations (Laurence et al., 1997; Liu et al., 1997; Long et al., 1999; Mookerjee and Yu, 1999; Darrat and Zhong, 2000; Lee et al., 2001; Groenewold et al., 2003, 2004; Lima and Tabak, 2004; Ma, 2004; Seddighi and Nian, 2004). Taken as a whole, no consensus has been reached. On one hand, the efficiency studies reported by various authors (Liu et al., 1997; Laurence et al., 1997; Long et al., 1999; Lima and Tabak, 2004) did not find predictable patterns in Chinese stock market showing that Chinese stock market was efficient. On the other hand, Mookerjee and Yu (1999) and Ma (2004) argued that the markets are inefficient given that the random walk hypothesis is rejected by their efficiency tests. Moreover, there are some studies (Li, 2003; Hinich and Patterson, 2005) that found proof of profit predictability. But these studies did not do not thought this meant market inefficiency, since this predictability could be a result of spurious autocorrelation. To sum up, the Chinese stock market is found to be weak-form efficient most but not all the time, implying that in some periods historical information is not fully reflected by stock prices.

In addition, Zhang and Zhou (2001) proclaimed the Shanghai Stock Exchange (SHSE) is more efficient than the Shenzhen Stock Exchange (SZSE). Zhang et al. (2007) also pointed out that the momentum of the economic development of Shanghai has been significantly higher than Shenzhen, which led to a faster development of the Shanghai stock market. Since more companies have chosen to be listed in the Shanghai Stock Exchange, the market capitalization of SHSE is significantly higher than SZSE. All these positive factors contributed to the higher efficiency of SHSZ.

Part III. Broader Form Efficiency

In part II, we talk about studies on weak form efficiency of Chinese stock market. In this part, we’ll talk about Chinese market efficiency in a broader way — weak form, semi-strong form and strong form efficiency.

In the following part, we’ll analyze the hypothesis from four perspectives to have a deeper and more specific understanding about it.

The First Perspective –– the Role of Bank

The banks play a significant role in the whole Chinese financial system, and they are the core of the cash flow and capital allocation. Especially if the financial system is not complete and perfect, so the banks under the regulation of central bank will undertake some responsibilities of financial supervision and capital operation. In this perspective, we will analyze what kind of role the banks play in the financial system and how this kind of function influences the market efficiency.

As we all know, Chinese financial system used to been controlled by state owned banks. In early 1990s, when the stock exchanges were founded, banks played an important role in stock trading. Banks had a dominant effect on the stock market until 1996. Before 1994, some Chinese banks set up some departments or subsidiaries as stock brokers. These subsidiaries acted as security companies. But this kind of situation didn’t last long. It was realized that the direct involvement of banks to the stock market were risky and not appropriate. In 1994 banks were forbid to involve in stock market directly since it was realized that to involve financially dominant banks in stock market was risky and not appropriate. And those departments and subsidiaries set up by banks as stock brokers became independent brokers (Yisheng 1997). However, banks continued to influence the stock market by providing a substantial part of liquidity. How can they do that? Some scholars had studied about that. Surry (2000) studied that after 1994 banks still impacted the stock by providing funds for stock trading and in 1996 regulations forbade banks to do this. However in early 2000, the 1996 regulations turned invalid and banks became important sources of capital for stock investment again.

From the above literature review we can see, changes in regulations which control the relationship between the banks and the stock market are taken by the government to mitigate the banks’ dominant impact on the stock market and to enhance the Chinese stock market efficiency. Did this regulation really work?

Groenewold et al. (2003) studies the market efficiency. It seems banks may have two opposite effects. On one side, in the long run, limiting the dominant banks will help the growth of other institutional investors like mutual funds, brokers, and the this competition in the long run will benefit market efficiency. On the other hand, banks brought huge liquidity to the market. Limiting banks’ involvement will make the market less efficient in the short run. They used three period samples: before 1996 when banks were dominant in the stock market, and during 1996-2000 when banks were separated from the stock market, and after 2001 when banks reentered the market. They found for both Shanghai and Shenzhen Exchanges, the banks drawing back increased market predictability and deceased the market efficiency, also efficiency improved when banks came back to the market. They concluded that the liquidity explanation applied in the short-run, excluding banks from markets reduced the liquidity thus slowing the information diffusion, which made the market less efficient.

The Second Perspective –– the Regulation and Policy Effect

An efficient stock market should be random, but we find that there is a significant influence factor––regulation. When the government promulgates laws and regulations, the related stock will fluctuate. That is the regulation effect.

First of all, let’s focus on two examples. (Examples need links, otherwise it seems you make it up.)

The first example is about how the government regulation affects the related industry companies’ stock price. On February 15, 2006, the ministry of finance issued a formal criterion to obey with regard to investment real estate, and this regulation should be effective for the listed companies first on January 1, 2007. After a series of new regulations issued, the stock market had a larger reaction.

During that week when the regulation issued, the trend of property stocks is strong. For instance, China Vanke (000002) went up to a new peak, and Oceanwide Construction (000046) got a short-term 50% rise. A large number of listed companies’ in which investment real estate has a large proportion in total assets benefited from this piece of news, and their stock price kept rising up in a few days and some even rose by daily limit. We find that the promulgation of the new guidelines will directly affect the share price of listed companies. And since there is a trend, it is not pure random walk and may not be semi-strong efficient.

Different from the above example, the second one shows how the SOE’s own policy about dividend and other decision influence the stock price. On December 18, 2010, Guodian Power Development Company (GPDC) announced three important decisions: First, from 2010 to 2012, annual cash dividends should be not lower than 50% of its distributable profit; Second, GPDC owns a 50% equity of Inner Mongolia Energy CO., LTD.; Third, the company will use five-year time to complete the transition goal set initially in the "12th five-year plan". After this information disclosed, GPDC stock price instantly rose up, and once rose more than 3%. explanation for the following picture

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Some other research studies this regulation effect from the empirical perspective, and they use some data and empirical models to analyze this problem. Most of kinds of papers (show me the reference) get a same conclusion that in Chinese stock market, regulations will have an important influence on stock price. Regulation 当然会影响股价啦，关键是股市反应的是否很快，投资者是否能从里面赚到钱，能赚到钱就不是semistrong efficient. 能不能赚钱要看有没有trend，这个很容易。

The Third Perspective –– Calendar Effects

An efficient stock market should be random. If there is a pattern of the change of stock price, then the market is not efficient. Among those patterns, we focus on the calendar effects of Chinese market. If the calendar effects persist, investor could make money by observing historical pattern and make abnormal return. The long existence of calendar effects implies the weak form of efficiency is violated, let alone semi-strong and strong form of efficiency. So we want to know whether Chinese stock market has calendar effects, and more importantly whether the effects are long lasting.

Let’s take January effect as an example. Many stock markets have January effect: US stock markets (Rozeff and Kinney 1976), Australian Stock Exchange (Officer 1975), Canadian market (Tinic, Barone-Adesi and West 1990), Tokyo Stock Exchange (Aggarwal, Rao and Hiraki 1990), Italian market (Barone 1990), and London Exchange (Lewis 1989). There are usually two explanations for this. One is for taxable capital gains, the other is for window dressing for institutional investors (Dyl 1977 and Gompers 2001). To reduce taxable capital gains in those countries, investors always realize losses in December. Institutional investors often sell the losing components of their portfolio to make portfolio look nicer before the reporting day in Jan, and buy back after reporting date to remain portfolio component. But China do not have capital gain tax and the institutional investors effect is not clear, the above two explanations may not apply to China.

Kling and Gao (2005) Studied the calendar effects in China. They first used index monthly return from 1990 to 2002 for Shanghai and Shenzhen Exchanges. The result was a very weak evidence for February effect, and the joint hypothesis that there is no monthly effect was not rejected. Then they use stock data from 1990-2001, including 34790 monthly return data from Shanghai Exchange and 29790 from Shenzhen Exchange. They tried to figure out whether the January exists by standard regression model with dummies for month and for individual stocks (Model 1) and an approximation (Model 2):

Model 1

Model 2

The following Table(最后用标号写明) shows the result. The vertical axis is the average monthly return and the horizontal axis represents the months. We can see the average return drops from about April to December. Kling and Gao (2005) said this result exhibited January effect, with western year end to Chinese year end around Spring Festival.

Table Monthly Time Pattern of Model 1 and Model 2

Then they moved to test whether this effect was weakened by investors taking this opportunity to make money. They modified model 2 to allow for intercept shifts and coefficients. They found the monthly calendar pattern become flatter and flatter. One comparison is showed in Table X and Y. We can see the calendar effects in 2001 is weaker than in 1992 for both Shanghai and Shenzhen Exchanges , which was evidence that the market is closer to efficient.

Table Fitted Monthly Calendar Effects for Shanghai Exchange in 1992 and 2001

Table Fitted Monthly Calendar Effects for Shenzhen Exchange in 1992 and 2001

The Fourth Perspective ––Analysts PK Indices

Perhaps the most direct and convincing way to see whether the market is semi-strong form efficient is just following the definition of semi-strong form efficiency and figuring out whether financial analyst could outperform indices after risk adjustment. When the market is semi-strong efficient, analysts making investment using public information cannot outperform market before costs and should underperform market after costs.

Malkiel (2007) studied whether financial professionals could beat Chinese A-share market and H-share market.

He found for A-share market, in contrast to the US market where well diversified market index usually outperform professionally managed mutual fund, the equity portion [2] of mutual funds in mainland China significantly outperform market index even after expense during 1998 to 2006. Table X shows the comparison.

Table Managed Equity Funds in China Compared with Local A-Share Indexes

1998-2006

Return of Managed Funds* (%)

Return of Shanghai Stock Index** (%)

Return of Shenzhen Stock Index** (%)

Average Annual Return

20.75

16.20

16.20

* Return is measured by the return of the equity portion of the managed fund portfolio. Included in the calculation are the returns from all open- and closed-end funds that are restricted to buying local shares.

**These differences of over 450 basis points may be overstated by as much as 150 basis points since the returns from the indexes measure only price changes while the returns from the managed funds are total returns including dividend payments.

SOURCE: Bosera Asset Management Co.

However, H-share market performed very differently. Malkiel (2007) used FTSE/Xinhua 25 Stock Index (FXI) as a bench mark. FXI is composed of Chinese corporations’ H-shares. He compared US and HK mutual funds’ performance in investing Chinese shares available to foreigners with this index, and found most mutual funds cannot beat the index after expense both in US and HK. Table X shows only two US funds’ sharp ration is higher than the index during 2001 to 2007. Figure Y shows only three HK funds’ annualized returns are higher than the index before expense during 2003 to 2006. This is evidence that Chinese H-share market is almost semi-strong efficient.

Table Sharp Ratios of US Mutual Funds Investing In Chinese Companies vs. FXI Sharp Ratio

Table Annualized Returns of HK Mutual Funds Investing In Chinese Companies VS FXI Annualized Return

Conclusion

The above discussion showed the Chinese stock market is not weak-form efficient at the beginning. One proof is the calendar effect around 1992. As the market developed the calendar effect seems to disappear, which means the weak-form efficiency became possible around 2001. [3] During the last decade, we have seen transformed individual investors who learnt a lesson from speculation, a rapid growth of institutional investors some of whom adopt value investment strategy, the reform of non-tradable shares which liberalized a large portion of the market, the laws and regulations becoming more complete. As so many improvements took place, maybe the stock market is more efficient and serves capital allocation function better now, we wish.

The Chinese stock market is not semi-strong efficient. Evidence is that we usually have increasing trend after good news release which can be exploited to make abnormal return and the equity portion of mutual funds in mainland China significantly outperform market index even after expense during 1998 to 2006. As the market is not semi-strong efficient, it is certainly not strong form efficient. No wonder, article no.5 of Chinese Security Law forbids insider trading.

Chinese stock market is still very special. It is full of Chinese characteristics. The government is still learning to regulate the market better and the regulation is changing fast. [4] The state –owned banks used to play a dominant role. The financial institution growth is not adequate. No tradition of law. Corruption is rampant and corporate governance is bad (Malkiel 2007). We are waiting to see where the Chinese stock market is going.

Reference

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