Directory UMM :Data Elmu:jurnal:J-a:Journal Of Banking And Finance:Vol24.Issue12.2001:
Journal of Banking & Finance 24 (2000) 1875±1902
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The eect of market segmentation on stock
prices: The China syndrome
Qian Sun a, Wilson H.S. Tong
b,*
a
b
1C-75, Nanyang Business School, Nanyang Technological University, 639798, Singapore
Department of Finance, School of Business and Management, Hong Kong University of Science and
Technology, Clearwater Bay, Kowloon, Hong Kong
Received 22 April 1999; accepted 4 September 1999
Abstract
China has an A-share market that is open only to local investors and a B-share
market that is open only to foreign investors. Contrary to what has been observed in
other markets with a similar segmented structure, the China B shares trade at a discount
relative to the A shares. We show that the phenomenon can still be explained by basic
economic principles. Speci®cally, the existence of the H-share and the ``red-chip''
markets in Hong Kong provide good substitutes for the B-share market. We ®nd that
when more H shares and red chips are listed in Hong Kong, the B-share discount becomes larger. This is consistent with the model of dierential demand elasticity proposed by Stulz and Wasserfallen (Stulz, R., Wasserfallen, W., 1995. Review of Financial
Studies 8, 1019±1057). Ó 2000 Elsevier Science B.V. All rights reserved.
JEL classi®cation: G10; G15
Keywords: Market segmentation; A, B, and H shares; Red chips; China market;
Demand elasticity
*
Corresponding author. Tel.: +852-2358-7666; fax: +852-2358-1749.
E-mail addresses: aqsun@ntu.edu.sg (Q. Sun), wilson@ust.hk (W.H.S. Tong).
0378-4266/00/$ - see front matter Ó 2000 Elsevier Science B.V. All rights reserved.
PII: S 0 3 7 8 - 4 2 6 6 ( 9 9 ) 0 0 1 2 1 - 1
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Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1. Introduction
The bene®ts of international diversi®cation attract free capital to move
across borders. Such bene®ts prompt investors to pay higher prices for foreign
stocks than what they would pay at home. Indeed, in segmented markets where
companies issue restricted shares that only local citizens can hold and unrestricted shares that can be held by both local and foreign investors, studies
uniformly ®nd that unrestricted shares trade at premium prices relative to those
of restricted shares. 1 Similarly, the share values of country funds are also
found to be higher than their net asset values (NAVs), just the opposite of the
``closed-end fund puzzle'' in which fundsÕ share values are lower than the
NAVs. 2
A notable exception is China. Bailey (1994) ®rst documented that, in China,
prices of B shares (the equivalent to unrestricted shares in other markets) are
selling at a discount relative to their A-share counterparts (the equivalent to
restricted shares). 3 It is puzzling why China is so dierent from other markets.
Is the cost of capital cheaper to Chinese investors than to foreign investors?
Are Chinese investors risk seekers and willing to pay high prices on their share?
What deter foreign investors from investing in the China B-share market to
reap diversi®cation bene®ts? Can existing arguments and factors that explain
the price premium in other markets also explain the opposite phenomenon in
China?
There are only limited studies on this ``strange'' phenomenon. In his pioneer
work, Bailey (1994) suggests lower cost of capital for Chinese citizens may be
the reason as there are few investment alternatives for Chinese investors.
However, as the study was carried out quite early, Bailey has only one-year
weekly data from 1992 to 1993 of two stocks in the Shanghai market and six
stocks in the Shenzhen market to analyze. Rigorous tests are not possible. A
later work by Ma (1996) ®nds that the B-share premium is negatively related to
the domestic beta. That means when A-share beta is high, the A-share price is
also high. This requires China investors to be irrational and risk seeking. A
recent paper by Bailey et al. (1999) provides a comprehensive study on eleven
countries that have similar segmentation structure. They examine various
factors that can potentially explain the price premium phenomenon, and ex-
1
See Hietala (1989) on Finland, Lam et al. (1990) on Singapore, Bailey and Jagtiani (1994) on
Thailand, Stulz and Wasserfallen (1995) on Switzerland, and Domowitz et al. (1997) on Mexico.
See also a comprehensive study by Bailey et al. (1999).
2
See Bonser-Neal et al. (1990), De Long and Shleifer (1992), and the comprehensive study by
Nishiotis (1997).
3
Technically speaking, the B-share market is also a restricted market ± restricted to only foreign
investors. Local investors are not allowed to trade B shares in China.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1877
plicitly acknowledge that China is a ``strange case'' and dicult to be explained.
The contribution of this paper is to show a new and viable economic explanation to the phenomenon. The explanation hinges to a peculiar situation in
the China foreign shares. Alongside the B-share market, there is a liquid Hshare market and a ``red-chip'' market in Hong Kong. As will be explained
later, H shares and red chips are close substitutes for B shares. Hence, unlike
other markets, China has more than one market available for foreign investors
to invest. If the H-share and red-chip markets are attractive enough to foreign
capital, the demand for B shares will then be quite elastic, leading to low
equilibrium price of B shares for a given share supply. Indeed, our results
provide strong supporting evidence. Although various factors identi®ed by
other studies are also related to the B-share price discount phenomenon, the Hshare and red-chip issues in Hong Kong provide strong explanatory power.
Another piece of supporting though weaker evidence is that the bond issue can
also explain the B-share discount. Given that most individuals in China do not
have many alternative means to invest, bonds can be an important substitute
for A shares. We view all these as consistent with the argument of Stulz and
Wasserfallen (1995). There are other factors contributing to the phenomenon.
We ®nd some evidence on Chinese investors being speculative. It is conceivable
that limited investment alternatives can heat up the speculative sentiment of
unseasoned Chinese investors in the stock market. They may also be more
optimistic on ®rmsÕ future growth than foreign investors but it is dicult to
test. Also, we ®nd some evidence that foreign investors are more sensitive than
local investors to changes in macroeconomic conditions, as the in¯ation rate
and change in ChinaÕs ocial reserve contribute to the discount phenomenon.
This paper proceeds as follows: Section 2 lays out the issue and hypotheses.
Some background information about the Chinese market is presented in Section 3. Data and methodology are given in Section 4. Results are discussed in
Sections 5 and 6. Section 7 provides some concluding thoughts.
2. Price premium and possible explanations
Many emerging capital markets impose restrictions on foreign ownership of
their domestic stocks. Companies in these markets can issue two classes of
shares, restricted shares that can be held only by local citizens and unrestricted
shares that can be held by both local and foreign investors. One major reason
for such an arrangement is to attract foreign investment without worrying
about the loss of ownership control to foreign investors. Since restricted shares
and unrestricted shares typically bear the same rights and obligations, their
values should, theoretically, be the same. Yet, all existing studies ®nd that
unrestricted shares trade at premium prices compared to restricted shares.
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China is an exception. As will be discussed later, Chinese companies issue A
shares strictly to local investors and B shares strictly to foreign investors. It is
found that A-share prices are higher than B-share prices. Hence, arguments
and factors found useful in explaining the phenomenon observed in other
markets may not be useful in explaining the China situation. We ®rst consider
four arguments provided in the existing literature as we seek to understand
what creates the special situation in the Chinese market.
2.1. The equilibrium pricing argument
When investing in domestic stocks, foreign investors can gain additional
diversi®cation bene®ts that domestic investors cannot. As a result, foreign
investors require a lower rate of return than domestic investors do. The difference in required rates of return leads to dierence in share prices. In a
CAPM world, this also means that the price dierence comes from the difference in the beta risk. Hietala (1989) ®nds supporting evidence for this argument by demonstrating that dierences in the beta risk can explain the price
premium in the Finnish market.
On the other hand, based on a simple dividend growth model, share price
dierence can also be seen as driven by the dierence in expectations on the
®rmÕs growth rate by dierent classes of investors. Speci®cally, if the A-share
investors expect higher ®rm growth rate than the B-share investors do, the Bshare price will trade at a discount rather than at a premium relative to the Ashare price. To paraphrase Domowitz et al. (1998), market segmentation leads
to cross-market dierences in information. The A-share price better re¯ects
information and expectations held by Chinese locals and the B-share price
better re¯ects information and expectations held by foreign investors.
2.2. Dierential demand argument
We are particularly interested in the model set up in Stulz and Wasserfallen
(1995) that based on the dierence in demand elasticity of two share classes. In
such a scenario, it is optimal for the domestic ®rm to strategically restrict issuing shares to foreign investors. As long as foreign investors have a relatively
inelastic demand on domestic shares, the ®rm can successfully price-discriminate by charging foreign investors a higher share price. Bailey and Jagtiani
(1994) and Domowitz et al. (1997) ®nd evidence that changes in the share
supply have explanatory power for the price premium. This indicates that the
demand curve is downward sloping and thus indirectly supports the model.
Certainly ®rms in China do not have the freedom to issue shares in such a
strategic way. In fact, the State Planning Committee and the China Securities
Regulatory Commission (CSRC) set national quotas for the amount of new
shares issued each year in China. Furthermore, ®rms must obtain special ap-
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1879
proval from the CSRC to issue foreign shares. Yet, the idea of dierences in
demand elasticities behind the model of Stulz and Wasserfallen (1995) can still
be important. Speci®cally, the China B-share discount phenomenon may be
due to foreign investors facing a more elastic demand curve, while local Chinese investors are facing a less elastic one. An important determining factor for
elasticity of demand is the availability of substitutes. If there are more substitutes for a good, the elasticity of demand for that good will be higher. Bailey
(1994) argues that there are few investment alternatives for Chinese investors.
Even bank deposit rates are too low to be attractive. 4 In that case, the demand
elasticity for A shares may indeed be low. Yet, government bonds may be
important substitutes for equity stock. Interest rates on treasury bonds are set
at about 150±200 bp above the savings rates with comparable maturities. Investors like to buy bonds and hold them for the coupon and repayment at the
end. It is hence conceivable that bond issues take away a certain amount of
domestic capital from the A-share market. A recent case is the government
bond issue to ®nance the huge budget de®cit of the Chinese government. According to a newspaper report, there were long lines of Chinese investors
waiting in each of the thousand oces to subscribe to the bond issue. 5
On the other hand, if foreign investors could gain diversi®cation bene®ts
through investing in Chinese stocks other than B shares, the demand elasticity
for B shares would indeed be high. As will be discussed in the next section, H
shares are nothing more than the B-share equivalent in Hong Kong. Red chips
are essentially Chinese companies incorporated in Hong Kong. Foreign investors would achieve the same kind of diversi®cation bene®ts investing in H
shares and red chips or in B shares. The value and attraction of red chips to
foreign investors can be revealed through the fact that in November 1998, the
International Financial Corporation (IFC) added 11 red-chip stocks into their
emerging market composite index. The explanation given was that red-chip
stocks have occupied an important position in the eyes of international investors. 6 As such, the existence of these H shares and red chips are bound to
make foreign investorsÕ demand on B shares very elastic.
2.3. A few important factors: Information, liquidity, and currency risk
Diversi®cation bene®ts tempt foreign investors to invest in the domestic
market but there are investment barriers that deter such cross-border in4
Yet, bank deposits make up the absolute majority of the individualsÕ ®nancial assets in China.
Seventy percent of the total amount of ®nancial property of individuals are in the form of bank
deposits; 20% is in cash; and only 10% is in forms of government bonds, enterprise bonds and
stocks (Yu et al., 1998, p. 6).
5
Hong Kong Economic Journal, 10 March 1999.
6
Hong Kong Economic Journal, 4 November 1998.
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vestments. A survey by Chuhan (1994) ®nds that liquidity problems and
limited information are two key hurdles for investing in emerging markets.
Nishiotis (1997) also ®nds that these ``indirect barriers'' have explanatory
power for the dierence in closed-end country fund premiums over their
NAVs.
These two deterring factors can also work at the ®rm level. Bailey and
Jagtiani (1994) argue that it is easier for foreign investors to acquire information on large ®rms than on small ®rms, so foreign investors are willing to
pay a higher premium to invest in large ®rms. On the other hand, relatively
illiquid stocks have a higher expected return and are thus priced lower to
compensate investors for increased trading costs, as suggested by Amihud and
Mendelson (1986). Bailey and JagtianiÕs cross-sectional results con®rm the
explanatory power of these two factors on price premium in the Thai market.
Domowitz et al. (1997) ®nd supporting evidence for the information availability factor in the Mexican market but not the liquidity factor. They show
that the explanatory power comes mainly from share supply. Liquidity has
only transitory impact on price premium.
Nishiotis (1997) also argues that foreign investors are more sensitive than
local investors to changes in economic factors. Foreign investors can adjust
their portfolios across dierent markets easily while domestic investors are
typically restricted to their domestic market. These macro factors can be important to the understanding of the B-share discount in the Chinese market. If
these barriers and hurdles are signi®cant, drawing foreign investors to China
may indeed require a share price discount. We believe currency risk is one such
important macro factor. As China is increasingly opening up to the outside
world, its economy depends more on the foreign sectors like international
trade, foreign investment and tourism. Hence, currency stability is highly related to macroeconomic stability. If investors of dierent share classes respond
dierently to the currency risk factor, that would be re¯ected in the share
prices. 7
Domowitz et al. (1997) show evidence that higher perceptions of exchange
rate risk imply less foreign investment and hence lower price premium. Interestingly, in another paper on country and currency risk, Domowitz et al. (1998)
®nd that increases in perceived currency risk widen the gap between the
Mexican country fund price premium and the fundÕs NAV. This is consistent
with a recent working paper by Yeyati and Ubide (1998). They study the behavior of closed-end country fund discounts covering the period of the Mexican and the East Asian crises. They ®nd that the ratio of country fund prices
7
Notice that B-share prices are traded in foreign currencies (either in HKD or USD) and hence,
theoretically, foreign investors do not have ``transactional exposure'' to RMB devaluation risk.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1881
to their fundamental value increases dramatically during a ®nancial crisis. They
interpret that as international investors being less (more) sensitive than domestic investors to changes in local (global) market conditions. Hence, their
argument is dierent from that of Nishiotis (1997).
In any event, barriers and hurdles like information availability, liquidity
premium, and currency risk may also be useful in understanding the B-share
discount in the Chinese market. If these barriers and hurdles are signi®cant,
drawing foreign investors to China may indeed require a share price discount.
On the other hand, if the situation improves, more foreign capital may then
¯ow into these markets to narrow down the price gap between A shares and B
shares.
2.4. Speculation argument
Lastly, there is a ``popular'' view of the speculative fever of Chinese investors. If limited investment alternatives mean a relatively inelastic demand for A
shares, they can also mean a possible speculative fever. In fact, erratic events
like the lottery ticket prices for IPOs being much higher than the stock prices
themselves and stock purchases leading to riots in Shenzhen did happen in the
early period. When unseasoned Chinese investors speculate on shares with
limited supply, it is conceivable that the share prices are pushed beyond their
actual values. This can be related to the argument of dierence in expected
growth rates. If Chinese investors are too optimistic and have unrealistic view
on the growth potential of the ®rms, they will drive up the A-share prices
relative to the B-share prices. Certainly, persistent dierence in expected
growth rates indicates market ineciency.
In this paper, we test mainly the dierential demand argument and the three
important factors. The equilibrium pricing argument can only explain price
premium but not price discount of unrestricted shares. Also, the ®ndings of Ma
(1996) require China investors to be risk lovers. On the other hand, Bailey and
Jagtiani (1994) do not ®nd any signi®cant relationship between ®rm betas and
the price premium in the Thai market. The comprehensive study of Bailey et al.
(1999) on the 11 markets also con®rms that the equilibrium pricing model
cannot explain the price premium phenomenon. Hence, we think it cannot be
an explanation for the Chinese phenomenon either. 8 For the speculative argument, although there are many anecdotal evidences for that, rigorous tests
are dicult to construct.
8
In the earlier version of this paper, we did test the beta factors and did not ®nd statistical
signi®cance.
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3. The Chinese market
A major eort in ChinaÕs reforms is to privatize state-owned enterprises. The
government selects some state-run factories and restructures them to allow the
most attractive parts of these plants to form new companies. Hence, a new
company so formed is often only a fraction of the original enterprise. 9 Shares
are then issued and sold to the public as well as to foreign investors.
3.1. The public A and B shares
A Chinese company can issue ®ve types of shares in the domestic market:
state shares, legal person shares, employee shares, tradable A shares and B
shares. Only the last two types of shares are freely tradable. A shares are ordinary equity shares available exclusively to Chinese citizens and domestic
institutions. When going public, companies are required to issue no less than
25% of their total outstanding shares as tradable A shares.
B shares are issued to attract foreign capital. The ®rst B-share issue was in
1992. Firms can choose to list their B shares on either of the two national
exchanges, the Shanghai Stock Exchange (SHSE, established in December
1990) and the Shenzhen Stock Exchange (SZSE, established in April 1991), but
not both. B shares can only be bought by and traded amongst foreign investors. Since the RMB is not convertible under capital accounts, B shares are
traded in either US dollars (in the SHSE) or HK dollars (in the SZSE). 10
3.2. The foreign H and N shares
Compared with the newly established Chinese stock market, Hong KongÕs
mature market should make a bigger contribution in channeling foreign funds
to mainland Chinese enterprises. Indeed, beginning in 1993, Chinese enterprises started applying to list in Hong Kong as H shares. They are selected for
their economic importance, management quality, technology, pro®tability and
international signi®cance. Led by Tsingtao Brewery, the ®rst batch of H shares
listed in the SEHK had great success. Tsingtao Brewery received 110 times
over-subscription and the six H-share companies together raised more than a
billion US dollars. There are currently 41 ®rms issuing H shares on the SEHK.
Firms that issue B shares or H shares also issue A shares but, as far as we
know, only three ®rm issues both B shares and H shares.
9
For example, Shanghai Petrochemical is basically a complete town with hotels, schools,
housing and a college. When listed in 1993, the company consisted only of some selected buildings,
a plant and equipment.
10
B shares are still denominated in RMB nominally but quoted and traded in USD or HKD.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1883
There are N shares listed in the New York Stock Exchange but the market
has been very thin. To limit foreign ownership, the Chinese government allows
no more than 49% of a companyÕs convertible shares to be B, H or N shares.
The breakdown ®gures are given in Table 1.
The ®gures reveal the fact that the privatization of SOEs is quite limited. On
the average, less than 40% of total shares are issued for public holding. Shares
issued for foreign ownership (B-shares and H-shares) are minimal.
3.3. The red chips
There are some state-backed companies that typically represent the interests
of ChinaÕs leading ministries, the State Council, and provincial and municipal
authorities. These companies control companies in related industries around
the country. When these mainland ®rms look for expansion and overseas
capital, they typically ®nd ways to gain listing in Hong Kong, either through
direct IPO or through backdoor listing. As these companies are incorporated
and listed in Hong Kong, they are technically Hong Kong companies though
their capital and businesses are largely based in China. Companies like CITIC
Paci®c, COSCO Paci®c, Beijing Enterprises Holdings and Shanghai Industrial
Holdings are powerful, diversi®ed conglomerates that have grown rapidly by
injecting assets from their parent companies and raising funds for new investments. As such, they have acquired a nickname, ``red chips''. Unlike Hshare companies, which tend to specialize in a single activity like heavy industry or infrastructure projects, businesses in red-chip companies are more
diversi®ed.
4. Data and methodology
The panel-data method is used to test the hypotheses. Our regression model
is as follows:
Premit ai b0 Xit ci Premitÿ1 eit
i 1; 2; . . . ; N ; t 1; 2; . . . ; T :
1
Prem is the percentage price premium de®ned as PB ÿ PA =PA . PB and PA are
contemporaneous month end prices of B- and A-shares of the same company.
B-share is trading at a premium if PB ÿ PA =PA is greater than zero and at a
discount otherwise. As Shanghai B shares are quoted in US$, Shenzhen B
shares in Hong Kong dollars, and A shares in RMB, they are all converted into
USD denomination here. Individual observations of each series are measured
as deviations from the time-series mean of that series to ``sweep out'' the individual eect ai . We assume eit has a zero mean and is uncorrelated with Xit ;
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Table 1
Ownership distribution of Shanghai and Shenzhen listed companiesa
1994
1995
1996
1997
Panel A: The Shanghai Stock Exchange
State shares (%)
33.5
(28.9)
Legal person shares (%)
35.5
(31.9)
A shares (%)
19.9
(20.3)
Employee shares (%)
4.6
(8.5)
B shares (%)
4.0
(11.2)
H shares (%)
1.1
(6.0)
32.5
(30.3)
37.8
(33.3)
19.4
(20.3)
4.3
(9.5)
3.7
(10.7)
0.9
(5.4)
33.9
(28.9)
31.4
(29.4)
24.9
(18.1)
3.2
(7.4)
4.3
(11.8)
1.1
(6.0)
32.0
(26.8)
29.6
(27.5)
28.8
(15.8)
2.8
(6.3)
4.2
(11.8)
1.1
(5.9)
Panel B: The Shenzhen Stock Exchange
State shares (%)
28.1
(26.5)
Legal person shares (%)
34.1
(26.0)
A shares (%)
31.9
(14.1)
Employee shares (%)
2.3
(5.0)
B shares (%)
3.6
(8.1)
H shares (%)
0.0
(0.0)
35.7
(46.4)
38.1
(31.0)
17.4
(19.1)
7.6
(13.3)
2.9
(8.8)
0.2
(2.3)
34.5
(44.4)
33.0
(26.7)
24.8
(16.8)
5.5
(9.9)
3.3
(8.7)
0.3
(3.3)
31.1
(26.4)
30.8
(26.4)
29.6
(13.3)
4.0
(7.5)
3.7
(9.7)
0.5
(5.4)
Panel C: Number of listed companies
SHSE
A shares only
137
B shares only
2
Both A & B shares
32
152
4
32
251
6
36
333
11
39
SZSE
A shares only
B shares only
Both A & B shares
101
8
26
194
10
33
311
14
37
96
2
22
a
This table presents the average ownership for ®ve dierent types of investors across the listed
companies on both Shanghai and Shenzhen Stock Exchanges. H-share ownership is also presented.
The cross-sectional standard deviations are presented in parentheses (Source: Calculated from
various issues of the Shanghai Stock Exchange Statistics Annual, and the Fact Book of Shenzhen
Stock Exchange).
however, it may be heteroscedastic. The lag premium term Premitÿ1 is included
to ®lter out a high degree of auto-correlation as in Domowitz et al. (1997). Xit is
a vector of proxy variables used to test various hypotheses.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1885
4.1. Proxies to test the dierential demand argument
We ®rst test if the demand curve is downward-sloping. The ratio of the
outstanding number of A and B shares (NoB/NoA) captures the relative share
supply of the two markets. If demand curves are downward sloping, the
variable should enter signi®cantly negatively into the regression. When the
supply of B shares increases relative to the supply of A-shares, price pressure
would push B-share prices to drop relative to A-share prices.
To examine speci®cally the possibility of dierence in the elasticity of
domestic and foreign demands for A and B shares respectively, we look at
their substitutes. For an A-share substitute, we look at the bond issue. The
variable is the value of the government bond issue, ``Bond''. If it is indeed an
A-share substitute, the variable should be positively related to the price
premium.
For close substitutes of B-share stocks, we look at H shares and ``red-chip''
stocks. Two pairs of proxy variables are used to capture the possible impact of
H shares and red-chip stocks on the price premium: the number of H-share
®rms and red-chip ®rms listed in Hong Kong and their trading volume as a
percentage of SEHKÕs trading volume. If the dierence in elasticity of demand
is an important factor to the B-share discount, the four variables will be
negatively related to the price premium. Since the two pairs of variables are
highly correlated, they should be run in two separate regressions.
4.2. Proxies to test important factors
We use market capitalization ``MV'' to proxy for the information factor and
the ratio of trading volume (VolB/VolA) for the liquidity factor. The total
market capitalization of a ®rm is the sum of the A-share and B-share market
capitalization. If ®rm size is important, the variable should be positively related
to the price premium. If the B-share discount is due to the lack of liquidity of
the B-share market, the relative trading volume should be positively related to
the price premium.
It is not easy to come up with good proxies to capture the currency risk
factor. The ocial RMB exchange rate is highly regulated and the government
bond market is not well developed. We can only use some indirect variables.
The in¯ation rate is a possible one. Based upon simple purchasing power relationship, high in¯ation tends to deteriorate a countryÕs currency. China faced
a period of a high, two-digit in¯ation until 1996. To the extent that in¯ation
increases the risk of RMB depreciation, the variable would be negatively related to the price premium. Change in ChinaÕs foreign reserve (DFXR) is another useful variable. A deterioration of foreign reserve exerts downward
pressure to the currency. Hence, change in foreign reserve is expected to be
positively related to the premium variable.
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Although we do not intend to test the speculative argument, we think that
stock return volatility is a ``simple'' way to partially capture the speculative
activities of Chinese investors. Speci®cally, we look at the relative volatility
(StdB/StdA) where StdB and StdA are the standard deviation of B-share and
A-share returns, respectively. Given that the pair of A and B stocks share
identical information of the ®rm, any A-share volatility in excess of the B-share
volatility can be viewed as due to speculative trading. If excessive speculation
leads to the A-share price being traded at a premium relative to the corresponding B-share price, we would expect a positive relationship between the
variable and the B-share premium.
We work on monthly data except when calculating the monthly volatility,
we use daily price data. Exchange rates, share prices and trading volume are
from the Datastream International, supplemented with the Extel Database
when necessary. The number of shares outstanding is from the Taiwan Economic Journal (TEJ) Data Bank. Macroeconomic data are from the International Financial Statistics of IMF. Our sample has totally 40 H-share ®rms, 38
red-chip ®rms, 10 ®rms with both A- and H-shares, and 45 ®rms with both Aand B-shares. Among these 45 ®rms, 25 are listed on the SHSE and 20 on the
SZSE. The series span from April 1994 to February 1998.
We begin our sample study in April 1994, the time when the ®rst interbank
market in China began to operate. We believe the exchange rates then were
closer to the market-determined rates. 11 Also, we want to avoid the early
period when the Chinese stock markets were at the infant stage. As mentioned
before, erratic events happened in the early period.
5. Preliminary examination
5.1. General comparison
To get a general idea on the behavior of various markets, we compute
general statistics on share prices, return, volatility, trading volume, and market
value. The results are shown in Table 2.
Panel A gives the statistics of all 45 ®rms in our sample. Panels B and C
separate Shanghai ®rms from Shenzhen ®rms. Panel D gives the statistics of 10
®rms in our sample that issue both A shares and H shares. Panels E and F give
11
There used to be three RMB exchange rates, the ocial rate, the swap rate, and the black
market rate. The Chinese government uni®ed the former two rates in January 1994. An RMB black
market always exists but the scale is very small. According to newspaper reports, its trading takes
only 0.01% of the total foreign exchange trading in China. Hence, the black market rate may not
necessarily re¯ect the true value of the currency.
Table 2
Average monthly statistics on stock prices, trading volumes, and volatilitya
94.04±98.02
95.01±95.12
Panel A: Combined sample of 45 Shanghai and Shenzhen ®rms
Average B premium
)0.5635
Standard deviation
0.2665
Average A volume
25458.67
Average B volume
9234.32
Average A return
0.00666
Average B return
)0.00993
Average A volatility
0.03445
Average B volatility
0.03329
Average number of A shares
47120.09
Average number of B shares
95521.06
Average market value
78969.01
Standard deviation
76415.03
)0.3192
0.3732
27031.53
4506.85
)0.00490
)0.01943
0.04938
0.02673
39576.64
80090.01
65064.44
53979.59
)0.5400
0.2491
14071.79
19302.96
)0.01817
)0.02864
0.02739
0.02768
43503.61
87338.19
58238.85
47316.22
)0.6189
0.1711
36934.91
7000.63
0.03929
0.04237
0.03447
0.03842
48477.72
96408.45
72969.55
62818.98
)0.6792
0.1088
26940.83
5703.63
0.00689
)0.04453
0.03217
0.03679
53473.43
110343.60
113267.50
105745.50
Panel B: Sample of 25 Shanghai ®rms
Average B premium
Standard deviation
Average A volume
Average B volume
Average A return
Average B return
Average A volatility
Average B volatility
Average number of A shares
Average number of B shares
Average market value
Standard deviation
)0.4537
0.3559
29487.37
7173.72
0.01186
)0.01054
0.05245
0.02858
28426.36
92871.29
70152.06
62947.88
)0.6820
0.1363
10898.37
6786.38
)0.01825
)0.02602
0.02876
0.02842
31000.16
98480.53
63628.15
55573.43
)0.7003
0.1264
13821.88
5224.68
0.00452
0.01503
0.03166
0.03507
32875.23
106391.70
58921.55
44439.66
)0.7310
0.0941
15531.85
7405.50
0.01380
)0.03806
0.02999
0.03870
38060.88
122319.50
81921.01
73913.74
)0.4414
0.2732
)0.1512
0.3228
)0.3626
0.2444
)0.5172
0.1650
97.01±97.12
)0.6144
0.0894
1887
Panel C: Sample of 20 Shenzhen ®rms
Average B premium
Standard deviation
)0.6613
0.2159
16181.56
6651.38
0.00327
)0.01136
0.03404
0.03369
33221.44
106854.90
68766.28
61242.23
96.01±96.12
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
94.04±94.12
94.04±98.02
94.04±94.12
95.01±95.12
96.01±96.12
97.01±97.12
37055.05
12463.00
0.01089
)0.00813
0.03496
0.03279
64493.41
81353.72
91722.42
90317.76
23961.75
1173.25
)0.02583
)0.03054
0.04554
0.02440
53514.49
64113.41
58704.90
39117.74
18038.56
34948.68
)0.01807
)0.03190
0.02569
0.02675
59132.93
73410.25
51502.23
33093.19
65826.20
9220.57
0.08276
0.07655
0.03798
0.04260
67980.84
83929.43
90529.55
76520.34
41202.05
3576.29
)0.00173
)0.05262
0.03490
0.03441
72739.12
95373.83
152450.50
124768.30
Panel D: Sample of ®rms with both H and A shares
Average H premium
)0.26290
Standard deviation
0.66904
Average A volume
112011.80
Average H volume
162170.70
Average A return
0.00754
Average H return
)0.02005
Average A volatility
0.03458
Average H volatility
0.03178
Average number of A shares
217853.84
Average number of H shares
635811.89
Average market capitalization
535174.80
Standard deviation
907185.30
0.59082
1.04199
71508.56
79370.54
)0.00151
)0.02273
0.04737
0.02457
247273.29
627322.86
182769.82
330018.23
)0.03935
0.58978
108330.00
55176.39
)0.00544
)0.04020
0.03425
0.01649
210989.30
621126.00
272948.55
406984.70
)0.45239
0.36923
176775.20
75795.14
0.03286
0.02167
0.03245
0.01947
210989.30
621126.00
636144.22
976786.34
)0.52927
0.32533
95659.38
396988.90
)0.00790
)0.04648
0.02637
0.04425
210909.30
671126.00
962000.97
1256680.20
34
)0.05991
43046.86
0.01471
1008441.09
355953.75
36
)0.02122
40097.58
0.01212
1066300.95
308715.20
37
0.06369
112133.00
0.01283
1095677.93
541039.54
38
0.00937
454200.70
0.03724
1402903.62
1264266.62
Panel E: Red chips
Number of ®rms at year end
Average return
Average volume
Average volatility
Average number of shares
Average market capitalization
38
0.00380
186191.60
0.02522
1189959.48
678303.68
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Average A volume
Average B volume
Average A return
Average B return
Average A volatility
Average B volatility
Average number of A shares
Average number of B shares
Average market capitalization
Standard deviation
1888
Table 2 (Continued)
a
)0.01253
85870.84
0.02689
662717.9
240093.7
)0.02132
71170.92
0.02267
621405.6
169006.9
)0.02869
30018.91
0.01667
613032.8
129483.3
0.02155
49404.58
0.01751
631841.3
286264.1
)0.02560
181717.20
0.03630
742388.2
310923.4
This table provides information on average monthly premium, trading volume, return, volatility, number of shares outstanding and market capitalization for sample ®rms listed on the Shanghai, Shenzhen, and Hong Kong Stock Exchanges. The B-share premium is de®ned as (PB ± PA )/PA .
Similarly, the H-share premium is PB ÿ PA =PA . All prices are converted into US dollars. Return is derived from the log dierence of month-end prices.
Volatility is de®ned as the standard deviation of daily returns within a month. Market capitalization is the summation of market value of tradable A
and B (or H) shares of a ®rm. Market capitalization is in terms of thousand US$. Trading volume and number of outstanding shares are in thousand
shares.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Panel F: All H Shares
Average return
Average volume
Average volatility
Average number of shares
Average market capitalization
1889
1890
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
statistics of all red chips and H shares listed in Hong Kong during our sample
period.
To facilitate comparisons, for each variable, we compute the dierence between A shares and their corresponding B shares (or H shares). These variable
dierences (except the return dierence) are then normalized by their corresponding value of the A-share variable. For instance, the B-share volatility
dierential is computed as rB ÿ rA =rA . The cross-sectional average of the
variables over all 45 stock pairs in the sample is denoted as ``(B±A)/A Volatility''. Similarly, the H-share volatility dierential is computed as rH ÿ rA
=rA and the cross-sectional average of 10 stock pairs is denoted as ``(H±A)/A
Volatility''. The comparisons are graphically presented in various panels of
Fig. 1.
Panel A gives the ®rst sense of the issue discussed in this paper, the price
premiums. We compute two average premium series. ``(B±A)/A Price'' is the
cross-sectional average of B-share monthly price premiums of the 45 sample
®rms on the SHSE and SZSE. ``(H±A)/A Price'' is the cross-sectional average
of H-share monthly price premiums of the 10 sample ®rms on the SEHK. The
plot clearly shows that B shares are always traded at heavy discount. The
overall discount over the sample period is )0.56 (Panel A of Table 2). In fact,
based on the study of Bailey (1994), B shares were traded at discounts relative
to their A-share prices all along from March 1992 to February 1993.
Although our focus is on the B-share premium, a contrast with the H-share
premium can shed light on the issue. Notice that H shares were trading at a
premium relative to their corresponding A shares in the early sample period.
However, the premium could not be sustained and it turned into a discount
subsequently, just like with the B shares, only with a smaller magnitude. These
observations are so important that we will take a closer look after ®nishing
other comparisons.
In Panel B, we compare the return dierential (not normalized here). Notice
that returns of A shares are higher than the corresponding returns of B shares
and H shares. Although we do not intend to make rigorous tests here, this fact
suggests that the B-share discount would unlikely be explained by the dierence
in required rates of return by domestic and foreign investors. On the other
hand, this fact may be viewed as suggesting the possibility of the B-share
discount being driven by the dierence in expected growth rate. In Panel C, it is
surprising to see that although the overall B-share volatility is lower than the
A-share volatility, this is not always the case. On the other hand, the H-share
volatility is lower than the corresponding A-share volatility, except for 1997
when the sovereignty of Hong Kong was ocially returned back to China and
the Hang Seng Index reached its all time high at 16,673 in August. In terms of
share issue, Panel D indicates that ®rms tend to issue more shares to attract
foreign investors than to issue shares to local investors. This is more so for Hshare ®rms than for B-share ®rms, which con®rms the view that the mature
1891
Fig. 1. Comparison of A±B shares and A±H shares.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1892
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Fig. 2. Comparison of H shares and red-chip shares.
Hong Kong market is a better channel to attract foreign capital. 12 Panel E
shows that the trading volume of B shares is 65% lower than that of their Ashare counterparts. But the trading volume of H shares is 45% higher than that
of their corresponding A shares. Again, the big jump in the trading volume of H
shares in 1997 is due to the Hong Kong hand-over. In short, for the 45 A±B
pairs, the A-share market is more liquid, more volatile, and yields higher returns
than the B-share market. For the 10 A±H pairs, the situation is similar except
that the H-share market is more liquid. Notice that in Panel F, the market value
of ®rms issuing H-shares is almost 600% larger than the market value of ®rms
issuing B shares. Yet, as shown in Fig. 2, red-chip shares are even bigger.
On the average, red chips are 16% bigger than H-shares and have 40% more
outstanding stocks. 13 Not just that, their shares bear volatility that is 30%
lower than that of the H shares and have a trading volume that is 20% higher.
The return tends to be higher, too. All these point to the fact that the H-share
and red-chip markets are important and signi®cant counterparts of the A±Bshare markets.
5.2. Comparison of price premiums
Going back to the issue of the dierence between B-share and H-share
premiums, we take a closer look at Panel A of Fig. 1 by plotting the monthly
12
For certain, this does not mean foreign investors are major shareholders. Non-tradable shares
are excluded in the comparisons here.
13
The H shares here contain a larger set of 40 ®rms, which include the 10 matched H±A ®rms
examined above.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1893
Fig. 3. Average price premium. For the 25 sample companies that issue both A and B shares in the
Shanghai Stock Exchange, their monthly price premiums (de®ned as (PB ±PA )/PA ) are computed
through time. ``Avesh'' is the cross-sectional average of the 25 price premiums. For the 20 sample
companies that issue both A and B shares in the Shenzhen Stock Exchange, their monthly price
premiums (de®ned as (PB ±PA )/PA ) are computed through time. ``Avesz'' is the cross-sectional average of the 20 price premiums. ``Ave'' is the cross-sectional average of the combined 45 price
premiums. For the 10 sample companies that issue both A and H shares, their monthly price
premiums (de®ned as (PH ±PA )/PA ) are computed through time. ``Aveh'' is the cross-sectional average of the price premiums. Notice that the sample size of Aveh changes through time (see
footnote 12).
premiums through time in Fig. 3. The overall average premium of 45 ®rms,
now denoted as ``Ave'', is further decomposed into two average premium series. ``Avesh'' is the cross-sectional average of B-share premiums of the 25
sample ®rms on the SHSE and ``Avesz'' is the average premium of the 20
sample ®rms on the SZSE. The cross-sectional average premium of 10 H-shares
is now denoted as ``Aveh''.
It becomes clearer how the price premiums evolve through time. H shares
traded at premium initially until the end of 1994. 14 This is consistent with
what has been found in other markets. H shares, which were opened to foreign
investors, traded at a premium with respect to their A shares. Hence, what is
special about China is that the H-share premium is not sustained and that the
B-share market keeps trading at a discount. Notice that H-share discount tends
to be smaller than the B-share discount although, in a few incidences, it is
larger than the B-share discount in the Shenzhen Exchange. In fact, the dis-
14
Since H shares were listed on SEHK in sequence, the number of ®rms in calculating the
average H-share premium begins from one, the Tsingtao Brewery, and increases to six in mid-1994.
The full sample of ten ®rms begins in November 1995. But the subsequent H-share discount is not
due to the late-joining ®rms. Not reported here are data on the ®rst six H-share ®rms that all have
traded at a discount since 1995, some earlier some later.
1894
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
count in the Shenzhen Exchange is consistently smaller than in the Shanghai
Exchange. 15
As mentioned before, the speculation argument views price dierential as an
``A-share premium'' phenomenon. That is, Chinese investors keep chasing after
the limited supply of A-shares, which caused these shares to be overpriced.
Though we will test this argument later, the casual observation here already
suggests that this cannot be the only reason for the phenomenon. If the cause is
with the A shares, it is not easy to explain why H shares would trade at a
smaller discount than B shares. Recall that H-share ®rms have been chosen for
their good management and good pro®t potential. They also need to meet
stringent requirements set by the SEHK and have greater and better information disclosure than B-share ®rms. Hence, we would expect that Chinese
investors would chase more after ®rms issuing H shares than those issuing B
shares, leading to a larger H-share discount. However, if we view the phenomenon as a B-share discount, it can be easily interpreted as foreign investors
discounting less on H shares than on B shares due to the ``endorsement'' of the
H shares by the SEHK.
One more piece of information can be drawn from Panels E and F of Fig. 1.
Studies typically ®nd that ®rm size and market liquidity are important factors
for price premium. Yet, from our comparisons, it is clear that although Hshare ®rms are much larger in size and their shares are more heavily traded
than B-share ®rms, share prices of both H- and B-share ®rms trade at a discount relative to their A-share counterparts. This strongly suggests that ®rm
size and liquidity cannot be crucial factors for the price discount phenomenon.
6. Panel analysis results
After the general comparisons, we carry out more rigorous tests. A panel
regression of model (1) is done on the whole sample data and results are reported in Table 3.
Column (1) shows the basic result of the regression. For the dierential
demand argument, the ®rst variable to look at is ``NoB/NoA'', the relative
supply of B shares and A shares. The regression estimate is signi®cantly negative with a t-value of ÿ4:86. This is consistent with the hypothesis that the
greater the supply of B shares relative to A shares, the lower the B-share prices
15
We observe that companies listed in the SHSE tend to issue more B shares relative to A shares
than companies listed in the SZSE do. Also, according to newspaper reports, it is not uncommon
for Chinese investors to ®nd ways to trade on B shares. If it is easier for Chinese investors to trade
on the SZSE through their linkage in Hong Kong and/or if it is easier for them to get access to
HKD, then the SZSE might attract more local Chinese investors. In that case, it is conceivable that
B shares traded in the SZSE have less discount than their counterparts in the SHZE.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1895
Table 3
Pooled regression results (combined sample of Shanghai and Shenzhen ®rms)a
Total Panel Obs.
NoB/NoA
Bond
H
Red
(1)
(2)
(3)
(4)
2070
2070
2070
2070
)0.000435
()4.865)
0.000114
(2.354)
)0.005618
()5.542)
)0.020996
()7.048)
Hper
Redper
VolB/VolA
MV
In¯ation
DFXR
StdB/StdA
Prem()1)
0.001453
(1.968)
ÿ3:30 10ÿ7
()7.103)
)0.006014
()8.572)
0.001530
(2.158)
0.003112
(3.303)
0.649472
(41.539)
)0.000352
()3.835)
0.000164
(5.240)
)0.732701
()5.439)
)0.389733
()5.287)
0.001843
(2.473)
ÿ2:19 10ÿ7
()4.490)
)0.002568
()5.625)
0.000993
(1.695)
0.001189
(2.493)
0.733253
(48.326)
Trend
Adjusted R2
Durbin±Watson
0.7144
2.1017
0.7023
2.1256
)0.000390
()4.301)
0.000128
(2.652)
)0.005355
()5.302)
)0.019464
()6.531)
0.001570
(2.145)
ÿ3:45 10ÿ7
()7.506)
)0.006801
()9.560)
0.009030
(5.981)
0.004192
(3.758)
0.653474
(42.056)
)0.001002
()5.606)
0.7182
2.0766
)0.000300
()3.243)
0.000187
(5.974)
)0.750787
()5.596)
)0.356100
()4.839)
0.001962
(2.665)
ÿ2:45 10ÿ7
()5.070)
)0.001057
()2.087)
0.009853
(6.486)
0.002757
(3.145)
0.732628
(48.775)
)0.001239
()6.951)
0.7087
2.0760
a
A general ®xed-eects pooled regression model of the following form is run on share price premium:
Premit ai b0 Xit ci Premitÿ1 eit
i 1; 2; . . . ; N ; t 1; 2; . . . ; T :
``Prem'' is the percentage price premium de®ned as (PB ± PA )/PA . PB and PA are contemporaneous
month end prices of B- and A-shares of the same company. All prices are converted into USD
denomination. X are the chosen explanatory variables. All variables are transformed into deviation
form. ``No'' is the number of shares outstanding. ``Bond'' is the dollar amount of bond issue. ``H''
and ``Red'' are the number of H-share and red-chip companies listed in the Hong Kong stock
market. ``Hper'' and ``Redper'' are monthly H-share and Red-chip trading volume as a percentage
and Hong Kong market trading volume respectively. ``Vol'' is the trading volume. ``MV'' is the
market capitalization. ``In¯ation'' is the month
www.elsevier.com/locate/econbase
The eect of market segmentation on stock
prices: The China syndrome
Qian Sun a, Wilson H.S. Tong
b,*
a
b
1C-75, Nanyang Business School, Nanyang Technological University, 639798, Singapore
Department of Finance, School of Business and Management, Hong Kong University of Science and
Technology, Clearwater Bay, Kowloon, Hong Kong
Received 22 April 1999; accepted 4 September 1999
Abstract
China has an A-share market that is open only to local investors and a B-share
market that is open only to foreign investors. Contrary to what has been observed in
other markets with a similar segmented structure, the China B shares trade at a discount
relative to the A shares. We show that the phenomenon can still be explained by basic
economic principles. Speci®cally, the existence of the H-share and the ``red-chip''
markets in Hong Kong provide good substitutes for the B-share market. We ®nd that
when more H shares and red chips are listed in Hong Kong, the B-share discount becomes larger. This is consistent with the model of dierential demand elasticity proposed by Stulz and Wasserfallen (Stulz, R., Wasserfallen, W., 1995. Review of Financial
Studies 8, 1019±1057). Ó 2000 Elsevier Science B.V. All rights reserved.
JEL classi®cation: G10; G15
Keywords: Market segmentation; A, B, and H shares; Red chips; China market;
Demand elasticity
*
Corresponding author. Tel.: +852-2358-7666; fax: +852-2358-1749.
E-mail addresses: aqsun@ntu.edu.sg (Q. Sun), wilson@ust.hk (W.H.S. Tong).
0378-4266/00/$ - see front matter Ó 2000 Elsevier Science B.V. All rights reserved.
PII: S 0 3 7 8 - 4 2 6 6 ( 9 9 ) 0 0 1 2 1 - 1
1876
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1. Introduction
The bene®ts of international diversi®cation attract free capital to move
across borders. Such bene®ts prompt investors to pay higher prices for foreign
stocks than what they would pay at home. Indeed, in segmented markets where
companies issue restricted shares that only local citizens can hold and unrestricted shares that can be held by both local and foreign investors, studies
uniformly ®nd that unrestricted shares trade at premium prices relative to those
of restricted shares. 1 Similarly, the share values of country funds are also
found to be higher than their net asset values (NAVs), just the opposite of the
``closed-end fund puzzle'' in which fundsÕ share values are lower than the
NAVs. 2
A notable exception is China. Bailey (1994) ®rst documented that, in China,
prices of B shares (the equivalent to unrestricted shares in other markets) are
selling at a discount relative to their A-share counterparts (the equivalent to
restricted shares). 3 It is puzzling why China is so dierent from other markets.
Is the cost of capital cheaper to Chinese investors than to foreign investors?
Are Chinese investors risk seekers and willing to pay high prices on their share?
What deter foreign investors from investing in the China B-share market to
reap diversi®cation bene®ts? Can existing arguments and factors that explain
the price premium in other markets also explain the opposite phenomenon in
China?
There are only limited studies on this ``strange'' phenomenon. In his pioneer
work, Bailey (1994) suggests lower cost of capital for Chinese citizens may be
the reason as there are few investment alternatives for Chinese investors.
However, as the study was carried out quite early, Bailey has only one-year
weekly data from 1992 to 1993 of two stocks in the Shanghai market and six
stocks in the Shenzhen market to analyze. Rigorous tests are not possible. A
later work by Ma (1996) ®nds that the B-share premium is negatively related to
the domestic beta. That means when A-share beta is high, the A-share price is
also high. This requires China investors to be irrational and risk seeking. A
recent paper by Bailey et al. (1999) provides a comprehensive study on eleven
countries that have similar segmentation structure. They examine various
factors that can potentially explain the price premium phenomenon, and ex-
1
See Hietala (1989) on Finland, Lam et al. (1990) on Singapore, Bailey and Jagtiani (1994) on
Thailand, Stulz and Wasserfallen (1995) on Switzerland, and Domowitz et al. (1997) on Mexico.
See also a comprehensive study by Bailey et al. (1999).
2
See Bonser-Neal et al. (1990), De Long and Shleifer (1992), and the comprehensive study by
Nishiotis (1997).
3
Technically speaking, the B-share market is also a restricted market ± restricted to only foreign
investors. Local investors are not allowed to trade B shares in China.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1877
plicitly acknowledge that China is a ``strange case'' and dicult to be explained.
The contribution of this paper is to show a new and viable economic explanation to the phenomenon. The explanation hinges to a peculiar situation in
the China foreign shares. Alongside the B-share market, there is a liquid Hshare market and a ``red-chip'' market in Hong Kong. As will be explained
later, H shares and red chips are close substitutes for B shares. Hence, unlike
other markets, China has more than one market available for foreign investors
to invest. If the H-share and red-chip markets are attractive enough to foreign
capital, the demand for B shares will then be quite elastic, leading to low
equilibrium price of B shares for a given share supply. Indeed, our results
provide strong supporting evidence. Although various factors identi®ed by
other studies are also related to the B-share price discount phenomenon, the Hshare and red-chip issues in Hong Kong provide strong explanatory power.
Another piece of supporting though weaker evidence is that the bond issue can
also explain the B-share discount. Given that most individuals in China do not
have many alternative means to invest, bonds can be an important substitute
for A shares. We view all these as consistent with the argument of Stulz and
Wasserfallen (1995). There are other factors contributing to the phenomenon.
We ®nd some evidence on Chinese investors being speculative. It is conceivable
that limited investment alternatives can heat up the speculative sentiment of
unseasoned Chinese investors in the stock market. They may also be more
optimistic on ®rmsÕ future growth than foreign investors but it is dicult to
test. Also, we ®nd some evidence that foreign investors are more sensitive than
local investors to changes in macroeconomic conditions, as the in¯ation rate
and change in ChinaÕs ocial reserve contribute to the discount phenomenon.
This paper proceeds as follows: Section 2 lays out the issue and hypotheses.
Some background information about the Chinese market is presented in Section 3. Data and methodology are given in Section 4. Results are discussed in
Sections 5 and 6. Section 7 provides some concluding thoughts.
2. Price premium and possible explanations
Many emerging capital markets impose restrictions on foreign ownership of
their domestic stocks. Companies in these markets can issue two classes of
shares, restricted shares that can be held only by local citizens and unrestricted
shares that can be held by both local and foreign investors. One major reason
for such an arrangement is to attract foreign investment without worrying
about the loss of ownership control to foreign investors. Since restricted shares
and unrestricted shares typically bear the same rights and obligations, their
values should, theoretically, be the same. Yet, all existing studies ®nd that
unrestricted shares trade at premium prices compared to restricted shares.
1878
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
China is an exception. As will be discussed later, Chinese companies issue A
shares strictly to local investors and B shares strictly to foreign investors. It is
found that A-share prices are higher than B-share prices. Hence, arguments
and factors found useful in explaining the phenomenon observed in other
markets may not be useful in explaining the China situation. We ®rst consider
four arguments provided in the existing literature as we seek to understand
what creates the special situation in the Chinese market.
2.1. The equilibrium pricing argument
When investing in domestic stocks, foreign investors can gain additional
diversi®cation bene®ts that domestic investors cannot. As a result, foreign
investors require a lower rate of return than domestic investors do. The difference in required rates of return leads to dierence in share prices. In a
CAPM world, this also means that the price dierence comes from the difference in the beta risk. Hietala (1989) ®nds supporting evidence for this argument by demonstrating that dierences in the beta risk can explain the price
premium in the Finnish market.
On the other hand, based on a simple dividend growth model, share price
dierence can also be seen as driven by the dierence in expectations on the
®rmÕs growth rate by dierent classes of investors. Speci®cally, if the A-share
investors expect higher ®rm growth rate than the B-share investors do, the Bshare price will trade at a discount rather than at a premium relative to the Ashare price. To paraphrase Domowitz et al. (1998), market segmentation leads
to cross-market dierences in information. The A-share price better re¯ects
information and expectations held by Chinese locals and the B-share price
better re¯ects information and expectations held by foreign investors.
2.2. Dierential demand argument
We are particularly interested in the model set up in Stulz and Wasserfallen
(1995) that based on the dierence in demand elasticity of two share classes. In
such a scenario, it is optimal for the domestic ®rm to strategically restrict issuing shares to foreign investors. As long as foreign investors have a relatively
inelastic demand on domestic shares, the ®rm can successfully price-discriminate by charging foreign investors a higher share price. Bailey and Jagtiani
(1994) and Domowitz et al. (1997) ®nd evidence that changes in the share
supply have explanatory power for the price premium. This indicates that the
demand curve is downward sloping and thus indirectly supports the model.
Certainly ®rms in China do not have the freedom to issue shares in such a
strategic way. In fact, the State Planning Committee and the China Securities
Regulatory Commission (CSRC) set national quotas for the amount of new
shares issued each year in China. Furthermore, ®rms must obtain special ap-
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1879
proval from the CSRC to issue foreign shares. Yet, the idea of dierences in
demand elasticities behind the model of Stulz and Wasserfallen (1995) can still
be important. Speci®cally, the China B-share discount phenomenon may be
due to foreign investors facing a more elastic demand curve, while local Chinese investors are facing a less elastic one. An important determining factor for
elasticity of demand is the availability of substitutes. If there are more substitutes for a good, the elasticity of demand for that good will be higher. Bailey
(1994) argues that there are few investment alternatives for Chinese investors.
Even bank deposit rates are too low to be attractive. 4 In that case, the demand
elasticity for A shares may indeed be low. Yet, government bonds may be
important substitutes for equity stock. Interest rates on treasury bonds are set
at about 150±200 bp above the savings rates with comparable maturities. Investors like to buy bonds and hold them for the coupon and repayment at the
end. It is hence conceivable that bond issues take away a certain amount of
domestic capital from the A-share market. A recent case is the government
bond issue to ®nance the huge budget de®cit of the Chinese government. According to a newspaper report, there were long lines of Chinese investors
waiting in each of the thousand oces to subscribe to the bond issue. 5
On the other hand, if foreign investors could gain diversi®cation bene®ts
through investing in Chinese stocks other than B shares, the demand elasticity
for B shares would indeed be high. As will be discussed in the next section, H
shares are nothing more than the B-share equivalent in Hong Kong. Red chips
are essentially Chinese companies incorporated in Hong Kong. Foreign investors would achieve the same kind of diversi®cation bene®ts investing in H
shares and red chips or in B shares. The value and attraction of red chips to
foreign investors can be revealed through the fact that in November 1998, the
International Financial Corporation (IFC) added 11 red-chip stocks into their
emerging market composite index. The explanation given was that red-chip
stocks have occupied an important position in the eyes of international investors. 6 As such, the existence of these H shares and red chips are bound to
make foreign investorsÕ demand on B shares very elastic.
2.3. A few important factors: Information, liquidity, and currency risk
Diversi®cation bene®ts tempt foreign investors to invest in the domestic
market but there are investment barriers that deter such cross-border in4
Yet, bank deposits make up the absolute majority of the individualsÕ ®nancial assets in China.
Seventy percent of the total amount of ®nancial property of individuals are in the form of bank
deposits; 20% is in cash; and only 10% is in forms of government bonds, enterprise bonds and
stocks (Yu et al., 1998, p. 6).
5
Hong Kong Economic Journal, 10 March 1999.
6
Hong Kong Economic Journal, 4 November 1998.
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Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
vestments. A survey by Chuhan (1994) ®nds that liquidity problems and
limited information are two key hurdles for investing in emerging markets.
Nishiotis (1997) also ®nds that these ``indirect barriers'' have explanatory
power for the dierence in closed-end country fund premiums over their
NAVs.
These two deterring factors can also work at the ®rm level. Bailey and
Jagtiani (1994) argue that it is easier for foreign investors to acquire information on large ®rms than on small ®rms, so foreign investors are willing to
pay a higher premium to invest in large ®rms. On the other hand, relatively
illiquid stocks have a higher expected return and are thus priced lower to
compensate investors for increased trading costs, as suggested by Amihud and
Mendelson (1986). Bailey and JagtianiÕs cross-sectional results con®rm the
explanatory power of these two factors on price premium in the Thai market.
Domowitz et al. (1997) ®nd supporting evidence for the information availability factor in the Mexican market but not the liquidity factor. They show
that the explanatory power comes mainly from share supply. Liquidity has
only transitory impact on price premium.
Nishiotis (1997) also argues that foreign investors are more sensitive than
local investors to changes in economic factors. Foreign investors can adjust
their portfolios across dierent markets easily while domestic investors are
typically restricted to their domestic market. These macro factors can be important to the understanding of the B-share discount in the Chinese market. If
these barriers and hurdles are signi®cant, drawing foreign investors to China
may indeed require a share price discount. We believe currency risk is one such
important macro factor. As China is increasingly opening up to the outside
world, its economy depends more on the foreign sectors like international
trade, foreign investment and tourism. Hence, currency stability is highly related to macroeconomic stability. If investors of dierent share classes respond
dierently to the currency risk factor, that would be re¯ected in the share
prices. 7
Domowitz et al. (1997) show evidence that higher perceptions of exchange
rate risk imply less foreign investment and hence lower price premium. Interestingly, in another paper on country and currency risk, Domowitz et al. (1998)
®nd that increases in perceived currency risk widen the gap between the
Mexican country fund price premium and the fundÕs NAV. This is consistent
with a recent working paper by Yeyati and Ubide (1998). They study the behavior of closed-end country fund discounts covering the period of the Mexican and the East Asian crises. They ®nd that the ratio of country fund prices
7
Notice that B-share prices are traded in foreign currencies (either in HKD or USD) and hence,
theoretically, foreign investors do not have ``transactional exposure'' to RMB devaluation risk.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1881
to their fundamental value increases dramatically during a ®nancial crisis. They
interpret that as international investors being less (more) sensitive than domestic investors to changes in local (global) market conditions. Hence, their
argument is dierent from that of Nishiotis (1997).
In any event, barriers and hurdles like information availability, liquidity
premium, and currency risk may also be useful in understanding the B-share
discount in the Chinese market. If these barriers and hurdles are signi®cant,
drawing foreign investors to China may indeed require a share price discount.
On the other hand, if the situation improves, more foreign capital may then
¯ow into these markets to narrow down the price gap between A shares and B
shares.
2.4. Speculation argument
Lastly, there is a ``popular'' view of the speculative fever of Chinese investors. If limited investment alternatives mean a relatively inelastic demand for A
shares, they can also mean a possible speculative fever. In fact, erratic events
like the lottery ticket prices for IPOs being much higher than the stock prices
themselves and stock purchases leading to riots in Shenzhen did happen in the
early period. When unseasoned Chinese investors speculate on shares with
limited supply, it is conceivable that the share prices are pushed beyond their
actual values. This can be related to the argument of dierence in expected
growth rates. If Chinese investors are too optimistic and have unrealistic view
on the growth potential of the ®rms, they will drive up the A-share prices
relative to the B-share prices. Certainly, persistent dierence in expected
growth rates indicates market ineciency.
In this paper, we test mainly the dierential demand argument and the three
important factors. The equilibrium pricing argument can only explain price
premium but not price discount of unrestricted shares. Also, the ®ndings of Ma
(1996) require China investors to be risk lovers. On the other hand, Bailey and
Jagtiani (1994) do not ®nd any signi®cant relationship between ®rm betas and
the price premium in the Thai market. The comprehensive study of Bailey et al.
(1999) on the 11 markets also con®rms that the equilibrium pricing model
cannot explain the price premium phenomenon. Hence, we think it cannot be
an explanation for the Chinese phenomenon either. 8 For the speculative argument, although there are many anecdotal evidences for that, rigorous tests
are dicult to construct.
8
In the earlier version of this paper, we did test the beta factors and did not ®nd statistical
signi®cance.
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Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
3. The Chinese market
A major eort in ChinaÕs reforms is to privatize state-owned enterprises. The
government selects some state-run factories and restructures them to allow the
most attractive parts of these plants to form new companies. Hence, a new
company so formed is often only a fraction of the original enterprise. 9 Shares
are then issued and sold to the public as well as to foreign investors.
3.1. The public A and B shares
A Chinese company can issue ®ve types of shares in the domestic market:
state shares, legal person shares, employee shares, tradable A shares and B
shares. Only the last two types of shares are freely tradable. A shares are ordinary equity shares available exclusively to Chinese citizens and domestic
institutions. When going public, companies are required to issue no less than
25% of their total outstanding shares as tradable A shares.
B shares are issued to attract foreign capital. The ®rst B-share issue was in
1992. Firms can choose to list their B shares on either of the two national
exchanges, the Shanghai Stock Exchange (SHSE, established in December
1990) and the Shenzhen Stock Exchange (SZSE, established in April 1991), but
not both. B shares can only be bought by and traded amongst foreign investors. Since the RMB is not convertible under capital accounts, B shares are
traded in either US dollars (in the SHSE) or HK dollars (in the SZSE). 10
3.2. The foreign H and N shares
Compared with the newly established Chinese stock market, Hong KongÕs
mature market should make a bigger contribution in channeling foreign funds
to mainland Chinese enterprises. Indeed, beginning in 1993, Chinese enterprises started applying to list in Hong Kong as H shares. They are selected for
their economic importance, management quality, technology, pro®tability and
international signi®cance. Led by Tsingtao Brewery, the ®rst batch of H shares
listed in the SEHK had great success. Tsingtao Brewery received 110 times
over-subscription and the six H-share companies together raised more than a
billion US dollars. There are currently 41 ®rms issuing H shares on the SEHK.
Firms that issue B shares or H shares also issue A shares but, as far as we
know, only three ®rm issues both B shares and H shares.
9
For example, Shanghai Petrochemical is basically a complete town with hotels, schools,
housing and a college. When listed in 1993, the company consisted only of some selected buildings,
a plant and equipment.
10
B shares are still denominated in RMB nominally but quoted and traded in USD or HKD.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1883
There are N shares listed in the New York Stock Exchange but the market
has been very thin. To limit foreign ownership, the Chinese government allows
no more than 49% of a companyÕs convertible shares to be B, H or N shares.
The breakdown ®gures are given in Table 1.
The ®gures reveal the fact that the privatization of SOEs is quite limited. On
the average, less than 40% of total shares are issued for public holding. Shares
issued for foreign ownership (B-shares and H-shares) are minimal.
3.3. The red chips
There are some state-backed companies that typically represent the interests
of ChinaÕs leading ministries, the State Council, and provincial and municipal
authorities. These companies control companies in related industries around
the country. When these mainland ®rms look for expansion and overseas
capital, they typically ®nd ways to gain listing in Hong Kong, either through
direct IPO or through backdoor listing. As these companies are incorporated
and listed in Hong Kong, they are technically Hong Kong companies though
their capital and businesses are largely based in China. Companies like CITIC
Paci®c, COSCO Paci®c, Beijing Enterprises Holdings and Shanghai Industrial
Holdings are powerful, diversi®ed conglomerates that have grown rapidly by
injecting assets from their parent companies and raising funds for new investments. As such, they have acquired a nickname, ``red chips''. Unlike Hshare companies, which tend to specialize in a single activity like heavy industry or infrastructure projects, businesses in red-chip companies are more
diversi®ed.
4. Data and methodology
The panel-data method is used to test the hypotheses. Our regression model
is as follows:
Premit ai b0 Xit ci Premitÿ1 eit
i 1; 2; . . . ; N ; t 1; 2; . . . ; T :
1
Prem is the percentage price premium de®ned as PB ÿ PA =PA . PB and PA are
contemporaneous month end prices of B- and A-shares of the same company.
B-share is trading at a premium if PB ÿ PA =PA is greater than zero and at a
discount otherwise. As Shanghai B shares are quoted in US$, Shenzhen B
shares in Hong Kong dollars, and A shares in RMB, they are all converted into
USD denomination here. Individual observations of each series are measured
as deviations from the time-series mean of that series to ``sweep out'' the individual eect ai . We assume eit has a zero mean and is uncorrelated with Xit ;
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Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Table 1
Ownership distribution of Shanghai and Shenzhen listed companiesa
1994
1995
1996
1997
Panel A: The Shanghai Stock Exchange
State shares (%)
33.5
(28.9)
Legal person shares (%)
35.5
(31.9)
A shares (%)
19.9
(20.3)
Employee shares (%)
4.6
(8.5)
B shares (%)
4.0
(11.2)
H shares (%)
1.1
(6.0)
32.5
(30.3)
37.8
(33.3)
19.4
(20.3)
4.3
(9.5)
3.7
(10.7)
0.9
(5.4)
33.9
(28.9)
31.4
(29.4)
24.9
(18.1)
3.2
(7.4)
4.3
(11.8)
1.1
(6.0)
32.0
(26.8)
29.6
(27.5)
28.8
(15.8)
2.8
(6.3)
4.2
(11.8)
1.1
(5.9)
Panel B: The Shenzhen Stock Exchange
State shares (%)
28.1
(26.5)
Legal person shares (%)
34.1
(26.0)
A shares (%)
31.9
(14.1)
Employee shares (%)
2.3
(5.0)
B shares (%)
3.6
(8.1)
H shares (%)
0.0
(0.0)
35.7
(46.4)
38.1
(31.0)
17.4
(19.1)
7.6
(13.3)
2.9
(8.8)
0.2
(2.3)
34.5
(44.4)
33.0
(26.7)
24.8
(16.8)
5.5
(9.9)
3.3
(8.7)
0.3
(3.3)
31.1
(26.4)
30.8
(26.4)
29.6
(13.3)
4.0
(7.5)
3.7
(9.7)
0.5
(5.4)
Panel C: Number of listed companies
SHSE
A shares only
137
B shares only
2
Both A & B shares
32
152
4
32
251
6
36
333
11
39
SZSE
A shares only
B shares only
Both A & B shares
101
8
26
194
10
33
311
14
37
96
2
22
a
This table presents the average ownership for ®ve dierent types of investors across the listed
companies on both Shanghai and Shenzhen Stock Exchanges. H-share ownership is also presented.
The cross-sectional standard deviations are presented in parentheses (Source: Calculated from
various issues of the Shanghai Stock Exchange Statistics Annual, and the Fact Book of Shenzhen
Stock Exchange).
however, it may be heteroscedastic. The lag premium term Premitÿ1 is included
to ®lter out a high degree of auto-correlation as in Domowitz et al. (1997). Xit is
a vector of proxy variables used to test various hypotheses.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1885
4.1. Proxies to test the dierential demand argument
We ®rst test if the demand curve is downward-sloping. The ratio of the
outstanding number of A and B shares (NoB/NoA) captures the relative share
supply of the two markets. If demand curves are downward sloping, the
variable should enter signi®cantly negatively into the regression. When the
supply of B shares increases relative to the supply of A-shares, price pressure
would push B-share prices to drop relative to A-share prices.
To examine speci®cally the possibility of dierence in the elasticity of
domestic and foreign demands for A and B shares respectively, we look at
their substitutes. For an A-share substitute, we look at the bond issue. The
variable is the value of the government bond issue, ``Bond''. If it is indeed an
A-share substitute, the variable should be positively related to the price
premium.
For close substitutes of B-share stocks, we look at H shares and ``red-chip''
stocks. Two pairs of proxy variables are used to capture the possible impact of
H shares and red-chip stocks on the price premium: the number of H-share
®rms and red-chip ®rms listed in Hong Kong and their trading volume as a
percentage of SEHKÕs trading volume. If the dierence in elasticity of demand
is an important factor to the B-share discount, the four variables will be
negatively related to the price premium. Since the two pairs of variables are
highly correlated, they should be run in two separate regressions.
4.2. Proxies to test important factors
We use market capitalization ``MV'' to proxy for the information factor and
the ratio of trading volume (VolB/VolA) for the liquidity factor. The total
market capitalization of a ®rm is the sum of the A-share and B-share market
capitalization. If ®rm size is important, the variable should be positively related
to the price premium. If the B-share discount is due to the lack of liquidity of
the B-share market, the relative trading volume should be positively related to
the price premium.
It is not easy to come up with good proxies to capture the currency risk
factor. The ocial RMB exchange rate is highly regulated and the government
bond market is not well developed. We can only use some indirect variables.
The in¯ation rate is a possible one. Based upon simple purchasing power relationship, high in¯ation tends to deteriorate a countryÕs currency. China faced
a period of a high, two-digit in¯ation until 1996. To the extent that in¯ation
increases the risk of RMB depreciation, the variable would be negatively related to the price premium. Change in ChinaÕs foreign reserve (DFXR) is another useful variable. A deterioration of foreign reserve exerts downward
pressure to the currency. Hence, change in foreign reserve is expected to be
positively related to the premium variable.
1886
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Although we do not intend to test the speculative argument, we think that
stock return volatility is a ``simple'' way to partially capture the speculative
activities of Chinese investors. Speci®cally, we look at the relative volatility
(StdB/StdA) where StdB and StdA are the standard deviation of B-share and
A-share returns, respectively. Given that the pair of A and B stocks share
identical information of the ®rm, any A-share volatility in excess of the B-share
volatility can be viewed as due to speculative trading. If excessive speculation
leads to the A-share price being traded at a premium relative to the corresponding B-share price, we would expect a positive relationship between the
variable and the B-share premium.
We work on monthly data except when calculating the monthly volatility,
we use daily price data. Exchange rates, share prices and trading volume are
from the Datastream International, supplemented with the Extel Database
when necessary. The number of shares outstanding is from the Taiwan Economic Journal (TEJ) Data Bank. Macroeconomic data are from the International Financial Statistics of IMF. Our sample has totally 40 H-share ®rms, 38
red-chip ®rms, 10 ®rms with both A- and H-shares, and 45 ®rms with both Aand B-shares. Among these 45 ®rms, 25 are listed on the SHSE and 20 on the
SZSE. The series span from April 1994 to February 1998.
We begin our sample study in April 1994, the time when the ®rst interbank
market in China began to operate. We believe the exchange rates then were
closer to the market-determined rates. 11 Also, we want to avoid the early
period when the Chinese stock markets were at the infant stage. As mentioned
before, erratic events happened in the early period.
5. Preliminary examination
5.1. General comparison
To get a general idea on the behavior of various markets, we compute
general statistics on share prices, return, volatility, trading volume, and market
value. The results are shown in Table 2.
Panel A gives the statistics of all 45 ®rms in our sample. Panels B and C
separate Shanghai ®rms from Shenzhen ®rms. Panel D gives the statistics of 10
®rms in our sample that issue both A shares and H shares. Panels E and F give
11
There used to be three RMB exchange rates, the ocial rate, the swap rate, and the black
market rate. The Chinese government uni®ed the former two rates in January 1994. An RMB black
market always exists but the scale is very small. According to newspaper reports, its trading takes
only 0.01% of the total foreign exchange trading in China. Hence, the black market rate may not
necessarily re¯ect the true value of the currency.
Table 2
Average monthly statistics on stock prices, trading volumes, and volatilitya
94.04±98.02
95.01±95.12
Panel A: Combined sample of 45 Shanghai and Shenzhen ®rms
Average B premium
)0.5635
Standard deviation
0.2665
Average A volume
25458.67
Average B volume
9234.32
Average A return
0.00666
Average B return
)0.00993
Average A volatility
0.03445
Average B volatility
0.03329
Average number of A shares
47120.09
Average number of B shares
95521.06
Average market value
78969.01
Standard deviation
76415.03
)0.3192
0.3732
27031.53
4506.85
)0.00490
)0.01943
0.04938
0.02673
39576.64
80090.01
65064.44
53979.59
)0.5400
0.2491
14071.79
19302.96
)0.01817
)0.02864
0.02739
0.02768
43503.61
87338.19
58238.85
47316.22
)0.6189
0.1711
36934.91
7000.63
0.03929
0.04237
0.03447
0.03842
48477.72
96408.45
72969.55
62818.98
)0.6792
0.1088
26940.83
5703.63
0.00689
)0.04453
0.03217
0.03679
53473.43
110343.60
113267.50
105745.50
Panel B: Sample of 25 Shanghai ®rms
Average B premium
Standard deviation
Average A volume
Average B volume
Average A return
Average B return
Average A volatility
Average B volatility
Average number of A shares
Average number of B shares
Average market value
Standard deviation
)0.4537
0.3559
29487.37
7173.72
0.01186
)0.01054
0.05245
0.02858
28426.36
92871.29
70152.06
62947.88
)0.6820
0.1363
10898.37
6786.38
)0.01825
)0.02602
0.02876
0.02842
31000.16
98480.53
63628.15
55573.43
)0.7003
0.1264
13821.88
5224.68
0.00452
0.01503
0.03166
0.03507
32875.23
106391.70
58921.55
44439.66
)0.7310
0.0941
15531.85
7405.50
0.01380
)0.03806
0.02999
0.03870
38060.88
122319.50
81921.01
73913.74
)0.4414
0.2732
)0.1512
0.3228
)0.3626
0.2444
)0.5172
0.1650
97.01±97.12
)0.6144
0.0894
1887
Panel C: Sample of 20 Shenzhen ®rms
Average B premium
Standard deviation
)0.6613
0.2159
16181.56
6651.38
0.00327
)0.01136
0.03404
0.03369
33221.44
106854.90
68766.28
61242.23
96.01±96.12
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
94.04±94.12
94.04±98.02
94.04±94.12
95.01±95.12
96.01±96.12
97.01±97.12
37055.05
12463.00
0.01089
)0.00813
0.03496
0.03279
64493.41
81353.72
91722.42
90317.76
23961.75
1173.25
)0.02583
)0.03054
0.04554
0.02440
53514.49
64113.41
58704.90
39117.74
18038.56
34948.68
)0.01807
)0.03190
0.02569
0.02675
59132.93
73410.25
51502.23
33093.19
65826.20
9220.57
0.08276
0.07655
0.03798
0.04260
67980.84
83929.43
90529.55
76520.34
41202.05
3576.29
)0.00173
)0.05262
0.03490
0.03441
72739.12
95373.83
152450.50
124768.30
Panel D: Sample of ®rms with both H and A shares
Average H premium
)0.26290
Standard deviation
0.66904
Average A volume
112011.80
Average H volume
162170.70
Average A return
0.00754
Average H return
)0.02005
Average A volatility
0.03458
Average H volatility
0.03178
Average number of A shares
217853.84
Average number of H shares
635811.89
Average market capitalization
535174.80
Standard deviation
907185.30
0.59082
1.04199
71508.56
79370.54
)0.00151
)0.02273
0.04737
0.02457
247273.29
627322.86
182769.82
330018.23
)0.03935
0.58978
108330.00
55176.39
)0.00544
)0.04020
0.03425
0.01649
210989.30
621126.00
272948.55
406984.70
)0.45239
0.36923
176775.20
75795.14
0.03286
0.02167
0.03245
0.01947
210989.30
621126.00
636144.22
976786.34
)0.52927
0.32533
95659.38
396988.90
)0.00790
)0.04648
0.02637
0.04425
210909.30
671126.00
962000.97
1256680.20
34
)0.05991
43046.86
0.01471
1008441.09
355953.75
36
)0.02122
40097.58
0.01212
1066300.95
308715.20
37
0.06369
112133.00
0.01283
1095677.93
541039.54
38
0.00937
454200.70
0.03724
1402903.62
1264266.62
Panel E: Red chips
Number of ®rms at year end
Average return
Average volume
Average volatility
Average number of shares
Average market capitalization
38
0.00380
186191.60
0.02522
1189959.48
678303.68
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Average A volume
Average B volume
Average A return
Average B return
Average A volatility
Average B volatility
Average number of A shares
Average number of B shares
Average market capitalization
Standard deviation
1888
Table 2 (Continued)
a
)0.01253
85870.84
0.02689
662717.9
240093.7
)0.02132
71170.92
0.02267
621405.6
169006.9
)0.02869
30018.91
0.01667
613032.8
129483.3
0.02155
49404.58
0.01751
631841.3
286264.1
)0.02560
181717.20
0.03630
742388.2
310923.4
This table provides information on average monthly premium, trading volume, return, volatility, number of shares outstanding and market capitalization for sample ®rms listed on the Shanghai, Shenzhen, and Hong Kong Stock Exchanges. The B-share premium is de®ned as (PB ± PA )/PA .
Similarly, the H-share premium is PB ÿ PA =PA . All prices are converted into US dollars. Return is derived from the log dierence of month-end prices.
Volatility is de®ned as the standard deviation of daily returns within a month. Market capitalization is the summation of market value of tradable A
and B (or H) shares of a ®rm. Market capitalization is in terms of thousand US$. Trading volume and number of outstanding shares are in thousand
shares.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Panel F: All H Shares
Average return
Average volume
Average volatility
Average number of shares
Average market capitalization
1889
1890
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
statistics of all red chips and H shares listed in Hong Kong during our sample
period.
To facilitate comparisons, for each variable, we compute the dierence between A shares and their corresponding B shares (or H shares). These variable
dierences (except the return dierence) are then normalized by their corresponding value of the A-share variable. For instance, the B-share volatility
dierential is computed as rB ÿ rA =rA . The cross-sectional average of the
variables over all 45 stock pairs in the sample is denoted as ``(B±A)/A Volatility''. Similarly, the H-share volatility dierential is computed as rH ÿ rA
=rA and the cross-sectional average of 10 stock pairs is denoted as ``(H±A)/A
Volatility''. The comparisons are graphically presented in various panels of
Fig. 1.
Panel A gives the ®rst sense of the issue discussed in this paper, the price
premiums. We compute two average premium series. ``(B±A)/A Price'' is the
cross-sectional average of B-share monthly price premiums of the 45 sample
®rms on the SHSE and SZSE. ``(H±A)/A Price'' is the cross-sectional average
of H-share monthly price premiums of the 10 sample ®rms on the SEHK. The
plot clearly shows that B shares are always traded at heavy discount. The
overall discount over the sample period is )0.56 (Panel A of Table 2). In fact,
based on the study of Bailey (1994), B shares were traded at discounts relative
to their A-share prices all along from March 1992 to February 1993.
Although our focus is on the B-share premium, a contrast with the H-share
premium can shed light on the issue. Notice that H shares were trading at a
premium relative to their corresponding A shares in the early sample period.
However, the premium could not be sustained and it turned into a discount
subsequently, just like with the B shares, only with a smaller magnitude. These
observations are so important that we will take a closer look after ®nishing
other comparisons.
In Panel B, we compare the return dierential (not normalized here). Notice
that returns of A shares are higher than the corresponding returns of B shares
and H shares. Although we do not intend to make rigorous tests here, this fact
suggests that the B-share discount would unlikely be explained by the dierence
in required rates of return by domestic and foreign investors. On the other
hand, this fact may be viewed as suggesting the possibility of the B-share
discount being driven by the dierence in expected growth rate. In Panel C, it is
surprising to see that although the overall B-share volatility is lower than the
A-share volatility, this is not always the case. On the other hand, the H-share
volatility is lower than the corresponding A-share volatility, except for 1997
when the sovereignty of Hong Kong was ocially returned back to China and
the Hang Seng Index reached its all time high at 16,673 in August. In terms of
share issue, Panel D indicates that ®rms tend to issue more shares to attract
foreign investors than to issue shares to local investors. This is more so for Hshare ®rms than for B-share ®rms, which con®rms the view that the mature
1891
Fig. 1. Comparison of A±B shares and A±H shares.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1892
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
Fig. 2. Comparison of H shares and red-chip shares.
Hong Kong market is a better channel to attract foreign capital. 12 Panel E
shows that the trading volume of B shares is 65% lower than that of their Ashare counterparts. But the trading volume of H shares is 45% higher than that
of their corresponding A shares. Again, the big jump in the trading volume of H
shares in 1997 is due to the Hong Kong hand-over. In short, for the 45 A±B
pairs, the A-share market is more liquid, more volatile, and yields higher returns
than the B-share market. For the 10 A±H pairs, the situation is similar except
that the H-share market is more liquid. Notice that in Panel F, the market value
of ®rms issuing H-shares is almost 600% larger than the market value of ®rms
issuing B shares. Yet, as shown in Fig. 2, red-chip shares are even bigger.
On the average, red chips are 16% bigger than H-shares and have 40% more
outstanding stocks. 13 Not just that, their shares bear volatility that is 30%
lower than that of the H shares and have a trading volume that is 20% higher.
The return tends to be higher, too. All these point to the fact that the H-share
and red-chip markets are important and signi®cant counterparts of the A±Bshare markets.
5.2. Comparison of price premiums
Going back to the issue of the dierence between B-share and H-share
premiums, we take a closer look at Panel A of Fig. 1 by plotting the monthly
12
For certain, this does not mean foreign investors are major shareholders. Non-tradable shares
are excluded in the comparisons here.
13
The H shares here contain a larger set of 40 ®rms, which include the 10 matched H±A ®rms
examined above.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1893
Fig. 3. Average price premium. For the 25 sample companies that issue both A and B shares in the
Shanghai Stock Exchange, their monthly price premiums (de®ned as (PB ±PA )/PA ) are computed
through time. ``Avesh'' is the cross-sectional average of the 25 price premiums. For the 20 sample
companies that issue both A and B shares in the Shenzhen Stock Exchange, their monthly price
premiums (de®ned as (PB ±PA )/PA ) are computed through time. ``Avesz'' is the cross-sectional average of the 20 price premiums. ``Ave'' is the cross-sectional average of the combined 45 price
premiums. For the 10 sample companies that issue both A and H shares, their monthly price
premiums (de®ned as (PH ±PA )/PA ) are computed through time. ``Aveh'' is the cross-sectional average of the price premiums. Notice that the sample size of Aveh changes through time (see
footnote 12).
premiums through time in Fig. 3. The overall average premium of 45 ®rms,
now denoted as ``Ave'', is further decomposed into two average premium series. ``Avesh'' is the cross-sectional average of B-share premiums of the 25
sample ®rms on the SHSE and ``Avesz'' is the average premium of the 20
sample ®rms on the SZSE. The cross-sectional average premium of 10 H-shares
is now denoted as ``Aveh''.
It becomes clearer how the price premiums evolve through time. H shares
traded at premium initially until the end of 1994. 14 This is consistent with
what has been found in other markets. H shares, which were opened to foreign
investors, traded at a premium with respect to their A shares. Hence, what is
special about China is that the H-share premium is not sustained and that the
B-share market keeps trading at a discount. Notice that H-share discount tends
to be smaller than the B-share discount although, in a few incidences, it is
larger than the B-share discount in the Shenzhen Exchange. In fact, the dis-
14
Since H shares were listed on SEHK in sequence, the number of ®rms in calculating the
average H-share premium begins from one, the Tsingtao Brewery, and increases to six in mid-1994.
The full sample of ten ®rms begins in November 1995. But the subsequent H-share discount is not
due to the late-joining ®rms. Not reported here are data on the ®rst six H-share ®rms that all have
traded at a discount since 1995, some earlier some later.
1894
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
count in the Shenzhen Exchange is consistently smaller than in the Shanghai
Exchange. 15
As mentioned before, the speculation argument views price dierential as an
``A-share premium'' phenomenon. That is, Chinese investors keep chasing after
the limited supply of A-shares, which caused these shares to be overpriced.
Though we will test this argument later, the casual observation here already
suggests that this cannot be the only reason for the phenomenon. If the cause is
with the A shares, it is not easy to explain why H shares would trade at a
smaller discount than B shares. Recall that H-share ®rms have been chosen for
their good management and good pro®t potential. They also need to meet
stringent requirements set by the SEHK and have greater and better information disclosure than B-share ®rms. Hence, we would expect that Chinese
investors would chase more after ®rms issuing H shares than those issuing B
shares, leading to a larger H-share discount. However, if we view the phenomenon as a B-share discount, it can be easily interpreted as foreign investors
discounting less on H shares than on B shares due to the ``endorsement'' of the
H shares by the SEHK.
One more piece of information can be drawn from Panels E and F of Fig. 1.
Studies typically ®nd that ®rm size and market liquidity are important factors
for price premium. Yet, from our comparisons, it is clear that although Hshare ®rms are much larger in size and their shares are more heavily traded
than B-share ®rms, share prices of both H- and B-share ®rms trade at a discount relative to their A-share counterparts. This strongly suggests that ®rm
size and liquidity cannot be crucial factors for the price discount phenomenon.
6. Panel analysis results
After the general comparisons, we carry out more rigorous tests. A panel
regression of model (1) is done on the whole sample data and results are reported in Table 3.
Column (1) shows the basic result of the regression. For the dierential
demand argument, the ®rst variable to look at is ``NoB/NoA'', the relative
supply of B shares and A shares. The regression estimate is signi®cantly negative with a t-value of ÿ4:86. This is consistent with the hypothesis that the
greater the supply of B shares relative to A shares, the lower the B-share prices
15
We observe that companies listed in the SHSE tend to issue more B shares relative to A shares
than companies listed in the SZSE do. Also, according to newspaper reports, it is not uncommon
for Chinese investors to ®nd ways to trade on B shares. If it is easier for Chinese investors to trade
on the SZSE through their linkage in Hong Kong and/or if it is easier for them to get access to
HKD, then the SZSE might attract more local Chinese investors. In that case, it is conceivable that
B shares traded in the SZSE have less discount than their counterparts in the SHZE.
Q. Sun, W.H.S. Tong / Journal of Banking & Finance 24 (2000) 1875±1902
1895
Table 3
Pooled regression results (combined sample of Shanghai and Shenzhen ®rms)a
Total Panel Obs.
NoB/NoA
Bond
H
Red
(1)
(2)
(3)
(4)
2070
2070
2070
2070
)0.000435
()4.865)
0.000114
(2.354)
)0.005618
()5.542)
)0.020996
()7.048)
Hper
Redper
VolB/VolA
MV
In¯ation
DFXR
StdB/StdA
Prem()1)
0.001453
(1.968)
ÿ3:30 10ÿ7
()7.103)
)0.006014
()8.572)
0.001530
(2.158)
0.003112
(3.303)
0.649472
(41.539)
)0.000352
()3.835)
0.000164
(5.240)
)0.732701
()5.439)
)0.389733
()5.287)
0.001843
(2.473)
ÿ2:19 10ÿ7
()4.490)
)0.002568
()5.625)
0.000993
(1.695)
0.001189
(2.493)
0.733253
(48.326)
Trend
Adjusted R2
Durbin±Watson
0.7144
2.1017
0.7023
2.1256
)0.000390
()4.301)
0.000128
(2.652)
)0.005355
()5.302)
)0.019464
()6.531)
0.001570
(2.145)
ÿ3:45 10ÿ7
()7.506)
)0.006801
()9.560)
0.009030
(5.981)
0.004192
(3.758)
0.653474
(42.056)
)0.001002
()5.606)
0.7182
2.0766
)0.000300
()3.243)
0.000187
(5.974)
)0.750787
()5.596)
)0.356100
()4.839)
0.001962
(2.665)
ÿ2:45 10ÿ7
()5.070)
)0.001057
()2.087)
0.009853
(6.486)
0.002757
(3.145)
0.732628
(48.775)
)0.001239
()6.951)
0.7087
2.0760
a
A general ®xed-eects pooled regression model of the following form is run on share price premium:
Premit ai b0 Xit ci Premitÿ1 eit
i 1; 2; . . . ; N ; t 1; 2; . . . ; T :
``Prem'' is the percentage price premium de®ned as (PB ± PA )/PA . PB and PA are contemporaneous
month end prices of B- and A-shares of the same company. All prices are converted into USD
denomination. X are the chosen explanatory variables. All variables are transformed into deviation
form. ``No'' is the number of shares outstanding. ``Bond'' is the dollar amount of bond issue. ``H''
and ``Red'' are the number of H-share and red-chip companies listed in the Hong Kong stock
market. ``Hper'' and ``Redper'' are monthly H-share and Red-chip trading volume as a percentage
and Hong Kong market trading volume respectively. ``Vol'' is the trading volume. ``MV'' is the
market capitalization. ``In¯ation'' is the month