1. Introduction
Ten years after ‘Black Monday’ — the stock market crash of October 1987 — the world market slumped again following a new record fall in Hong Kong’s Hang
Seng Index of 1438.31 index points i.e. − 13.7 on October 28, 1997. A new record increase of 1705.41 index points i.e. 18.82 was set in Hong Kong on the
following day and it was believed that this led the recovery of the stock markets around the globe. This recent share price turmoil in Hong Kong broke both the
records for 1-day point-loss and 1-day point-gain of the Hang Seng Index. The huge falls in Hong Kong led to big declines in London and other European
markets, leading to a collapse of the New York Stock Exchange, which in turn reverberated around the world The Economist, 1997.
Some investors might have entered into the volatile equity arena in early 1997, by investing in some China-backed stocks like H shares and red chips in Hong Kong.
The basic question they need to know the answer to is whether the returns on these China related stocks behave similarly because they both: 1 have China related
business; and 2 are listed on the Stock Exchange of Hong Kong or whether other factors are involved. This question has implications for investors who wish to
diversify their portfolios by investing in these stocks.
Defining ‘red-chip’ stock is difficult, as there are currently so many Chinese companies listed on the Stock Exchange of Hong Kong SEHK. The term ‘red
chip’ is financial jargon used in the securities market rather than legitimate terminology used in the official books of the SEHK. Red chips are Chinese
companies incorporated in Hong Kong and listed on the SEHK. Therefore, they have to follow the same set of rules governing the listing of securities and to comply
with the same set of disclosure requirements SEHK, 1997 as other locally listed companies. There are no ‘explicit’ additional listing and disclosure requirements for
red chips. The SEHK does have a separate chapter on listing rules
1
for issuers incorporated in the People’s Republic of China PRC i.e. H-share issuers SEHK,
1997 and it has published a guidebook
2
for listing Chinese companies in Hong Kong SEHK, 1996.
For the purposes of the SEHK Listing Rules, ‘H shares’ are broadly defined as overseas listed foreign shares which are listed on the SEHK and subscribed for and
traded in Hong Kong dollars. In summary, the PRC issuers are subject to the additional requirements SEHK, 1997 as follows:
1. ‘‘PRC issuers are expected to present their annual accounts in accordance with Hong Kong or international accounting standards;
2. The articles of association of PRC issuers must contain provisions which will reflect the different nature of domestic shares and overseas listed foreign shares
including H shares and the different rights of their respective holders; and
1
That is, requirements for new listings and rules which must be continuously complied with by the listed companies.
2
A guide, in layman terms, to the regulatory framework and listing requirements for potential investors in, and prospective issuers of, securities in China incorporated companies.
3. Disputes involving holders of H shares and arising from a PRC issuer’s articles of association, or from any rights or obligations conferred or imposed by the
Company Law and any other relevant laws and regulations concerning the affairs of the PRC issuer, are to be settled by arbitration in either Hong Kong
or the PRC at the election of the claimant.’’
Both red chips and H shares are China-backed securities, although the issuers of H shares have to comply with ‘additional’ listingdisclosure requirements, while no
such additional requirement is imposed on the issuers of red chip. Some H shares have turned up as backdoor listings using locally listed companies as a vehicle,
while others are listed as partners of Hong Kong companies China concepts. That is why many people are confused about what a ‘red chip’ really is and
how it is different from other China stocks like H shares. However, the recent market reactions to these two types of shares appear to be different.
In fact, a cooling in enthusiasm for China-backed shares started before the recent crash, which prompted a fall of over 30 in the red chip index in 1997. Some
investors find it difficult to forecast the performance of these red chips, while some financial analysts cannot explain the return behavior and volatility of the red
chips.
To illustrate, China Everbrights one of the red chips price-earnings PE ratio, on average, was over 1000 during the year and occasionally exceeded even 2000
over the last few months. The pioneering issue in July 1993 of Tsingtao Brewery H-share was 111 times oversubscribed, whereas Beijing Enterprises red chip was
1368 times oversubscribed in May 1997. The PE ratio of the Hang Seng China- affiliated Corporations Index HSCCI this is often called the ‘red chip index’ on
October 27, 1997 was 27.14, which contrasts to 16.96 for the Hang Seng China Enterprises Index HSCEI this is frequently called the ‘H-share index’ and 12.67
for the Hang Seng Index HSI.
The major objective of this study is to examine whether the red chip or H-share market processes information faster than the other China-backed securities because
stocks trading in Hong Kong appear to be subject to less manipulation and have easier access to information. In addition, most red chips are typically managed by
executives from the West who are headquartered in Hong Kong Marriott, 1996. It has been argued that these red chips are better managed than those of the H
shares. We examine the hypothesis that the red chips have the ability to process information faster than the H shares and other China-backed securities. To this
end, we first examine the return behavior and the volatility of H shares and red chips listed in Hong Kong and also the Shanghai and Shenzhen common equities
listed in China.
Recently, there has been a considerable increase in literature on the relationship of conditional variance across financial markets and this relationship’s implications
concerning the information transmission mechanism. Ross 1989 uses a no-arbi- trage model to show information transmission is primarily related to the volatility
of price changes. Engle et al. 1990 provide an alternative interpretation that relates information processing time to variance movements. These developments
suggest price volatility has significant implications concerning information linkages between markets. In light of the literature, we analyze the information flow in the
four markets using a multivariate version of the exponential generalized autoregres- sive conditional heteroscedasticity in mean EGARCH-M model along with the
generalized error distribution GED.
This study is important to the finance literature for the following reasons:
It is a timely topic because of the rapid growth of the red chips and H shares in recent years. The Chinese government is continuing its effort to privatize its
state-owned enterprises in order to raise capital to revitalize the operation of these enterprises.
It is important to study the return and return volatility of China-backed securities because almost one in every six companies listed on the SEHK
recently is controlled by a PRC interest. A new China security is listed almost every week on the SEHK. The growth of China-affiliated corporations is
reflected in a 109.6 increase in 1996 of the Credit Lyonnais Securities Asia Red Chip Index. The combined value of red chips and H shares on the SEHK was
approaching HK232 billion i.e. US30 billion in June 1997 Leung and Surry, 1997.
Past studies in China equities have focused on the return behavior of A and B shares listed on the Shanghai and Shenzhen Stock Exchanges. We believe that
insufficient research effort has been devoted to the return behavior and the relationship among H shares, red chips, Shanghai and Shenzhen equities. Our
study shows that stock returns of these Chinese stocks have fatter tails relative to the normal distribution. We have carried out our analysis using the
EGARCH-M model along with GED, which allows for variable kurtosis in the data.
Both types of shares H shares and red chips might be influenced by some common factors like political risk and government influence. Information
might have been transmitted between the issuers of red chips and the issuers of H shares. The return behavior of these two types of shares and the
return volatility between the two markets might be related. We, therefore examine the spillover effects among the H share, red-chip, Shanghai and
Shenzhen security markets. An examination of the linkages across the four markets may shed light on how investors perceive the information flow across
markets.
The paper is organized as follows. The next section presents the background to our research. The third section describes the research design and methodology.
Empirical results of this study are discussed in the fourth section. The final section gives some concluding remarks.
2. Background to the research
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