Chinese Dual-Class Shares Listed in Hong Kong and Mainland China

MA-Thesis / Master von Patrick Müller

Abstract:

This paper aims at explaining the phenomenon of price anomalies between dual-class shares of companies located in mainland China (hereafter China). A-shares listed on either the Shanghai Stock Exchange (SHSE) or Shenzhen Stock Exchange (SZSE) command a premium over the price of the corresponding firm’s H-shares traded at the Stock Exchange of Hong Kong (HKSE). This pricing puzzle arises from the segmentation of Chinese equity markets – H-shares may be exclusively acquired by Hong Kong residents and international investors whereas A-shares are restricted to mainland Chinese investors. Although both classes of stock are entitled to the same future cash flows, investors are only willing to buy H-shares at a price significantly lower than that of A-shares. This unique setup offers the opportunity to test competing theories about the effects of market segmentation on asset pricing and to examine the factors that induce the price gap between cross-listed shares on different stock exchanges.

Knowledge of the variables determining the price spread between H- and A-shares can make valuable contributions in a number of ways. Firstly, companies in mainland China pursuing initial public offerings (IPO) or seasoned equity offerings (SEO) may base their financing decision on a more thorough understanding of the parameters affecting stock prices of cross-listings in the respective markets. Secondly, policymakers in emerging country stock markets may draw conclusions concerning the design of foreign ownership regulation and investment restraints imposed on domestic and foreign investors. Lastly, international and local investors may build on a more profound understanding of the H- versus A-share discount (hereafter H-share discount) to narrow down attractive investment opportunity sets, especially in the light of the latest regulatory changes on the Chinese equity market.

As of August 2007 the government body monitoring and regulating the national currency, China’s State Administration of Foreign Exchange (SAFE), loosened its rigorous foreign exchange policy. Prior to the recent SAFE ruling, the annual amount to be freely converted from Chinese Yuan Renminbi (RMB) into foreign currencies was capped at a 50,000 United States Dollar (USD) limit. Under the new regime, mainland retail investors are granted unlimited convertibility of RMB into Hong Kong Dollar (HKD) – given that investments flow into the Hong Kong securities market. In the first place, policymakers might have intended to liberalize the Chinese capital account by gradually increasing the convertibility of China’s currency. Following this announcement, the HKSE experienced an almost 40 percent rally on its H-share listings.

It is unclear whether this surge was caused by cross-border flows of capital into the Hong Kong market or by speculative activity of Hong Kong and international investors. From the perspective of theory, providing access to the HKSE for Chinese investors has partially integrated the previously separated markets of China and Hong Kong. In such a situation, it should be anticipated that the stock prices of H- and A-shares converge, balance in a new equilibrium and, ultimately, reduce the H-share discount.

During an earlier, likewise transformational, event in 2001 Chinese investors had engaged in bidding up the prices of one share class until prices, which had been remarkably spread before the event, almost reached equality. In that year the China Securities Regulatory Commission (CSRC), the national stock exchange regulation authority, announced that domestic investors would be allowed to purchase B-shares that had formerly been traded by international investors only and exhibited a large discount compared to their respective A-share listings. Instantly, B-share prices rose dramatically, lowering the B-share discount from an average 75 percent to a historic low of 8 percent on average within weeks. Current market movements in Hong Kong signalled the commencement of an analogous trend for the H- and A-shares, when the average discount dropped by more than 10 percent points in the 5 trading days subsequent to the announcement of the new regulation.

Despite this market reaction, opening the Hong Kong market to Chinese investors had less impact on the H-share discount than the historic CSRC move in the B-share segment. This suggests that markets for Hong Kong H-shares and China A-shares in the same firms are strongly segmented. Since the institutional frameworks are similar, it seems a promising approach to build on theories developed in B-share studies, transfer findings with strong verification to the analysis of the H-share discount puzzle in this paper and conduct time-series and cross-sectional regressions to differentiate which concepts have the highest empirical validity.

Compared to the large number of scientific articles on the B- versus A-share discount, researchers in the field have devoted rather little attention to the subject of the H-share discount. Nonetheless, numerous insights and hints can be drawn from existing studies treating the B-share pricing anomaly.

It is the purpose of this paper to thoroughly review existing literature on the theory of market segmentation and use recent data to test the validity of selected concepts in an empirical analysis of the H-share discount.

Hence, this paper is structured as follows: In chapter two, equity markets in China, key players, institutions and regulations are introduced to establish the necessary degree of familiarity with the rules of equity trading in greater China. Some implications of market interferences by government entities and the recent boom in China’s A-shares will be reflected. The literature review in chapter three is, besides a summary of the results from prior B- and H-share studies, dedicated to a discussion of different theories on market segmentation, foreign ownership restriction and asset pricing as well as their applicability in the context of China.

In chapter four, empirical evidence on the H-share discount and descriptive statistics on the data sample will be presented. Based on daily share prices, mean and weighted discounts will be calculated to demonstrate the dimension of the price spread. The statistical analysis is covered in chapter five. Regressions of individual stock returns on different market indices will help to clarify which systematic market risks influence H- and A-share prices.

Subsequently, data sources, modifications and the model specifications for the statistical analysis derived from the theories in the previous chapters are introduced. The panel data analysis of the time series data for the 37 dual listings of A- and H-shares will be presented and interpreted in order to explain the time-series and cross-sectional variability of H-share discounts. Within chapter six the empirical findings and their interpretation are summarized before conclusions, recommendations and hints on future research areas are outlined.

Table of Contents:

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Chapter 2.2, Market Regulations and State Ownership:

Core regulators on Chinese equity markets are the SAFE and the CSRC. The SAFE is in charge of designing and implementing the balance of payments for China. With the long-term goal of achieving an equilibrium balance of payment position, the SAFE analyzes the capital account and foreign exchange movements in order to assess the feasibility of future moves towards free RMB convertibility.

The supervisory activity of the SAFE extends from managing and monitoring inward and outward bound foreign exchange transactions to setting the target exchange rate for the present currency peg. Based on foreign exchange analysis and market research the SAFE drafts recommendations for the foreign exchange policy of the Chinese central bank, the People’s Bank of China. As a result, China had pegged the RMB to the value of the USD since 1994, permitting minor swings of 0.3 percent around 8.2270 RMB on the USD, because Chinese policymakers intended to induce stable import prices for foreign consumer markets to maintain the growth of the export-driven domestic production.

Upon pressure by the United States and neighboring countries, the USD peg was abandoned and transitioned into a currency basket peg. This basket currently contains ten currencies that are dominated by the USD, EUR and JPY. Since inception of the new peg, the exchange rate was allowed to float within a 0.3 percent band on every trading day. Partially unleashing the RMB has resulted in a RMB appreciation of roughly 9 percent versus the USD until September 2007 since the removal of the USD peg in July 2005. Despite this RMB revaluation, it remains to be doubted that the Chinese currency is currently priced at its intrinsic value.

The Chinese government has continued to push the RMB/USD relation towards a target rate, frequently buying large quantities of USD, and has accumulated more than 1.3 trillion USD. World Bank figures document that the RMB/USD exchange rate should be approximately 1.9 based on purchase power parity. Along with the peg, the SAFE has maintained a policy that does not allow Chinese citizens and firms to freely convert their RMB holdings into foreign currencies except for the annual amount of USD 50,000 whereby every transaction has to be registered with the SAFE. However, over the fruitful years of growth, many individuals and businesses have amassed large quantities of money they must now invest within China because there are only limited opportunities for international assets diversification.

First, the managed RMB convertibility isolates Chinese markets from global market mechanisms that balance the demand for and supply of RMB at its efficient price. Second, domestic liquidity faces a restricted set of investment alternatives in China. Unless they want to invest in low-yield savings accounts whose returns hardly compensate for inflation losses, retail investors and likewise restricted institutional investors will most likely divert their funds into Chinese equity markets.

This mechanism could account for some of the excessive increases Chinese equity markets have seen in the last months. It also helps to explain why the government has recently urged large Chinese firms like the Bank of China or China Citic Bank to sell shares to the public, because an increase in shares supplies could take some steam off domestic equity markets.

In its role as the national capital market regulator, the CSRC closely monitors national securities and futures markets in China. The institution is in charge of overseeing all capital market transactions, e.g. fulfilment of listing requirements at the stock exchanges, trading activity by market participants or compliance with governance principles regarding the disclosure of information. In this function, the CSRC has initiated a reform of the split share structure in Chinese equity markets.

The split share structure refers to the existence of tradable and non-tradable shares owned by the state or legal persons. When the share structure reform was launched in May 2005, about two thirds of shares in Chinese companies were non-negotiable. The following low level of free floating shares, limited transfer options for strategic holdings and lacking incentives arising from non-tradable and thus basically unpriced shares imposed enormous barriers on stock transactions and efficient capital allocation.

Hence, the CSRC began to liberate markets by initiating a pilot scheme that allowed 4 pioneer firms to convert their non-negotiable shares into freely tradable shares. Shortly after this experimental phase, another 42 pilot firms joined the project before participation was offered to all firms listed at the SHSE and the SZSE. Until July 2006, more than 80 percent of domestically listed Chinese firms had completed or were in the process of enforcing the state-shareholding reform. To make all their shares tradable, listed companies undergoing the reform had to offer additional shares or funds to private investors to compensate them for potential losses in the value of their portfolios when the publicly-owned shares are introduced to the market. According to the reform offers made public, the companies or major shareholders, by means of negotiation among stockholders, should offer about three shares per ten shares to tradable shareholders, so as to make all their shares tradable.