Market Segmentation and Stock Prices Discount in the Chinese Stock Market: Revisiting B-share Discounts in the Chinese Stock Market

Transcription

1 Asia-Pacific Journal of Financial Studies (2008) v37 n1 pp1-40 Market Segmentation and Stock Prices Discount in the Chinese Stock Market: Revisiting B-share Discounts in the Chinese Stock Market Bong-Soo Lee Florida State University, Tallahassee, USA Oliver Rui The Chinese University of Hong Kong, Hong Kong, China Wenfeng Wu Shanghai Jiao Tong University, Shanghai, China This is one of the nine accepted papers among 143 papers that were submitted to the solicitation by Asia-Pacific Journal of Financial Studies in the special Call-for-Papers event in 2007 Abstract This paper explores the determinants of B-share discounts in the Chinese stock market based on a unique regulatory change in We find that the B-share discounts declined substantially after the lifting of restrictions on foreign ownership in China, but the H- share discount remained virtually unchanged. Using the intraday data, we find that information flows from the B-share markets to the A-share markets increase significantly after the event, because domestic investors rush into the B-share markets. Using various cross-sectional analyses, we also find that relative supply and behavioral factors such as relative spread (or liquidity) and relative risk affect the discounts throughout the sample period. Keywords: Market Segmentation; Chinese Stock Markets; Information Flow; B-share Discount; Behavioral Factor * Corresponding Author. Address: Faculty of Business Administration, The Chinese University of Hong Kong, Shatin, Hong Kong, China; oliver@baf.msmail.cuhk.edu.hk. Tel: ; Fax:

2 Market Segmentation and Stock Prices Discount in the Chinese Stock Market 1. Introduction In many emerging capital markets, stock markets are segmented to allow companies to issue shares that attract foreign funds while minimizing the market destabilization risk and the loss of ownership control to foreign investors. In these segmented markets, two classes of shares are commonly issued: restricted shares that can only be held and traded by local investors, and unrestricted shares that can be held and traded by both local and overseas investors. Although restricted and unrestricted shareholders receive the same rights and entitlements, it has been observed in most markets that unrestricted shares usually trade at a premium over restricted shares. 1) In China, some firms issue two types of shares: class A shares, which are denominated in Renminbi (RMB) and traded among Chinese citizens, and class B shares, which are denominated in foreign currencies (U.S. dollar in Shanghai and Hong Kong dollar in Shenzhen) and originally traded among non-chinese citizens or overseas Chinese. 2) Apart from the ownership restrictions, these two classes of shares are the same; owners have equal rights to cash flows and voting privileges. 3) In contrast to stock markets with similar ownership segmentation, China s stock market has substantial and persistent price discounts instead of premium on foreignonly shares relative to domestic-only shares. 4) Bailey (1994) analyzes eight Chinese B-share stocks for the period from March 1992 to March 1993 and finds a significant discount in the B-share prices relative to the A-share prices. This phenomenon is confirmed by studies of Ma (1996), Fung, Lee, and Leung (2000), and Chen, Lee, and Rui (2001). 1) Hietala (1989), Bailey and Jagtiani (1994) and Domowitz, Glen, and Madhavan (1997) find that foreign shares are trade at a premium over local shares in Finland, Thailand and Mexico, respectively. 2) In terms of B shares listed on the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE), overseas investors are described as foreign legal and natural persons; legal and natural persons from Hong Kong, Macau, and Taiwan; and other investors who have been approved by the People s Bank of China. However, the State Council rules state that Chinese living overseas and remitting money inwards are permitted to trade in B shares, thus creating conditions whereby local traders can open accounts in the name of overseas relatives and friends. 3) Studies of voting class premiums include Smith and Amoaka-Adu (1995) for the Toronto Exchange, Lease, McConnell, and Mikkelson (1983) for the American Stock Exchange, and Levy (1983) for the Jerusalem Exchange. All of these studies find a significant price premium for voting class shares. 4) It is impossible for companies to arbitrage pricing differences by issuing only the higher-priced A-shares because Chinese companies need government approval to be listed in stock markets. It is a highly political process subject to aggregate quotas. The other reason is that the firms issue lower-priced B-share to obtain foreign currency. 2

3 Asia-Pacific Journal of Financial Studies (2008) v37 n1 Over the years, academics have put forward various explanations for the price disparity that appears in segmented markets. Hietala (1989) provides evidence for the argument that the beta risk can explain the price premium in the Finnish market. Bailey and Jagtiani (1994) demonstrate that liquidity problems and information availability are factors that lead to the price difference in Thailand. Domowitz, Glen, and Madhavan (1997) find that the perception of exchange rate risk and foreign demand affect the share price gap in Mexico. The substantial price discount of B-shares in the Chinese stock market is often explained by asymmetry in market information. It has been well recognized in financial literature (Brennan and Cao, 1997; Kang and Stulz, 1997; Stulz and Wasserfallen, 1995) that foreign and domestic investors differ in the level of information that they possess about the value of domestic assets. Chakravarty, Sarkar and Wu (1998) argue that foreign investors have less information due to language barriers and different accounting standards. Consequently, investors demand a risk premium to compensate for their disadvantage in information relative to domestic investors. In contrast, Chui and Kwok (1998) suggest that domestic investors have problems in acquiring relevant and trustworthy firm information from domestic and foreign media. Hence, information usually flows from foreign to domestic investors. In fact, the information channels seem to be different for foreign and domestic investors. Cheng (2000) points out that foreign investors reportedly have better access to timely updates on the Chinese economy from media such as Reuters and other financial services. However, local investors have their own information sources, such as networks of relationships and gossip. Chen, Lee, and Rui (2001) fail to find any significant information flows between foreign and domestic investors using daily data until the end of Another explanation for the Chinese B-share discount is the liquidity hypothesis. Amihud and Mendelson (1986) suggest that relatively illiquid stocks have a higher expected return and are priced lower to compensate for increased trading costs. Poon, Firth and Fung (1998) argue that this also occurs in the Chinese stock market. Chen, Lee, and Rui (2001) find that the relative illiquidity of B-shares may be the primary reason for the price disparity. Other explanations include the differential demand elasticity hypothesis and the differential risk attitude hypothesis. Stulz and Wasserfallen (1995) suggest that an investment home bias that investors prefer local stocks to foreign stocks may lead to 3

4 Market Segmentation and Stock Prices Discount in the Chinese Stock Market price and demand imbalance among share classes. Like firms that issue both A- shares and B-shares, some firms in China issue both A-shares and H-shares that are listed in Hong Kong. Sun and Tong (2000) argue that the existence of the H-share and red-chip markets means that there are good alternatives for the B-share market, so that foreign investors demand for B-shares can be quite elastic. 5) Gordon and Li (1999) posit that legal restrictions create a segmented market and limit investment opportunities, so domestic investors have an inelastic demand for equity due to insufficient supply. Consequently, domestic investors push up A-share prices, resulting in B-share price discounting. The international asset pricing model suggests that required returns on risky assets depend on the assets exposure to risk factors and the corresponding market risk premium. Bailey and Jagtiani (1994) and Ma (1996) show that the price difference may be due to the investors attitudes toward risks. In their arguments, Chinese markets are highly speculative, and domestic investors may be highly risk tolerant and expect to earn money in the short run. Hence, A-share and B-share investors may have different degrees of risk aversion. Chen, Lee, and Rui (2001) test this hypothesis and find weaker evidence for the differential risk hypothesis than that for the liquidity hypothesis. To sum up, the explanations for the B-share price discount are inconclusive, and the phenomenon remains a puzzle. Bailey, Chung and Kang (1999) conclude that the B-share price discount in China is strange and difficult to explain. Since February 19, 2001 the trading on the B-share markets was not active relative to that on the A-share markets. The China Securities Regulatory Commission (CSRC) has allowed domestic residents to trade in B-share stocks to revitalize the market. This change provides us with the opportunity to examine whether the price disparity is primarily due to market segmentation or other factors. 6) The purpose of this study 5) H-share companies are companies incorporated in the People s Republic of China and approved by the China Securities Regulatory Commission for listing in Hong Kong. Shares of these Chinese enterprises are listed on the Hong Kong Exchange, and subscribed for and traded in Hong Kong dollars. Chinese domestic investors are forbidden from holding and trading in H-shares. Many H-share issuing companies have subsequently listed A-shares on either the SHSE or the SZSE. H-shares provide international investors with channels for investment in companies in China with fewer investment barriers and costs. Other than H-shares, there are red-chip companies listed in Hong Kong. Red-chip companies refer to mainland Chinese controlled firms that are incorporated outside China (mostly in Hong Kong) and traded on the Hong Kong Stock Exchange. 6) Loderer and Jacobs (1995) study the similar case of Nestle. The board of directors of Nestle AG allowed foreign investors to hold Nestle register stock on November 17, The decision had a tremendous impact on the prices of the firm s three classes of common stocks. 4

5 Asia-Pacific Journal of Financial Studies (2008) v37 n1 is to investigate the phenomenon of foreign shares discounts in the light of the lifting of restrictions on foreign ownership in China. We examine the roles of various factors not only in the pre- and post-event periods, but also in cross-sectional differences. The cross-sectional and time-series analyses will corroborate each other and provide us with clearer evidence of whether and how the market segmentation plays a significant role in price discount. This external shock controls for other institutional differences, such as legal, social and political factors. This topic is worth exploring in its own right given the vastness of the Chinese capital market, its rapid expansion, and its increased openness to foreign investments. This paper contributes in the following aspects. First, we investigate this unique event in China to gauge to what extent market segmentation can explain the stock price disparity. Second, in contrast to existing literature that uses daily data in the Granger causality tests, we use microstructure data to reveal the structure of information flows between the A-share and B-share markets. It is widely agreed that leadlag relationships between A-share and B-share stocks, if they indeed exist, do not last for an hour. Thus, a statistical analysis using daily data is very unlikely to find evidence of lead-lag relationships. The intraday data provides more illuminating findings for the two almost identical markets, which have the same location, the same trading time, the same trading mechanism, and the same trading information channel. Third, we investigate the role of various behavioral factors in explaining China s B-share discounts in the pre- and post-event periods. This is motivated by recent development of behavioral finance models which have become popular in explaining several market anomalies (e.g., short-horizon continuation and long-horizon reversals in returns, and excessive trading and volatility). We find that the B-share discount has greatly declined in response to the event (that is, the lifting of ownership restrictions); however, in case of H-shares, an alternative to B-shares that did not experience such relaxation in ownership restrictions, the discount has remained virtually unchanged. 7) This implies that the B-share discount is largely due to the market segmentation. The lifting of restrictions enhances information flows from the B-share market to the A-share market because domestic investors rush into the B-share market after the lifting. There are significant bidirectional information spillovers between the two markets for most of the sample 7) Sun and Tong (2000) find a significant discount in the H-share prices relative to the A-share prices. 5

6 Market Segmentation and Stock Prices Discount in the Chinese Stock Market firms, indicating that information segmentation vanishes with the lifting of ownership restrictions. The B-share discounts, although reduced, still remain and vary widely across firms after the event. As such, we study which factors determine the remaining discounts cross-sectionally and find that relative supply and behavioral factors such as relative spread (or liquidity) and relative risk are the primary determinants of the discounts across firms. The remainder of this paper is organized as follows. Section 2 provides background information about the relaxation of foreign ownership restrictions. Section 3 develops the methodology. Section 4 describes our data and discusses the empirical results, and Section 5 concludes the paper. 2. Background of the Relaxation of Foreign Ownership Restrictions The Shanghai Stock Exchange (SHSE) was established on December 19, 1990, and the Shenzhen Stock Exchange (SZSE) on July 3, The two exchanges are selfregulated, and cross listing is not allowed. In 1992, B share was introduced to utilize foreign funds, which was traded and held by foreign investors. China s stock market has expanded rapidly. At the end of 2006, 828 companies issued A shares and 54 companies issued B shares listed on the SHSE, with a total capitalization value of RMB8,656 billion. At the same time, 576 companies issued A shares and 57 companies issued B shares listed on the SZSE, with a total capitalization value of RMB 2,061 billion. These amounts were equal to about half of China s GDP. China adopted a quota system in equity public offering before March Due to the quota, some companies have to issue B-shares although B-shares are traded at a discount relative to A-shares. As most of B-shares are held by foreign institutional investors, B-share market is illiquid relative to A-shares, which are mostly held by domestic individual investors who trade frequently. In 2000, the annual turnover rate of B-share market was 136%, while that of A-share market was 477%. To enhance the liquidity of the B-share market, the China Securities Regulatory Commission (CSRC) announced the Notice on Issues Related to Individual Domestic Residents Investing in Foreign Currency Stocks Listed on the Domestic Stock Markets on February 19, ) Quite simply, it allowed domestic investors to trade in B- 8) See the Appendix for details. 6

7 Asia-Pacific Journal of Financial Studies (2008) v37 n1 share stocks. The market responded very enthusiastically. In the three months after the announcement, the domestic B-share brokerage accounts on the SHSE increased from 152,000 to 577,000, and the number on the SZSE rose from 130,000 to 319,000. B-share prices jumped sharply. The Shanghai and Shenzhen B-share indices increased by 178% and 122%, respectively, between February 19, 2001 and June 1, 2001, while the A-share indices rose by only 10.9% and 8.6%, for the same period respectively. Figures 1 and 2 demonstrate the impact of the event on the A-share and B-share composite price indices on the SHSE and SZSE, respectively. Like firms that issue both A-shares and B-shares, some firms in China issue both A-shares and H-shares that are listed in Hong Kong. Chinese domestic investors are forbidden from holding and trading in H-shares. In contrast to the responses of the B- share markets to the event, the H-share market in Hong Kong is virtually unaffected. Figure 3 shows the B-share and H-share discounts during the four-year windows before and after the event. The B-share price discount (A-share price premium) is defined as the ratio of the difference between the A-share price and the B-share price to the A-share price ((PA PB) /PA). Similarly, the H-share price discount is defined as (PA PH)/PA. In Figure 3, the B-share and H-share price discounts were at a similar level before the event. However, the B-share price discount declined considerably after Figure 1. The A-share and B-share composite index of the Shanghai Stock Exchange /3/5 99/5/5 99/7/5 99/9/5 99/11/5 00/1/5 00/3/5 00/5/5 00/7/5 00/9/5 00/11/5 01/1/5 01/3/5 01/5/5 01/7/5 01/9/5 01/11/5 02/1/5 02/3/5 02/5/5 02/7/5 02/9/5 02/11/5 03/1/5 03/3/5 03/5/5 20 SHSEA SHSEB where SHSEA is the Shanghai Stock Exchange A-share index while SHSEB is the Shanghai Stock Exchange B-share index. 7

8 Market Segmentation and Stock Prices Discount in the Chinese Stock Market Figure 2. The A-share and B-share composite index of the Shenzhen Stock Exchange /3/5 99/5/5 99/7/5 99/9/5 99/11/5 00/1/5 00/3/5 00/5/5 00/7/5 00/9/5 00/11/5 01/1/5 01/3/5 01/5/5 01/7/5 01/9/5 01/11/5 02/1/5 02/3/5 02/5/5 02/7/5 02/9/5 02/11/5 03/1/5 03/3/5 03/5/5 SZSEA SZSEB where SZSEA is the Shenzhen Stock Exchange A-share index while SZSEB is the Shenzhen Stock Exchange B-share index. the event, whereas the H-share price discount remained virtually unchanged. This finding implies that the H-share may not be a good substitute for the B-share, and that market segmentation is the primary reason for the B-share price discount before the event. Figure 3. Plot of Average B share price discounts and H share price discounts /3/5 99/5/5 99/7/5 99/9/5 99/11/5 00/1/5 00/3/5 00/5/5 00/7/5 00/9/5 00/11/5 01/1/5 01/3/5 01/5/5 01/7/5 01/9/5 01/11/5 02/1/5 02/3/5 02/5/5 02/7/5 02/9/5 02/11/5 03/1/5 03/3/5 03/5/5 BDiscount HDiscount where B Discount is the B-share price discount defined as ((PA PB)/ PA) while H Discount is the H-share price discount defined as (PA PH)/ PA 8

9 Asia-Pacific Journal of Financial Studies (2008) v37 n1 3. Methodology 3.1 Changes in Information Flows After the relaxation of the ownership restrictions, it is quite possible that there are shifts in the information flows between the A-and B-share markets, because domestic residents were allowed to trade B-shares. To test the change in information flows between the two markets after the event, we employ Granger-causality tests in returns and volatilities, which are commonly used to investigate information flows between two variables in the prediction context. According to Granger (1969), if the prediction of current value of y using past values of x and y is more accurate than the prediction without using past values of x in the mean-square error sense, then x Granger-causes y. The following bivariate autoregression is used to test for the information flows between A-share and B-share stock returns: m m xt = α0 + αixt i + βiyt i + εt, i= 1 i= 1 m m yt = γ 0 + γixt i + δiyt i + ηt i= 1 i= 1 (1) Suppose that x t and y t are the A-share and B-share returns, respectively. If a standard F-test does not reject the hypothesis that β i = 0 for all i, then B-share returns do not Granger-cause A-share returns. Similarly, if A-share returns Grangercause B-share returns, then the γ i coefficient will be jointly different from zero. If there is significant information flow between the two share markets, then either A- share returns help to predict B-share returns or vice versa. Therefore, we should observe a causal relation between the two types of shares. 9) 9) The vector autoregressions we use for causality tests assume that the variables in the system are stationary. The most common test for stationarity is the test for a unit root. We employ both Dickey-Fuller test (1979) and the Phillips-Perron test (1988). We find that the null hypothesis that the stock return series are nonstationary (i.e., have a unit root) is rejected. The results are consistent with those of Lee and Rui (2000). 9

10 Market Segmentation and Stock Prices Discount in the Chinese Stock Market 3.2 Potential Determinants of B-share Price Discounts To explain the B-share price discount across firms, we analyze potential determinants of differences in the levels of B-share prices. Relative supply: Gordon and Li (1999) argue that legal restrictions create segmented markets and limit investment opportunities. One institutional characteristic of the Chinese stock market is that listed companies are sponsored and controlled by government-related entities. Most listed companies are business units that have been carved out of state-owned enterprises. There are three distinct classes of ownership shares: state shares, legal entity shares, and tradable publicly owned shares. State shares are held by the central or local governments. These shares are prohibited from trading. Legal entity shares are owned by separate legal entities, such as financial institutions, other enterprises, and the foreign partners of incorporated joint ventures. These shares cannot be traded either. Only tradable publicly owned shares can be freely traded on the stock exchange. Based on the statistics of the CSRC, 37% of listed firms shares are owned by the state, 20% by legal entities and 33% are tradable publicly owned shares during It has been estimated that Chinese citizens hold RMB10 trillion deposits in the banking system. 10) Thus, domestic investors big demand for equity combined with insufficient supply pushes up the price of class A-shares. This suggests that the discount increases as the domestic supply of A shares decreases. As an empirical proxy for the relative supply across firms, we adopt the Domowitz, Glen, and Madhavan (1997) ratio of tradable B shares to total tradable shares. If the differential supply hypothesis holds, the discount is a positive function of the relative supply proxy. Differential risk: Ma (1996) argues that the B-share price discount is associated with investors attitudes toward risk. He points out that Chinese markets are highly speculative and domestic investors are highly risk tolerant. According to the asset pricing theory, the present prices would be lower to compensate for the higher risks. The B-share prices are lower than A-share prices because B-share risks are higher than A-share risks. We employ the systematic risk measure, beta, calculated from the 10) Bailey (1994) attributes the B-share discount to a lower opportunity cost of investable capital for domestic citizens who have been highly constrained in earning opportunities for their savings. Though domestic citizens have many alternatives to invest after 2000 including houses, cars, bonds and insurance policies, the stock market still remains a major venue for domestic investors based on surveys. 10

11 Asia-Pacific Journal of Financial Studies (2008) v37 n1 standard market model as a proxy for risk level. The relative risk is the ratio of A- share beta to B-share beta. Therefore, we would expect the relative risk to be negatively correlated with the discounts across firms. Relative turnover (liquidity): As previous studies (e.g., Bailey and Jagtiani, 1994; Chen, Lee, and Rui, 2001) show, the relatively illiquid B-shares have a higher expected return and are thus priced lower to compensate investors for the increased trading costs. The relative liquidity is, therefore, a possible reason for discounts across firms. We employ relative turnover: the ratio of turnover in B shares to turnover in A shares as a proxy for the relative liquidity. The turnover is defined as the ratio of the number of shares traded to the number of shares tradable. After the relaxation of foreign ownership restrictions on B-shares, their trading volume soars rapidly and prices moved upward. Hence, we would expect to observe a negative relationship between the discount and relative turnover. Relative spread (liquidity): Amihud and Mendelson (1986) show that stock prices may deviate from the equilibrium value since the bid-ask spread compensates the uninformed investors submitting limit orders for bearing the costs of asymmetric information. Other than turnover, we use the bid-ask spread as the liquidity proxy. The intraday spread data is helpful in finding how liquidity explains the B-share discount. Relative spread is defined as the ratio of A-share spread to B-share spread. Like relative turnover, we would expect the discount to be negatively correlated with relative spread. Relative adverse selection: It is argued that the asymmetric information between domestic investors and foreign investors drives the B-share discount (Bailey and Jagtiani, 1994; Chui and Kwok, 1998; and Chakavarty, Sarkar, and Wu, 1998). The spread decomposition literature suggests that the asymmetric information cost is reflected in the bid-ask spread, while the spread covers the order processing costs incurred by the providers of market liquidity (Glosten and Harris, 1988; Lin, Sanger, and Booth, 1995; and Brockman and Chung, 1999). The spread decomposition model provides us with a channel to directly investigate the asymmetric information explanation. 11) We follow 11) Chinese stock market is an order-driven market, in which there are no market makers or floor traders with special obligations or differential access to trading opportunities. Public limit buy (bid) and sell (ask) orders enter the fully automated computerized trading system. The limit buy orders are queued from the highest to the lowest price, and sell orders queued from the lowest to the highest. The standing orders are matched according to the price-time priority principle. The best three buy and sell orders in 11

12 Market Segmentation and Stock Prices Discount in the Chinese Stock Market Lin, Sanger, and Booth (1995) to estimate the adverse selection component of the bidask spread using the following equation: Δ Qt+ 1 = λzt + et+ 1 (2) where Q is the bid-ask spread midpoint (in logarithms), z is the difference between the transaction price (in logarithms) and Q, λ is the adverse selection component, and e is a normally distributed error term. The relative adverse selection is the ratio of A-share λ coefficient to B-share λ coefficient. Since adverse selection cost is a part of illiquidity cost, we would expect a negative relation between the B-share discount and relative adverse selection. Behavioral factors: Investor trading behavior may affect the price. The difference between A-share and B-share prices may be due to the different behaviors of A-share and B-share investors. According to Daniel, Hirshleifer, and Subrahmanyam (1998), Statman, Thorley, and Vorkink (2003), and Gervais and Odean (2001), among others, if investor overconfidence increases, then trading volume, volatilities, and the shorthorizon autocorrelation of returns will increase. Since trading volume and volatilities are used as proxies for liquidity and risk, respectively, the relative turnover (or relative spread) and relative risk discussed above can be thought of as behavioral factors. As a proxy for the short-horizon autocorrelation of returns, we employ the first order autocorrelation of weekly return. We calculate the five 1 st order weekly return autocorrelations from Monday to Monday, Tuesday to Tuesday, Wednesday to Wednesday, Thursday to Thursday, and Friday to Friday. We then calculate the mean of the absolute value of the five 1 st order autocorrelations. The difference between two classes of investor behavior is proxied by the relative autocorrelation, which is defined as the ratio of the mean value of 1 st order A-share return autocorrelations to B-share return autocorrelations. Earnings difference: International accounting standards (IAS) are used to prepare accounting reports for B-shareholders, while China s domestic accounting rules (DAS) are used to prepare them for A-shareholders. Chen, Firth, and Kim (2002) show that IAS earnings information is incorporated into the prices and returns of B-shares. In 12 the queues are displayed to the investors. The highest buy price in the queue is defined as the bid price, and the lowest sell price as the ask price.

13 Asia-Pacific Journal of Financial Studies (2008) v37 n1 contrast, A-share investors appear to place most weight on DAS earnings, and only recently has there been an association with IAS information. Thus, the accounting measure difference is likely to affect the discount across firms. We employ the ratio of the difference between DAS earnings and IAS earnings to DAS earnings as one potential explanatory factor. Other control factors: We also include other factors that have been identified in early studies (Ma 1996; Chen, Lee and Rui 2001). Firm size is measured as the market value of the stock at the end of 2000 and The total market value of a stock is calculated as the sum of the untradable shares value, the A-share market value, and the B-share market value. The untradable shares value is the product of the number of untradable shares multiplied by the average of the A-share price and the B-share price. The tradable A-shares and B-shares market value equals the product of the number of shares and their corresponding trading prices. Book to market value (B/M) is measured as the book value of the stock divided by the market value of the stock. The book values used in our empirical tests are based on the domestic accounting standard (DAS). 12) Another factor that we consider is state-ownership, which is calculated as the ratio of state-owned shares to total shares. Governmental shareholders often have objectives that deviate from profitability. For example, the state may place high emphasis on maintaining social order and affecting wealth redistribution, which may favor companies employing more workers than is dictated by efficiency consideration alone (Fan and Wong 2005). Different levels of ownership concentration may explain the B-share price discount. 4. Empirical Analysis 4.1 Data We use a pre-event two-year sample from March 1, 1999 to February 18, 2001, and a post-event two-year sample from June 1, 2001 to May 31, 2003, because there were still foreign currency limits on B-share trading between February 19, 2001 and June 1, ) There were 38 dually listed stocks on the SHSE during the pre-event and 12) We use the book values based on the IAS as well. The results remain qualitatively consistent. 13) Since December 16, 1996, both markets have used a daily price limit of 10% based on the previous day s closing price. Most of B-share stocks hit their price limits during that period. So we exclude those data from our sample. 13

14 Market Segmentation and Stock Prices Discount in the Chinese Stock Market post-event periods. Three stocks are excluded because they were PT (particular transfer) companies, which were only traded on Friday each week. 14) On the SZSE, three stocks are eliminated from 36 stocks for the same reason. Hence, the total sample includes 68 stocks. Our daily and intraday A-share and B-share data were retrieved from the China Stock Market & Accounting Research database (CSMAR). The microstructure data include transaction prices and volumes as well as liquidity measures (bids, asks, and depths) taken at five-minute intervals. 15) The H-share data is from DATASTREAM. The B-share prices in U.S.$ for the SHSE and in H.K.$ for the SZSE are converted to RMB using the daily official exchange rate. 4.2 Differences in Factors over Time Since we have two years of time-series data for the pre- and post-event periods, we comparatively analyze the pre- and post-event periods. Table 1 summarizes the basic statistics of the various factors that we introduced above. It also shows t-statistics for the difference test of factors between the pre-event and post-event periods. The B- share discounts for the 68 stocks declined substantially from an average of 80% before the event to an average of 47% after the event. However, the post-event discounts varied widely across firms, from 12% to 72%, whereas the pre-event discounts varied from 65% to 89%. Hence, the standard deviation of the post-event discounts is about twice that of the pre-event discounts. This observation prompts further analyses of the factors that affect cross-sectional variations in the B-share discounts for the post-event period. The A-share return is less than the B-share return before the event, while it is more than the B-share return after the event. The relative supply is greater than 0.5, which indicates that the average numbers of tradable B-shares are greater than 14) Firms that have reported losses for three consecutive years and have been suspended by the exchanges are called Particular Transfer (PT) firms. 15) Investigation of intraday lead-lag relationship involves high frequency data, and observations on the two series are probably unequally spaced in time. One way to deal with the problem is to choose a long unit time interval so that the number of missing observations is small. So we take five-minute interval. We use mid-point quotes rather than transactions prices to avoid statistical anomalies associated with bid-ask bounces. The tick size in China is 0.01, which does not change with stock price level. 14

15 Asia-Pacific Journal of Financial Studies (2008) v37 n1 those of A-shares. 16) The relative risk variable is less than 1 before the event, which means that the B-share has higher systematic risks than the A-share. 17) As noted earlier, the returns of B-shares are higher than those of A-shares, which is consistent with the asset pricing theory that the higher B-share return compensates for the higher risk. After the event, the variable becomes greater than 1. However, the difference between the relative risks of two periods is insignificant. The relative turnover is significantly affected by the event. The relative turnover rises drastically from an average of 0.22 before the event to an average of 0.61 after the event. The test for difference of relative turnover between the pre-event and postevent periods is significant (p-value is 0.00). Another liquidity proxy, relative spread, shows the same trend. The relative spread rises from an average of 0.12 in pre-event period to an average of 0.61 in post-event period. However, the relative turnover is still less than 1, which implies that the B-share turnover is smaller than the A-share turnover even after the opening of B-Shares to domestic investors. The relative spread is less than 1, which implies that the B-share spread is larger than the A- share spread after the event. The two liquidity measures show that the B-share is less liquid than the A-share. This result is consistent with the differential liquidity hypothesis. The B-share discounts decline as the relative B-share liquidity increases after the event, but the B-share discounts remain because the A-shares are more liquid than B-shares. As for asymmetric information component of the spread, the relative adverse selection ratio is less than 1 during the window. This indicates that information asymmetry among investors in the B-share market is greater than that in the A-share market. In terms of the relative weekly return on 1 st order autocorrelation between A-shares and B-shares, it is greater than 1 before the event, which implies that the A-share investors are more confident than B-share investors. Although the difference in relative autocorrelation between the two periods is insignificant, the relative autocorrelation drops to less than 1 after the event. This is consistent with the fact that domestic investors rush into the B-share market after the event. Hence, the difference between the trading behavior of A-share investors and B-share investors becomes smaller. 16) As described in the previous section, in general only one-third of A-shares are tradable. 17) The betas of A- and B-share are estimated using 250 observations of daily returns. 15

16 Market Segmentation and Stock Prices Discount in the Chinese Stock Market Table 1. Summary statistics This table provides summary statistics of variables before and after the relaxation of the foreign ownership restriction. The pre-event two-year data from March 1, 1999 to February 18, 2001 is defined as the pre-event sample, and the post-event two-year data from June 1, 2001 to May 31, 2003 is defined as the post-event sample. The total of 68 stocks includes 35 stocks on the SHSE and 33 stocks on the SZSE. The difference t-statistics of mean value between pre-event and post-event is listed. Its p-value is in parentheses. Variable Mean Median Min Max Standard deviation Pre-event Post-event Mean Standard Median Min Max deviation Test for difference t-statistics Discount (0.0001) A-share return (0.0001) B-share return (0.0001) Relative supply (0.5163) Relative risk (0.2269) Relative turnover (0.0001) Relative spread ratio (0.0001) Relative adverse selection (0.6234) Relative autocorrelation (0.2910) 16

17 Asia-Pacific Journal of Financial Studies (2008) v37 n1 Earnings difference (0.9091) Firm size (RMB billion) (0.0121) B/M ratio (0.0002) State ownership (0.9722) Notes) Discount = (A -share price B-share price)/a-share price; Relative supply = B-shares tradable/(a-shares tradable + B-shares tradable); Relative risk = A-share beta/ B-share beta; Relative turnover = (B-share trading volume/b-shares tradable)/(a-share trading volume/a-shares tradable); Relative spread ratio = A-share spread/b-share spread and spread is calculated as relative spread: 2*(bid-ask)/(bid+ask) Relative adverse selection = A-share λ/b-share λ. The λ is estimated by the following spread decomposition regression model (Lin, Sanger, and Booth (1995) s equation (5)): Δ Qt+ = λ zt + et+ 1 1 where Q is the bid-ask spread midpoint (in logarithms), z is the difference between the transaction price (in logarithms) and Q, λ is the adverse selection component, and e is a normally distributed error term. Relative autocorrelation = A-share weekly return 1 st order autocorrelation/b-share weekly return 1 st order autocorrelation; Earnings difference = [earnings (domestic accounting standard) earnings (international accounting standard)]/earnings (domestic accounting standard). Firm size = [A-share price * A-Shares tradable + B-share price * B-shares tradable] + [(A-share price + B-share price)/2 * (Total shares A- shares tradable B-shares tradable)]; B/M ratio = book value/market value; where book value of equity is based on domestic accounting standard, and market value equals firm size; State ownership = % shares owned by government. 17

18 Market Segmentation and Stock Prices Discount in the Chinese Stock Market The pre-event earnings difference is calculated using the accounting data from January 1, 1999 to December 31, 2000, while the post-event earnings difference is estimated using data from January 1, 2001 to December 31, The average earnings difference increases from 0.19 to 0.21, but the difference is not significant. The post-event firm size increases significantly as B-share prices increase considerably. This leads to the average B/M ratio decreasing from 0.41 before the event to 0.30 after the event. State-ownership stayed at the same level of one-third throughout the sample period. 4.3 Changes in Information Flows Using daily data up to the end of 1997, Chen, Lee, and Rui (2001) find that there was no significant information flow between domestic investors and foreign investors. Here we want to examine whether the relaxation of foreign ownership restrictions affected the information flow in any way. Using intraday data, we conduct Grangercausality tests between the two classes of share returns for each firm before and after the event. 18) Since the volatilities are considered to reflect the information content (e.g., Anderson (1996) and Lee and Rui (2002)), we also test for the return volatilities of two classes of share. 19) We summarize the results of the causal relation tests in Panel A of Table 2, which reports the number of stocks that have causal relations between A-share returns (volatilities) and B-share returns (volatilities). 20) The test is based on a bivariate model of five-minute interval returns and volatility for each firm. Before the event, there is a Granger causality relation between A-share returns and B-share returns for 20 (18) out of 35 (33) stocks on the SHSE (SZSE). of 35 (33) stocks listed on SHSE (SZSE), 15 (14) A-share returns Granger-cause B-share returns in one direction. There is no stock whose B-share return Granger-causes A-share return in one direction, either on the SHSE or SZSE. After the event, A-share returns and B-share returns of 33 (31) stocks Granger-cause each other on the SHSE (SZSE). A-share return 18) To determine the appropriate lag length, we apply two different test procedures, Akaike s Information Criterion (AIC) and the likelihood ratio test for reduction in the number of lags in the VAR model, respectively. 19) We use the official daily closing exchange rate to convert the B-share prices into RMB. Since RMB is pegged to U.S. dollar, the exchange rate is constant during the day. 20) To save space, we do not report the detailed results of individual firms. 18

19 Asia-Pacific Journal of Financial Studies (2008) v37 n1 of one stock Granger-causes B-share return on the SHSE, but there is none on the SZSE. However, B-share return of one stock Granger-causes A-share return on the SHSE, and there are two on the SZSE. 21) Before the event, of 35 (33) stocks, A-share return volatilities and B-share return volatilities of two (three) stocks Granger-cause each other on the SHSE (SZSE). A- share return volatilities of 15 (17) stocks Granger-cause B-share return volatilities in one direction on the SHSE (SZSE). B-share return volatilities of three (one) stocks Granger-cause A-share return volatilities in one way on the SHSE (SZSE). After the event, A-share return volatilities and B-share return volatilities of 15 (eight) stocks Granger-cause each other on the SHSE (SZSE). In one direction, A-share return volatilities of eight (ten) stocks Granger-cause B-share return volatilities on the SHSE (SZSE). B-share return volatilities of six (nine) stocks Granger-cause A-share return volatilities on the SHSE (SZSE). 22) The results show that before the event there are bi-directional causality relations between A-share returns and B-share returns for more than half of the stocks, implying that there is information spillover between A-share and B-share markets. For most other stocks, A-share returns Granger-cause B-share returns in one direction. However, after the relaxation of the foreign ownership restrictions on B-shares, the number of stocks whose A-share returns (volatilities) and B-share returns (volatilities) Granger-cause each other increases significantly. The number of stocks whose A-share returns (volatilities) Granger-cause B-share returns (volatilities) in one way decreases significantly. This indicates that the ownership relaxation enhances the information flows from B-shares to A-shares because domestic investors rushed into the B-share market. As a result, there are significant bi-directional intraday information exchanges between the two markets for most stocks. To check the robustness of the results, we test for the causality relationship between the A-share and B-share indices as well. The results are reported in Panel B of Table 2. The causality between A and B share index returns confirms (or is consistent with) our individual firm causality tests reported in Panel A. We find that A share index returns (volatilities) and B share index returns (volatilities) Granger-cause each other both in the pre-event and the post-event period, on both the SHSE and the 21) The F-statistics for the counts across stocks are significant. 22) To check the robustness of the results, we also use the data adjusted for holiday and weekend effects. 19

20 Market Segmentation and Stock Prices Discount in the Chinese Stock Market SZSE. 23) In contrast to the finding of previous studies that there are no information flows between the two markets, our intraday tests results show that the information flows were significant, even before the event. Moreover, the bi-directional information flows indicate that there is no asymmetric information between investors in the two markets. However, the B-share discount still remains. That is, the information asymmetry is Table 2. Tests of information flows between A-share and B-share Panel A. The number of stocks that have information flows between A-share return (volatilities) and B-share return (volatilities) The following bivariate autoregression is used to test for the information flows between A- share and B-share stock returns: m x = α + α x + β y + ε, t 0 i t i i t i t i= 1 i= 1 m y = γ + γ x + δ y + η, t 0 i t i i t i t i= 1 i= 1 m m where x t and y t are the A-share and B-share returns, respectively. To save space, we do not report the detailed results of individual firms. We summarize the results of the causal relation tests. Shanghai Stock Exchange Shenzhen Stock Exchange A-share return and B-share return co- Granger-caused Only A-share return Granger-caused B-share return Only B-share return Granger-caused A-share return A-share return volatilities and B-share return volatilities co-granger-caused Only A-share return volatilities Granger-caused B-share return volatilities Only B-share return volatilities Granger-caused A-share return volatilities Pre-event Post-event Pre-event Post-event ) However, it is noticed that the null hypothesis that A-share index return does not Granger-cause B-share index return is more strongly rejected than the null of the opposite directional causality in the pre-event period. 20

21 Asia-Pacific Journal of Financial Studies (2008) v37 n1 Panel B. Information flows between A-share index and B-share index The following bivariate autoregression is used to test for the information flows between A- share and B-share stock returns: m x = α + α x + β y + ε, t 0 i t i i t i t i= 1 i= 1 m y = γ + γ x + δ y + η t 0 i t i i t i t i= 1 i= 1 m m Suppose that x t and y t are the A-share and B-share indices, respectively. Pre-event F-statistic Signif. H0: A12(L) = 0 Level Causal Relation Post-event F-statistic Signif. H0: A21(L) = 0 Level Causal Relation Shanghai A-share index return Granger-caused Shanghai B-share index return F(10,17616) = Yes F(10,23904) = Yes Shanghai B-share index return Granger-caused Shanghai A-share index return F(10,17616) = Yes F(10,23904) = Yes Shenzhen A-share index return F(10,17616) = Granger-caused Shenzhen B share index return Yes F(10,23904) = Yes Shenzhen B-share index return F(10,17616) = Granger-caused Shenzhen A share index return Yes F(10,23904) = Yes not the sole reason for the price discounts. The cross-sectional analysis in the next section further explores which factors explain the remaining B-share discount. 4.4 Cross-Sectional Analysis Univariate Analysis B-share discounts remain after the relaxation of ownership restrictions and vary widely across firms, from 12% to 72%. To provide preliminary evidence on the determinants of discounts across firms, we conduct a univariate analysis. We divide the firms into two groups based on the median of discounts and then test the difference between the mean (and median) of the potential explanatory variables between the 21

22 Market Segmentation and Stock Prices Discount in the Chinese Stock Market two groups. The results are reported in Table 3. Table 3. Univariate analysis of the determinants of B share price discounts The 68 firms are divided into two groups based on the median of B-share discounts. The large discount group contains 35 firms, and the small discount group contains 33 firms. The mean value and median value of each group are reported. The t-statistic test for difference between the means of the two groups and the z-statistics test for difference between the medians of two groups are also presented. Their P-values are in parentheses on the right of the t-statistics and z-statistics. Mean Median Variables Large discount (Discount > Median) Small discount (Discount < Median) Test for difference t-statistics Large discount (Discount > Median) Small discount (Discount < Median) Test for difference z-statistics Panel A: Pre-event Relative supply (0.0000) (0.0000) Relative risk (0.3281) (1.0000) Relative turnover (0.1505) (0.6302) Relative spread (0.0056) (0.0001) Relative adverse selection (0.0075) (0.0161) Relative autocorrelation (0.0113) (0.0541) Earnings difference (0.8505) (1.0000) Log of firm size (0.0047) (0.0039) B/M ratio (0.0001) (0.0008) State ownership (0.2085) (0.0541) Panel B: Post-event Relative supply (0.0001) (0.0161) Relative risk (0.0039) (0.0161) Relative turnover (0.0199) (0.0161) Relative spread (0.7470) (0.3356) Relative adverse selection (0.9050) (0.6302) Relative autocorrelation (0.7874) (0.6302) Earnings difference (0.6655) (0.3356) Log of firm size (0.7894) (0.3356) B/M ratio (0.0009) (0.0001) State ownership (0.1429) (0.3356) Notes) For the definition of variables, see Table 1. 22