rocky road crossing the river - china's stock market history and issues

Jonas Short: 4123861 T12214

Introduction to Chinese Financial Markets

The Rocky Road Crossing the River: The Chinese Stock Market and I ts Current Issues

Section I: Introduction

In the year 1990 there was no stock exchange in China. In a little more than 2 decades, 2,352

companies listed on the Shanghai Stock Exchange (SSE), and the Shenzhen Stock Exchange

(SZSE) with a combined market capitalisation of $3.3 trillion US dollars. This figure is larger

than the entire gross domestic product of both Canada and Australia put together. As of 2011

the total market capitalisation of listed companies equated to 46.3% of China’s GDP (World

Bank 2011). There are over 55 million individual stock holders (Bloomberg, 2012), a figure

that was at 134.9 million in 2008 (Luo and Yao, 2009), or roughly 10% of the population.

However, given its young age and breakneck growth (London’s stock exchange was founded

in 1801, China’s market cap is larger), many problems abound in China’s stock market

modernization. This essay will seek to identify these problems followed by recommendations

to the Chinese government, but only before the unique characteristics of the Chinese stock

markets are explained. This will be followed by concluding thoughts and recommendations to

tie in China’s problems with its prospects for the future.

Section II: China’s Stock Market Idiosyncrasies

China currently operates under a segmented market meaning that there are different types of

shares and ownership structure, each with their own rules and restrictions. The segmented

ownership structure refers to the different rights that an ownership of a share can offer. There

are three different types: legal person share, state owned share, and public share. The public

shares are freely tradable as are common in most stock markets in the developed nations.

Legal person shares refer to state approved institutions, usually firms under the control of the

1



same local government (Su, 2003). The state owned shares are managed by the State Asset

Management Bureau (SAMB), the key difference is that SAMB pass on dividends to the

Ministry of Finance, meaning an institution or individual does not receive dividends unlike

legal person shares (ibid.). Xu Lilai (2011) claims that non-tradable shares (legal and state

owned shares) equate to more than two thirds of all listed shares in the SSE. Though this was

reformed by 2005 when the CRSC agreed to make all non-tradable shares available to the

public, ending decades of split-share ownership. However, the plan to do this in 2006 was

scrapped as an announcement lead shares tumbling, so the policy was never fully

implemented (De Bondt, Peltonen, and Santabarbara, 2011). However, the government did

allow firms to end split-share ownership under privately agreed terms with existing

shareholders, in some cases administering more shares to them as compensation (Yeh et. al,

2009). This is a fair compromise in my opinion, given the fact that existing tradable shares

would reduce in value if a glut of non-tradable shares suddenly became available. Indeed, all

new IPOs must make their shares tradable (Neftci, and Yuan Menager-Xu, 2007) the

difference is, some companies agreed to have shares tradable, but not in full circulation. The

segmented share classes relate to different types of shares, with different restrictions. The

share classes involve A, B, H, S, N, and L shares. A-shares are available to domestic Chinese

investors, and a small section of CRSC-approved foreign investors with a Qualified Foreign

Institutional Investor (QFII) licence. These shares are traded solely in RMB. B-shares can

only be purchased in foreign currency, so as expected, the market is a lot thinner than A-

shares; the total market capitalisation of B-shares is 0.47% of A-shares in the SSE and 2.39%

of A-shares in the SZSE (Wu, 2010). H-shares are mainland based companies, which are

listed in Hong Kong. This type of share follows the guidelines as any typical share would

when available on the Hong Kong stock exchange. The other share types also relate to

foreign listings, the L-shares and N-shares are share types which are listed on the London and

2



New York stock exchanges respectively. In February of 2001, the government permitted

domestic investors to purchase B-shares providing it was made using foreign currency

deposits. While previously, there was quite a disparity in terms of B-shares being able to

command a discount, as discovered by the work of Ahlgren, Sjo, and Zhang (2009) the A-

share premium was caught up by the B-share after February 2001. Illustrating how the

relaxation of government restrictions decreases the disparity between different share types. In

November 2002 the Chinese government permitted the sale of A-shares to foreign investors.

However, they must be approved by the CSRC for admission onto the QFII program, and are

subject to many restrictions. They are capped with how much capital these institutional

investors can deploy, as well as displaying years of experience, and holding a certain number

of assets under management. The restrictions were eased last year however; capital quota was

extended to $80bn, which is eight times more than the quota in September 2006, which

according to Ting, Yen, and Chiu (2008) at the time accounted for 10% of the total amount of

investment in both stock exchanges. In addition, firms were required to have a minimum of

$5bn dollars under management, though this has been reduced to $500mln (Financial Times,

2012). In 2005 both the Company Law and the Securities law were amended (Luo, Morgan,

and Yao, 2010) to allow short selling, margin trading, and commercial banks to invest in the

equity market. The move towards margin lending and short selling was extended in 2012, to

allow all qualified fund managers the chance to engage in these services through the

establishment of the new Centralised Securities Lending Exchange, which facilitates

borrowing securities without the need of a brokerage firm as was previously the requirement

(Financial Times, 2012). The leadership of the CSRC under Guo Shuqing appeared to be

accelerating China’s reform process; however, on March 18th 2013 he was replaced by Bank

of China chairman Xiao Gang (Bloomberg, 2013).

3



Section III: Lack of Financial Innovation

This issue encompasses three further distinctions that make the Chinese stock market unique

namely; psychology, hedging, and investment professionalism.

While psychology should be less of a determinant in pricing a stock than a firm’s

fundamentals; behavioural psychology in stock markets comes unto its own during manias.

These are extreme price-misalignments that can be attributed not to economic fundamentals,

but to a herd mentality. The consequences of the herd mentality can mean that stocks are

wildly overvalued during the boom phase, and undervalued during the bust phase. Luo and

Yao (2009) attribute three factors to investment psychology during the boom phase ‘greed’,

‘envy, and ‘speculation’, and during the bust phase ‘fear’, ‘lack of confidence’ and

‘disappointment’, Luo and Yao (2009) acknowledge that the shortcomings of behavioural

psychology are prevalent all over the world, they assert that these factors function uniquely in

China. Lim and Brooks (2009) believe that the investors in the Chinese stock market behave

like noise traders, who purely speculate, and treat the market like a casino. This issue of herd

mentality is exacerbated by restriction in financial innovation, and lack of investment

professionalism. Since the CSRC limits the use of hedging tools to offset risk, the

overvaluations in stock prices can be particularly stark. Another impact is that profits can

only be made in a bull market. Many investors are convinced that rises are the general trend

while falls are only temporary (Cheng, 2009). This tendency towards over optimism reached

a pinnacle when the average P/ E ratio of all the companies listed on the SSE was 73 in

November 2007, compared to less than 20 for the companies on the S&P 500. Considering

that in normal cases, maximum acceptable P/E ratio should not exceed the discount rate

acceptable to investors. For example, in 2000, taking the interest rate of five-year time

deposits (2.304% after deducting the interest rate tax) as the discount rate, then the maximum

4



acceptable P/E ratio is 43.4. This represents a sizeable diversion from the mean (ibid.).

However, the good times did not last, and the bubble popped when ‘fear’, and ‘lack of

confidence’ soon led to abject ‘disappointment’ as by 4 November 2008, the SSE composite

index went down to 1,707. By this time, the average P/ E ratio of Chinese companies was less

than 20 (Luo and Yao, 2009). After a period of wild volatility, rational prices begin to surface

after a crisis when normality resumes. Shiller (1981) proposes a method of analysing how

volatile a stock market is by its fluctuation post an event. It is the famous testing method of

Variance Limit. It measures the proportion of the fluctuation of share prices (variance) to that

of the post-event rational stock prices (variance), which reflect whether it is fluctuating

excessively. In the view of Cheng (2009), it can, on the whole, represent the extent of

speculation in the market. According to Shiller’s calculation, the fluctuation of the S&P 500

Index from 1878 to 1978 is 5.6 times that of the post-event rational stock prices. Cheng

(2009) selected the data sample from the Shanghai Stock Exchange from January 1993 to

December 2000 to test the variance limit, and found that fluctuation of the Shanghai Stock

Exchange Composite Index was 69 times that of the post-event rational stock prices.

However, the author feels that this is a crude analysis given that each event is different, and

therefore the market will have behaved differently. The ‘event’ could be a mania, an

unexpected political development, or a medical catastrophe, and each event would evoke a

different market response of varying severity. In any case, what is clear is that an issue of

psychology proposed by Luo and Yao (2009) has been exacerbated by a lack of viable

alternatives for capital; this all points to China’s stock market not reflecting the macro

picture. Research published by Fidelity International (2011) found that every time a country

reaches an average personal income of $5,000 per capita, their stock market booms.

However, once China surpassed that mark the SSE dropped from 6000 to roughly 2200 as of

April 2013 as evidenced in figure 1.

5



Fig 1: The 2006 boom and 2008 bust - to April 2013 (Yahoo Finance, 2013).

According to the Securities law, buying on the margin (borrowing money to buy stock) is

forbidden mainly for the sake of keeping away all possible risks and their proliferation.

However, Cheng (2009) believes that the introduction of the mechanism will assist in

guaranteeing the stable functioning of the spot market, where transactions are conducted

instantly. Liu and Shen (2000) conducted research analysing the risk of systematic failings in

the Chinese stock market as a result of a lack of alternative investment products, and found

that systematic risks account for a rather high proportion of overall risk. In the US, the UK

and France, the proportions of systematic risk to risks on the whole are 26.8%, 34.5% and

32.7%, respectively. However, in China, the proportion is high at 65.7%. Without a

mechanism allowing the necessary hedging tools to offset risks such as short selling,

developed debt markets, or a liberalized foreign exchange market, it will be very difficult to

avoid systematic risk. However, De Bondt, Peltonen and Santabarbara (2011) disagree with

the fact that a combination of Chinese herd mentality exacerbated by financial restriction

6



have been responsible for the boom and bust culture. As stated in section II, De Bondt et al

use a statistical approach to determine long-term price misalignments, and judge them as

booms and busts. Through their analysis, they have come to the conclusion that liberalizing

equity market reforms and positive excess liquidity, as measured by M2 or loan growth

beyond nominal GDP, help in explaining a significant part of the identified positive

misalignments of stock prices from their long-run equilibrium value.

In addition, a developed market needs experienced players in order to navigate the rational

path for more inexperienced individuals and institutions. In many other industries, China has

welcomed joint ventures with foreign firms in order to gain the necessary expertise to move

to a more sophisticated and innovative development stage. However, the government has

been slower to welcome foreign involvement in the Chinese stock market. Luo, Morgan and

Yao (2010) go further to assert that because of the lack of professional investment

knowledge, the Chinese investors buy shares randomly regardless of the performance of the

company. As a result, not only the banking sector stocks but virtually all the share prices have

been highly manipulated by the market index. The next section will go into greater detail

regarding how China’s retail investors have been unfairly treated as participants in their own

stock exchanges.

Section IV: Corporate Governance

The importance of effective corporate governance is difficult to overstate. This section will

discuss the Chinese deficiencies in enforcing good practice. Three themes will be underlined

within this section, namely accountability, short-term investing, and market manipulation.

7



Since the establishment of the stock market, the Chinese government has found it difficult to

relinquish majority control of State Owned Enterprises (SOEs). The stock market has mainly

been used as a tool to generate capital for expansion or –as is the case with some State

Owned Banks (Fraser and Howie 2011)- to clear-up a problematic balance sheet (Xu, 2011).

As previously mentioned in section II, the half-measure by the government of relinquishing

non-tradable shares has not fully sorted the issue of accountability in corporate governance,

the majority of shares are still not in full circulation. Indeed the fact that more than half of the

stocks are not floating has led to many consequences. It artificially magnifies the scale of

China’s stock market, greatly reduces its stability, and simplifies manipulation by the market

makers (Cheng, 2009). The market makers are defined as those that can quote both the buy

and sell prices of a stock, in other words, can dictate the movements of a company’s share

price (Radcliffe, 1997). Cheng (2009) identifies the market makers who manipulate the

Chinese stock market as often either institutional investors, fund companies, listed companies

and/or their dominant shareholders, other institutional investors and substantial capital

holders. The process of manipulation by the market makers includes five stages:

concentration of shares over time, lifting the share price, causing share price turbulence,

pushing up the share price to a high level, and then selling the shares. The key issue lies in its

unfairness, while market makers benefit, it is at the expense of the minority shareholders

(often individual investors), who are caught out by information asymmetry and are taken

along for the proverbial roller coaster ride, further driving up prices (Xu, 2011). There is

evidence that retail investors are tiring of this from reduced active brokerage accounts. Since

they make up 80% of daily turnover in the SSE and SZSE, they are a powerful force (CNBC,

2013).

8



Section V: Recommendations and Conclusion

Since the start of reform period, Deng Xiaoping has exercised caution with a gradualist

approach; crossing the river by feeling for stones. This method should continue, but at a

quicker pace. In order to make the booms and busts less stark, this essay recommends

introducing more avenues of finance. This would make the stock market less volatile as other

avenues would be explored. For example, instead of merely selling out of the stock market,

investors could have a flight to safety in Chinese government bonds, as has been the case

with the US in the financial crisis of 2008, this would make it easier for the Chinese

government to borrow money (because more demand for government bonds reduces its

interest rate), so a stimulus similar to 2008 can be applied once again to help China out of

turmoil.

A longer term measure would involve making the Chinese currency fully convertible. Given

China’s reliance on the export industry this would have to be done gradually, but a fully

convertible Yuan will allow Chinese investors to hedge their risk allowing them to sell Yuan

to invest abroad. In addition, a fully convertible currency would mean that one company

would finally be valued homogeneously because purchasing A shares in RMB would be just

as easy as purchasing H shares in HKD.

In addition, allowing more players into the market is a huge step in both correcting corporate

governance, improving the professionalism of the market, and the operation of state owned

enterprises. Recommended action involves removing the threshold of the QFII completely,

allowing foreign participants in the market. Greater professionalism will introduce a

contrarian nature to the market, making downturns shorter and less painful. For example,

during a mass selloff market, experienced foreign professionals could buy shares in a bear

market, which could help to revive the stock market in times of trouble. Furthermore, Chiu,

9



Ting, and Yen (2008) state that auditing practices would also be improved through adding

more foreign players. QFII licensees will demand that companies employ accounting

standards similar to the West. This will provide greater accountability resulting in fewer

fraudulent companies misleading domestic investors. However, Western regulators do not

necessarily guarantee against fraud, Enron was once the doyenne of the NYSE but it was

built on fraudulent accounting and lost investors billions of US dollars (PBS, 2001). This

brings me to my next point, liberalising the sell-short mechanism.

Selling short involves borrowing shares from a company and selling them immediately, with

a guarantee to buy them back at a later date hoping that the price will have dropped and

therefore pocketing the difference. The idea of making money when a stock falls in price is

often viewed with discomfort throughout the world. However, short sellers serve a vital role

in the operation of a stock market. Their incentive to find stocks which will fall in price has

meant that the short sellers often spot fraud before regulators. James Chanos was made a

well-known name around Wall Street after shorting Enron stock before the company was

revealed to be fraudulent (ibid.). In addition, short sellers serve to balance the market making

booms less pronounced and busts less painful. This is because while most market players will

drive up prices by buying with a herd like mentality, short sellers will help balance the

market by selling short the same stocks.

Allowing private shareholders to have a better say in how listed companies function will no

doubt improve performance as more accountability will usually lead to better practice, which

has been the case over the rest of the world (Tang and Wang, 2011). This will be done by

floating all shares rather than having some stock in non-full circulation. While it is clear that

the government do not want to ‘sell out’ to foreigners, a gradualist approach will suit all

parties. It will make clear that the path to further reform is consistent, sending positive signals

10



to the stock market, as well as ensuring a smooth transition as companies will get

progressively used to having private investors telling them what to do. Greater accountability

will limit the ability market makers have to manipulate investors, since multiple shareholders

are harder to collude and thus will be less inclined to commit financial crimes.

It is remarkable that China’s stock market is so early in its narrative given how fast it has

developed. However, it is not an accurate reflection of China’s macro economy. In order for

China’s stock market to be an accurate reflection of the macro environment, China must

ensure greater accountability for listed companies. In order to stem the harmful effects of the

stock market, greater liberalisation on market tools, as well as more mature alternative

markets for individuals to invest in can ensure that the stock market does not become such a

boon for savers, and a danger for the wider economy. However, should the Chinese

government take on the essay’s recommendations, it would become a truly international stock

market. Given that the stock markets will accurately reflect China’s macro economy, the

secondary market could see a tremendous boom, much the same as China’s GDP has

dramatically increased. This boom would also be more balanced given that the sell-short

mechanism would be liberalised. Previously non-tradable shares would be made available to

the public allowing for a more predictable system governed by the soundness of companies

and the will of the domestic investors, not manipulators. In order for China to reach this level,

incoming Chairman Xiao Gang must cross the river a little faster.

11



Bibliography

Ahlgren, N., Bo, S., and Zhang, J., 2009. Panel Cointegration of Chinese A and B Shares.

Applied Financial Economics, 19, 1859-71.

Chanos, J., 2002. Anyone Could Have Seen Enron Coming. PBS [online]. 6 February.

Available at: < http://www.pbs.org/wsw/opinion/chanostestimony.html> [Accessed

18th April 2013].

Cheng, S., 2009. An Analysis of China’s Stock Market in the First 10 Years. Review of

Pacific Basin Financial Markets and Policies, 12 (4), 629-653

Cookson, R., 2012. China lowers barrier to foreign investors. Financial Times [online] 21

June. Available at: < http://www.ft.com/cms/s/0/9901269a-bb6a-11e1-90e4-

00144feabdc0.html#axzz2Mn63TDcR> [Accessed on 10 March 2013].

De Bondt, G., Peltonen, T., Santabarbara, D., 2011. Booms and Busts in China’s stock

market: estimates based on fundamentals. Applied Financial Economics. 21, 287-

300.

Dongwei, S., 2003. Chinese Stock Markets: A Research Handbook. Singapore: World

Scientific Publishing.

Fidelity, 2011. A New Mr. and Mrs. Average is Coming to China [pdf] Available at: <

http://www.fidelity.com.sg/campaign/CCF/pdf/China_Market_Perspective_AnewMr

andMrsAverageiscomingtoChina.pdf> [Accessed 18th April 2013].

Frost, R., China stock investors empty 45,000 trading accounts amid rebound. Bloomberg

News, [online] 27 December. Available at: http://www.bloomberg.com/news/2012-

12

http://www.bloomberg.com/news/2012-12-27/china-stock-investors-empty-45-000-trading-accounts-amid-rebound.html

http://www.fidelity.com.sg/campaign/CCF/pdf/China_Market_Perspective_AnewMrandMrsAverageiscomingtoChina.pdf

http://www.fidelity.com.sg/campaign/CCF/pdf/China_Market_Perspective_AnewMrandMrsAverageiscomingtoChina.pdf

http://www.ft.com/cms/s/0/9901269a-bb6a-11e1-90e4-00144feabdc0.html#axzz2Mn63TDcR

http://www.ft.com/cms/s/0/9901269a-bb6a-11e1-90e4-00144feabdc0.html#axzz2Mn63TDcR

http://www.pbs.org/wsw/opinion/chanostestimony.html



12-27/china-stock-investors-empty-45-000-trading-accounts-amid-rebound.html

[Accessed 9 March 2013].

Howie, F.J.T., Walter, C.E., 2011. Red Capitalism: The Fragile Foundation of China’s

Extraordinary Rise. New Jersey: John Wiley & Sons.

Lee, T.S., Shu, P.G., Sui, Y.H., Yeh, Y.H., 2009. Non-Tradable Share Reform and Corporate

Governance in the Chinese Stock Market. Corporate Governance: An International

Review, 17(4), 457–475.

Lim, K.P., and Brooks, R.D., (2009). Price limits and stock market efficiency:

evidence from rolling bicorrelation test statistics. Chaos, Solitons and Fractals, 40(3), 1271-

1276.

Liu, S. and Shen, P., 2000. Chinese Capital Market Theoretical Research Collection. Beijing:

Social Science Literature Press.

Luo, D., Morgan S., Yao, S., 2010. Bank share prices and stock market integration in Greater

China. Journal of the Asia Pacific Economy, 15 (4), 388-395

Luo, D., Yao, S., 2009. The Economic Psychology of Stock Market Bubbles in China. The

World Economy. Oxford: Blackwell Publishing Ltd.

Neftci, S., Yuan Menager-Xu, M., 2007. China’s Financial Markets: An Insider’s Guide to

How the Markets Work. California: Elseview Academic Press.

Radcliffe, R.C., 1997. Investment: Concepts, Analysis, Strategy. Reading: Addison-Wesley

Education Publishers.

Ranasignhe, D., 2013. Will 2013 Bring More Pain or Gain for Chinese Stocks? CNBC

[online]. Available at: < http://www.cnbc.com/id/100313560 > [Accessed 20th

March 2013].

13

http://www.cnbc.com/id/100313560

http://www.bloomberg.com/news/2012-12-27/china-stock-investors-empty-45-000-trading-accounts-amid-rebound.html



Sender, H., 2012. China set to bolster short selling. Financial Times [online] 4 January.

Available at: <http://www.ft.com/cms/s/0/f9356138-36aa-11e1-9ca3-

00144feabdc0.html#axzz2Mn63TDcR> [Accessed on 10 March 2013].

Shiller, R.J., 1981.Do Stock Prices Move too Much to be Justified by Subsequent Changes in

Dividends? American Economic Review, 76, 421-436.

Tang, K., and Wang, C., 2011. Corporate Governance and Firm Liquidity: Evidence from the

Chinese Stock Market. Emerging Markets Finance & Trade, 47 (1), 47-60.

Ting, W., Yen, S.H., Chi, C.L., 2008. The influence of Qualified Foreign Institutional

Investors on the Association between Default Risk and Audit Opinions: Evidence

from the Chinese Stock Market. Corporate Governance: An International Review,

16 (5), 400-417.

World Bank: http://data.worldbank.org/indicator/CM.MKT.LCAP.GD.ZS/countries.

Xu, L., 2011. China's economy in the post-WTO environment: stock markets, FDI and

challenges of sustainability. Cheltenham: Edward Elgar.

Yahoo, 2013. Shanghai Composite Index. [online] Available at: <

http://uk.finance.yahoo.com/echarts?

s=000001.SS#symbol=000001.ss;range=5y;compare=;indicator=volume;charttype=area;cro

sshair=on;ohlcvalues=0;logscale=off;source=undefined;> [Accessed 22 April 2014].

14

http://uk.finance.yahoo.com/echarts?s=000001.SS#symbol=000001.ss;range=5y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;



http://data.worldbank.org/indicator/CM.MKT.LCAP.GD.ZS/countries

http://www.ft.com/cms/s/0/f9356138-36aa-11e1-9ca3-00144feabdc0.html#axzz2Mn63TDcR

http://www.ft.com/cms/s/0/f9356138-36aa-11e1-9ca3-00144feabdc0.html#axzz2Mn63TDcR

rocky road crossing the river - china's stock market history and issues

Documents