Description
The purpose of this paper is to examine the changes in B-share discounts across 76
Chinese stocks around an important regulatory event to understand the importance of political risk in
pricing stocks in emerging markets
Journal of Financial Economic Policy
A (partial) resolution of the Chinese discount puzzle: The 2001 deregulation of the B-
share market
G. Andrew Karolyi Lianfa Li Rose Liao
Article information:
To cite this document:
G. Andrew Karolyi Lianfa Li Rose Liao, (2009),"A (partial) resolution of the Chinese discount puzzle",
J ournal of Financial Economic Policy, Vol. 1 Iss 1 pp. 80 - 106
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A (partial) resolution
of the Chinese discount puzzle
The 2001 deregulation of the B-share market
G. Andrew Karolyi
Department of Finance, Fisher College of Business, Ohio State University,
Columbus, Ohio, USA
Lianfa Li
Department of Finance, School of Economics, Peking University, Beijing,
People’s Republic of China, and
Rose Liao
Department of Finance, Fisher College of Business, Ohio State University,
Columbus, Ohio, USA, and
Department of Finance and Economics, Rutgers Business School,
Rutgers, The State University of New Jersey, Newark, New Jersey, USA
Abstract
Purpose – The purpose of this paper is to examine the changes in B-share discounts across 76
Chinese stocks around an important regulatory event to understand the importance of political risk in
pricing stocks in emerging markets.
Design/methodology/approach – On February 19, 2001, the Chinese Securities Regulatory
Commission announced that Chinese residents would be allowed to own B-share classes of stocks
traded on both the Shanghai and Shenzhen stock markets. These share classes were previously
restricted to foreign investors while domestic residents were only permitted to hold A-share classes of
stock and were typically priced at a signi?cant discount. This regulatory change triggered a dramatic
decline of prevailing B-share discounts from 80 percent down to 40 percent.
Findings – The paper ?nds that the largest declines in the B-share discounts around this regulatory
event are concentrated in the ?rms with low government ownership stakes and are unrelated to the
?rms’ risks, relative supplies of shares outstanding and liquidity attributes.
Research limitations/implications – This surprising ?nding challenges the current wisdom
about what in?uences the B-share discount and particularly the role of political risk in explaining the
discount puzzle.
Originality/value – The paper offers an alternative interpretation for the B-share discount puzzle.
The ?ndings have important implications for China’s future ?nancial liberalization policies.
Keywords China, Political risk, Market segmentation, Stocks
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – F30, G32, G15
The authors thank Bai DongMing of the Asset Management Division of WanGuo Securities
for extensive discussions about the markets in China during February 2001. Comments from
Yakov Amihud, Warren Bailey, Cheol Eun, Roger Loh, Albert Menkveld, Asani Sarkar,
Ann Sherman, and Rene´ Stulz greatly improved the paper. The Dice Center for Financial
Economics provided ?nancial support. All remaining errors are the authors’ own.
JFEP
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Journal of Financial Economic Policy
Vol. 1 No. 1, 2009
pp. 80-106
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576380910962394
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1. Introduction
Interest in foreign equity markets, especially in emerging economies, has continued to
expand over the past decade. Even recent crises have not stopped global investors from
seeking higher returns and international diversi?cation opportunities in foreign stock
markets. In many markets, foreign investors still have to contend with investment
barriers in the form of restrictions on foreign equity ownership. Such barriers are of
particular interest because the limits they impose can induce a form of capital market
segmentation in which foreigners can trade local equities among themselves at a price
premium (or discount) relative to those shares traded by local investors. Segmentation
in the form of premiums and discounts on shares around the world with foreign
ownership restrictions has received considerable attention in the ?nance and
economics literature because it helps to understand what drives the demand for
cross-border investments in the ?rst place[1]. Researchers have rationalized the
existence of these premiums/discounts with hypotheses about differences in risk,
turnover and liquidity, differences in general supply and demand conditions of
restricted and unrestricted shares, as well as the asymmetry of information or risk
tolerances between foreign and local investors.
Foreign ownership restrictions in China’s stock market have been especially
perplexing for researchers because large and persistent price discounts, rather than the
usual premiums, have continued to exist for those shares restricted to foreign investors
(B-shares) relative to those only available to domestic residents (A-shares). Researchers
have rationalized the Chinese B-share discount (on average 80 percent) with
hypotheses about differences in risk (Bailey, 1994; Eun et al., 2001), in turnover and
liquidity (Chen et al., 2001), in general supply and demand conditions of restricted and
unrestricted shares (Sun and Tong, 2000), in the asymmetry of information between
foreign and local investors (Chan et al., 2008; Chakravarty et al., 1998; Chen et al., 2004),
as well as in behaviors (Mei et al., 2004). However, a consensus has not yet emerged.
As puzzling as is China’s B-share discount, another mystery has attracted more
attention; namely, how China has experienced the fastest economic growth with such a
weak legal and institutional environment. Allen et al. (2005) argue that China’s fast
economic growth is driven mainly by the private sector rather than through the
activities of the larger state-owned enterprises (SOEs). Indeed, considerable research
has focused on the economic effects of the dominance of state-ownership in the A-share
market. Contrary to research in other countries that shows how ?rms bene?t from
political connections, most of these papers on the A-share market unambiguously point
out the detrimental effect of government ownership in China[2]. Firms with high state
ownership have lower Tobin’s q ratios (Tian, 2001; Bai et al., 2004; Wei and Varela,
2003) and worse ?nancial operating performance (Qi et al., 2000). Firms with high state
ownership experience signi?cantly negative returns around the announcement of
related-party transactions with controlling interests in SOEs (Cheung et al., 2008).
Firms with higher state ownership and legal entity ownership are more likely to be
accused of fraud (Chen et al., 2006). Firms with politically-connected CEOs experience
signi?cantly worse post-initial public offerings (IPO) long-termstock returns (Fan et al.,
2007).
Undoubtedly, state ownership plays an important, if not paramount, role in
explaining Chinese ?rms’ valuations. A natural question arises whether the level of
state ownership can explain the B-share discount. If investors in the B- and A-share
Resolution of the
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markets have different perceived bene?ts (costs) of state ownership, the answer would
be yes. In fact, Fernald and Rogers (2002) study a panel of ?rms that have both A- and
B-shares from 1993 to 1997 and ?nd that foreign investors did pay relatively less for
stocks with high state ownership. One limitation of their study is that it is dif?cult to
ascertain just how economically important state ownership is for the discount puzzle.
Their study focuses on a period in which the level of state ownership did not change
and, more importantly, there was little temporal variation in the B-share discounts. As
a result, endogeneity problems likely inhibit analysis of the economic effects; do
investors choose to price a bigger discount for B-shares of ?rms with higher levels of
share ownership or has the state chosen to relinquish its stake in those ?rms with
lower discounts? One way to circumvent these limitations is by means of an exogenous
event that induces a signi?cant change in the B-share discount and one that we could,
in turn, use to identify whether the consequences were different for ?rms with different
levels of state ownership.
This paper exploits one such unique event which took place in 2001. On February
19, 2001, the Chinese Securities and Regulatory Commission (CSRC) announced that
Chinese residents would be allowed to own B-shares previously restricted to foreign
investors. The elimination of the foreign ownership restriction in China would have
predictably reduced the B-share discount and the consequence of this impact would
have been greater for those Chinese ?rms in which the foreign investors priced in the
larger premium for the level of state ownership. Indeed, we ?nd that the average
B-share discount declined from 80 percent before the event to 40 percent by the end of
2001, but strikingly the “new” investors intensively pursued B-shares of those ?rms
with lower, not higher, levels of state ownership. On average, ?rms with no state
ownership experienced a 15 percent larger discount decline than those with higher
state ownership. Furthermore, portfolios of B-shares with lower levels of state
ownership experienced a statistically signi?cant and economically large 7 percent
abnormal return around this two-week period relative to those with higher state
ownership.
Our cross-sectional regression analysis before and after the regulatory change
con?rms that B-share investors before the rule change undervalued stocks with higher
state ownership on a relative basis (the discount difference between the highest
state-ownership ?rms and lowest state ownership ?rms is 20 percent), but also shows
that B-share investors after the event undervalued stocks with higher state ownership
with even greater intensity (the average discount difference between the highest
state-ownership ?rms and lowest state ownership ?rms grew to 35 percent). What we
can infer is that those investors that took advantage of the new opportunity to enter
the B-share market after February 2001 appear to be just as wary of state ownership as
the previous foreign investors, and even more so at the margin. Existing studies
indicate that foreign investors command a higher premium for state ownership than
domestic investors, so we might expect that opening up the B-share market would
dissipate the higher premium for B-shares. We provide evidence that these investors
were mostly comprised of domestic Chinese residents – rather than new or existing
foreign investors – and that they priced the B-shares with high levels of state
ownership at a discount similar in magnitude to that by foreign investors. We explore
several alternative hypotheses later in the paper to sharpen this inference.
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Our paper is not the only study that has exploited the February 2001 event to examine
the B-share discount. The other studies, however, focus on other potential drivers of the
discount change around the event[3]. Our paper, however, is the ?rst to document a shift
of perceived political risk and its valuation consequences due to the participation of
different groups of investors during the event[4]. Indeed, this contribution is important
as we ?nd that the level of state ownership is the only statistically signi?cant variable in
the cross-sectional regression explaining discount changes. In terms of explanatory
power, it can explain 60 percent of the cross-sectional variation in discount changes. Our
paper also contributes importantly to the large existing literature on the B-share
discount puzzle in China, to the broader literature on foreign ownership restrictions and
equity price premiums, and ?nally to the newer burgeoning literature on the pricing of
political risk, privatizations and stock market development in emerging economies.
The next section provides a brief description of China’s stock exchanges and offers
institutional details about the CSRC announcement in 2001. Section 3 describes the
data, research design and results. Section 4 discusses several alternative hypotheses
and some anecdotal evidence along with our interpretation of the ?ndings. Section 5
summarizes the paper. We speci?cally discuss why we title our paper only a “partial”
resolution of the B-share puzzle and outline the institutional developments in this
market since 2001.
2. CSRC’s opening of the B-share market in 2001
Prior to 1992, foreign investors were not allowed to trade China’s stock. In 1992, the
CSRC allowed companies to issue so-called “special shares” that were restricted for
trading by foreign investors, denominated in either Hong Kong dollars (traded in
Shenzhen) or US dollars (traded in Shanghai). While these “special shares” later were
designated B-shares, the shares tradable by domestic residents were called A-shares.
The Securities Law of China (passed on July 1, 1999) explicitly recognized the equal
status of shareholders of both A- and B-shares[5]. Among over 1,250 A-shares, there
are only 86 stocks with simultaneous A- and B-share listings as of 2006 (Financial
Times, 2006). Overall, the B-share market has constituted a smaller proportion of the
total market capitalization and has been much less actively traded during the past
decade (Table 1 of Chen et al., 2001).
In a surprise announcement by the CSRC on February 19, 2001 (with the of?cial
approval of the State Council as of 11 a.m. of that day), domestic investors were
allowed to open trading accounts for B-shares. Immediately, both the Shanghai and
Shenzhen Stock Exchanges (the two major exchanges in China) suspended trading in
B-shares from February 20 through 23. Brokerages in China were inundated with so
many applications to open accounts (with minimum fund requirement of US$1,000)
that the CSRC extended the trading suspension imposed on B-shares for two more days
until February 28[6]. On February 28, 2001, the Shanghai and Shenzhen B-share
markets opened and many stocks hit their 10 percent daily price limits within hours
restraining potential trading volumes. Eventually, by early March 2001, B-share prices
increased dramatically and trading volumes were unusually high[7].
Figure 1 shows the distribution of the price ratio of A- to B-shares for our sample of
76 Shanghai and Shenzhen stocks during this period and demonstrates a dramatic
decline in the B-share discount. The median A-to-B share price ratio ?uctuated around
6-to-1 through much of 2000 and fell to below 4-to-1 at the end of 2000. Following the
Resolution of the
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market closure in the last ten days of February 2001, the median A-to-B price ratio
declined to just above 1-to-1 and remained until the end of 2001. We will present more
formal statistics of the magnitude of this B-share discount decline in the next section.
3. Data, research design and results
3.1 Data
To conduct our study, we require data on share prices as well as ?rm characteristics.
Datastream International is used to collect daily closing prices, trading volumes and
the numbers of shares outstanding data for 76 Chinese stocks listing both A- and
B-shares. These 76 stocks are evenly split between the Shanghai Stock Exchange
(SHSE) and the Shenzhen Stock Exchange (SZSE). We also obtain the foreign exchange
rates of the Chinese renminbi (Rmb.) yuan relative to the US dollar and Hong Kong
dollar, the local A-share index return, the local B-share index return and the Morgan
Stanley Capital International World Market Index (MSCI index) returns. China’s Wind
Info Company (www.wind.com.cn) has an equity database with ?nancial statement
data and is our source for the levels of state ownership as of 2001. We also checked
these data by hand with the of?cial websites of SHSE and SZSE.
Table I presents univariate tests of the changes in the B-share discounts around the
opening of the B-share market in February 2001. We examine average daily discounts
for each stock during the periods before and after February 2001 and test whether the
differences were signi?cantly different from zero. We also report similar tests for the
ratio of shares outstanding (denoted as SO
B
/(SO
A
þ SO
B
) where SO
i
is the shares
outstanding for share class i ), market cap, relative volatility (denoted as s
B
/s
A
, where s
i
is the standard deviation of the returns for share class i ), the volume ratio (or VO
B
/(VO
A
þ VO
B
) where VO
i
is the shares traded for share class i ), the cumulative past-one-month
returns performance on the A-shares (or Momentum), and for two market betas
from market model regressions of the A-shares on an equally weighted-index of
all A-share stocks (b
M
A
) and of the B-shares on the MSCI index (b
W
B
), respectively.
Figure 1.
Relative prices of A- to
B-shares for Chinese
stocks on Shenzhen and
Shanghai exchanges
0
5
10
15
20
25
01/1999 04/1999 07/1999 10/1999 01/2000 04/2000 07/2000 10/2000 01/2001 04/2001 07/2001 10/2001
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.
7
3
0
6
0
1
.
9
5
8
0
.
5
7
3
1
.
8
7
5
2
.
3
4
0
B
e
f
o
r
e
v
s
a
f
t
e
r
t
-
s
t
a
t
i
s
t
i
c
2
5
.
4
8
N
A
2
2
.
9
8
2
1
2
.
8
0
2
0
.
0
4
2
1
.
8
8
2
1
.
9
7
2
1
.
1
9
2
6
.
5
8
(
p
-
v
a
l
u
e
)
(
0
.
0
0
)
N
A
(
0
.
0
0
)
(
0
.
0
0
)
(
0
.
9
7
)
(
0
.
0
6
)
(
0
.
0
0
)
(
0
.
2
3
)
(
0
.
0
0
)
P
a
n
e
l
C
.
C
o
r
r
e
l
a
t
i
o
n
s
(
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
,
2
0
0
1
b
e
l
o
w
d
i
a
g
o
n
a
l
,
a
f
t
e
r
A
p
r
i
l
1
,
2
0
0
1
a
b
o
v
e
d
i
a
g
o
n
a
l
)
A
v
e
r
a
g
e
d
i
s
c
o
u
n
t
1
.
0
0
0
0
.
0
8
5
0
.
0
3
0
0
.
5
9
4
0
.
3
5
9
0
.
1
5
3
0
.
1
9
3
2
0
.
1
3
6
0
.
0
6
8
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
0
.
2
0
3
1
.
0
0
0
0
.
3
0
7
0
.
2
0
5
2
0
.
3
7
2
0
.
1
1
0
2
0
.
0
6
4
2
0
.
0
8
0
2
0
.
0
3
0
M
a
r
k
e
t
c
a
p
2
0
.
2
0
3
0
.
3
3
2
1
.
0
0
0
0
.
2
2
7
2
0
.
2
4
9
2
0
.
0
6
3
2
0
.
1
4
5
2
0
.
1
1
2
2
0
.
0
5
8
V
o
l
u
m
e
r
a
t
i
o
0
.
4
8
8
0
.
1
7
7
0
.
1
7
1
1
.
0
0
0
0
.
3
9
9
0
.
0
8
5
2
0
.
0
3
0
2
0
.
0
3
3
0
.
0
0
9
(
c
o
n
t
i
n
u
e
d
)
Table I.
Summary statistics of
Chinese B-share
discounts and other
attributes before and
after February 19, 2001
Resolution of the
Chinese discount
puzzle
85
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
v
e
r
a
g
e
d
i
s
c
o
u
n
t
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
a
s
o
f
2
0
0
1
M
a
r
k
e
t
c
a
p
(
R
m
b
,
m
i
l
l
i
o
n
s
)
V
o
l
u
m
e
r
a
t
i
o
(
V
O
B
/
V
O
A
þ
B
)
R
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
/
S
O
A
þ
B
)
R
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
(
s
B
/
s
A
)
M
o
m
e
n
t
u
m
L
o
c
a
l
m
a
r
k
e
t
b
e
t
a
s
o
f
A
-
s
h
a
r
e
s
W
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
s
R
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
0
.
1
2
1
2
0
.
3
5
7
2
0
.
3
0
2
0
.
3
6
5
1
.
0
0
0
2
0
.
0
8
6
0
.
0
4
3
0
.
1
3
7
2
0
.
0
7
6
R
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
0
.
1
1
5
0
.
2
3
6
0
.
1
9
9
0
.
6
0
6
0
.
0
8
4
1
.
0
0
0
2
0
.
0
1
7
2
0
.
5
0
7
2
0
.
0
4
6
M
o
m
e
n
t
u
m
0
.
4
1
2
2
0
.
0
9
1
2
0
.
2
3
3
0
.
0
0
3
0
.
0
3
5
2
0
.
2
4
2
1
.
0
0
0
0
.
1
3
4
0
.
1
6
1
L
o
c
a
l
m
a
r
k
e
t
B
e
t
a
s
o
f
A
-
s
h
a
r
e
s
2
0
.
2
3
6
2
0
.
1
2
7
0
.
0
2
1
2
0
.
2
6
2
2
0
.
0
2
2
2
0
.
1
9
1
2
0
.
2
1
8
1
.
0
0
0
0
.
2
2
4
W
o
r
l
d
m
a
r
k
e
t
B
e
t
a
s
o
f
B
-
s
h
a
r
e
s
0
.
2
6
4
2
0
.
1
5
2
2
0
.
2
8
4
0
.
0
9
7
0
.
1
1
9
0
.
0
8
4
0
.
1
9
5
2
0
.
0
6
4
1
.
0
0
0
N
o
t
e
s
:
T
h
e
d
i
s
c
o
u
n
t
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
d
i
f
f
e
r
e
n
c
e
b
e
t
w
e
e
n
t
h
e
c
l
o
s
i
n
g
A
-
s
h
a
r
e
s
t
o
c
k
p
r
i
c
e
(
P
A
)
a
n
d
c
l
o
s
i
n
g
B
-
s
h
a
r
e
s
t
o
c
k
p
r
i
c
e
(
P
B
)
o
n
a
c
u
r
r
e
n
c
y
-
a
d
j
u
s
t
e
d
b
a
s
i
s
d
i
v
i
d
e
d
b
y
A
-
s
h
a
r
e
p
r
i
c
e
a
s
(
(
P
A
2
P
B
)
/
P
A
)
;
n
u
m
b
e
r
o
f
d
a
y
s
i
s
t
h
e
d
a
i
l
y
o
b
s
e
r
v
a
t
i
o
n
s
a
v
a
i
l
a
b
l
e
f
r
o
m
J
a
n
u
a
r
y
2
,
2
0
0
0
t
h
r
o
u
g
h
D
e
c
e
m
b
e
r
3
1
,
2
0
0
1
;
t
h
e
p
e
r
i
o
d
f
r
o
m
F
e
b
r
u
a
r
y
1
,
2
0
0
1
t
o
M
a
r
c
h
3
1
,
2
0
0
1
i
s
e
x
c
l
u
d
e
d
;
g
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
i
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
C
h
i
n
e
s
e
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
i
n
t
h
e
e
n
t
e
r
p
r
i
s
e
;
S
O
B
/
S
O
A
þ
B
i
s
t
h
e
f
r
a
c
t
i
o
n
o
f
B
-
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
)
t
o
t
o
t
a
l
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
A
þ
B
)
;
r
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
(
s
B
/
s
A
)
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
r
a
t
i
o
o
f
t
h
e
t
r
a
i
l
i
n
g
o
n
e
-
m
o
n
t
h
s
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
o
f
d
a
i
l
y
r
e
t
u
r
n
s
o
n
A
a
n
d
B
s
h
a
r
e
s
,
r
e
s
p
e
c
t
i
v
e
l
y
;
V
O
B
/
V
O
A
þ
B
i
s
v
o
l
u
m
e
r
a
t
i
o
o
f
a
v
e
r
a
g
e
d
a
i
l
y
t
r
a
d
i
n
g
v
o
l
u
m
e
o
f
B
s
h
a
r
e
s
(
V
O
B
)
r
e
l
a
t
i
v
e
t
o
a
v
e
r
a
g
e
d
a
i
l
y
t
o
t
a
l
v
o
l
u
m
e
o
f
A
a
n
d
B
s
h
a
r
e
s
(
V
O
A
þ
B
)
;
m
a
r
k
e
t
c
a
p
i
s
i
n
l
o
g
s
a
n
d
d
e
n
o
m
i
n
a
t
e
d
i
n
y
u
a
n
;
m
o
m
e
n
t
u
m
i
s
t
h
e
c
u
m
u
l
a
t
i
v
e
p
a
s
t
-
o
n
e
-
m
o
n
t
h
r
e
t
u
r
n
s
o
n
A
s
h
a
r
e
s
;
l
o
c
a
l
m
a
r
k
e
t
B
e
t
a
s
o
f
A
-
s
h
a
r
e
s
i
s
c
o
m
p
u
t
e
d
u
s
i
n
g
O
L
S
w
i
t
h
d
a
i
l
y
r
e
t
u
r
n
s
o
v
e
r
t
h
e
t
r
a
i
l
i
n
g
m
o
n
t
h
o
f
A
-
s
h
a
r
e
s
o
n
a
n
e
q
u
a
l
l
y
-
w
e
i
g
h
t
e
d
i
n
d
e
x
o
f
a
l
l
A
-
s
h
a
r
e
s
a
n
d
w
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
s
i
s
c
o
m
p
u
t
e
d
u
s
i
n
g
O
L
S
w
i
t
h
d
a
i
l
y
r
e
t
u
r
n
s
o
v
e
r
t
h
e
t
r
a
i
l
i
n
g
m
o
n
t
h
o
f
B
-
s
h
a
r
e
s
o
n
t
h
e
M
S
C
I
i
n
d
e
x
;
t
w
o
c
o
r
r
e
l
a
t
i
o
n
t
a
b
l
e
s
f
o
r
e
a
c
h
s
u
b
s
a
m
p
l
e
(
p
r
e
-
a
n
d
p
o
s
t
-
e
v
e
n
t
)
a
r
e
r
e
p
o
r
t
e
d
i
n
P
a
n
e
l
C
;
n
u
m
b
e
r
o
f
o
b
s
e
r
v
a
t
i
o
n
s
i
s
7
6
Table I.
JFEP
1,1
86
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
Other statistics reported include the sample standard deviation, skewness, kurtosis, as
well as t-statistic associated with the null hypothesis that the variable of interest is equal
across the two subperiods. Panel C presents the correlations among these variables
before February 2001 (belowthe diagonal) and after February 2001 (above the diagonal).
The average B-share discount declines from 79.5 to 43.4 percent around February
2001, and this change is statistically signi?cantly different from zero (t-statistic of
25.5). There is greater cross-sectional dispersion in the discounts after the rule change.
We also observe statistically signi?cant increases in the B-share volume ratio, market
cap (though the magnitude is small), and in world market betas of the B-shares. The
statistically signi?cant but economically modest 4 percent A-share momentum
observed in the month before February 2001 is reversed in the month after the rule
change. The correlation between the discount and the government ownership stake is
positive (0.203) before B-share market opened up, but it declines signi?cantly
afterward (0.085). The other variables with noteworthy correlations include the volume
ratio, which is positively correlated with the discount before (0.489) and after the rule
change (0.594), and the ratio of shares outstanding, which is large and positive after
February 2001 (0.359), but smaller before that date (0.129).
3.2 Estimation methods
We estimate multivariate regression models of the B-share discounts computed before the
B-share market opened upandafterward, as well as of the change inthe B-share discounts
over this period. One important concern is that we measure as accurately as possible the
immediate impact of the rule change on the markets, but with as little statistical noise due
to imprecise measurement as possible. The tradeoff concerns the period over which to
measure the B-share discounts before and after the event as well as a number of the
control variables. We attempted various sample periods but report the results using
the “Before” period from February 1, 2001 through February 19, 2001 and the “After”
period from February 28 to April 1, 2001. All estimation is with ordinary least squares
(OLS) using t-statistics based on standard errors robust to heteroscedasticity using
White (1980).
The following regression models are estimated:
Discount
it
¼ g
0
þg
1
Govt ownership
it
þg
2
D_own
it
þg
3
VO
B
VO
AþB
it21
þg
4
SO
B
SO
AþB
it21
þg
5
MCAP
it21
þg
6
ðMomentumÞ
it21
þg
7
sA
sB
it21
þg
8
b
M
Ait21
þg
9
b
W
Bit21
þg
10
I
Shanghai;i
þ1
it
;
ð1Þ
DDiscount
it
¼ d
0
þd
1
Govt ownership
it
þd
2
D_own
it
þd
3
VO
B
VO
AþB
it21
þd
4
SO
B
SO
AþB
it21
þd
5
MCAP
it21
þd
6
ðMomentumÞ
it21
þd
7
sA
sB
it21
þd
8
b
M
Ait21
þd
9
b
W
Bit21
þd
10
I
Shanghai;i
þ1
it
;
ð2Þ
Resolution of the
Chinese discount
puzzle
87
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
where Discount
it
and DDiscount
it
denotes the pre- and post-event discount (a positive
value denotes a discount) and the change in the discount for ?rm i. The subscript t
denotes the period after the event and t 2 1 denotes that before the event. Govt
ownership
it
denotes the state ownership level in 2001 and D_own
it
is a dummy variable
that is equal to one if the ?rm’s government ownership in 2001 is equal to zero. We also
introduce a dummy variable for those stocks traded on the SHSE (I
Shanghai
). The rest of
the variables are as de?ned above.
Our central hypothesis outlines what we expect for the government ownership in
the B-share discount regression models in equations (1) and (2). Based on Fernald and
Rogers (2002), we expect a positive relationship (g
1
. 0) before the rule change and that
this relationship should weaken after the B-share market opened up (d
1
, 0). The dummy
variable for ?rms with no state ownership stakes are designed to capture potential
non-linearity in this relationship; we expect that the discount should be smaller for these
?rms (g
2
, 0) and that this difference should decline after the rule change (d
2
, 0).
We have expectations about the control variables in these equations. The volume
ratio is a (inverse) proxy for the relative liquidity in the A- and B-share markets, which
studies by Chen et al. (2001) have found to be important for the B-share discount puzzle.
If the liquidity hypothesis is correct, more liquid and thus more actively traded
B-shares should be associated with a smaller discount (g
3
, 0) and this should weaken
toward zero if the B-share market opens up (d
3
. 0). The differential demand
hypothesis is based on a model by Stulz and Wasserfallen (1995). They propose that
demand functions for domestic and foreign investors differ in terms of price elasticity.
Their model would predict that the B-share discount is smaller as foreign demand
increases[8]. As an empirical proxy, we use the ratio of outstanding B-shares to total
outstanding shares. In equilibrium, of course, the distinction between measures of
supply and demand may not be clear. If outstanding shares are primarily determined
by supply of shares by ?rms rather than demand by investors, we may observe the
discount across ?rms as a positive function of the ratio of B-shares to total shares
outstanding (g
4
. 0)[9]. After the rule change, the discount should decline more for
?rms with greater excess supply (d
4
, 0).
The differential risk hypothesis – ?rst delineated by Bailey (1994) for China and
later tested by Ma (1996) and Eun et al. (2001) – proposes that price differences are
in?uenced by investors’ attitudes toward risk. Since Chinese investors cannot readily
diversify overseas, the B-share discount will be greater the lower the systematic
exposures of the A-shares relative to other A-shares traded in China (g
8
, 0) and the
higher the systematic exposures of the B-shares relative to world market returns
(g
9
. 0). Sun and Tong (2000), Chen et al. (2001) and Eun et al. (2001) test the
hypothesis between the discount and these risks, but they uncover mixed evidence. We
also consider the volatility ratio as a proxy for relative risks and would predict that
higher relative total risk of B-shares should be associated with a larger B-share
discount (g
7
. 0). All three of these risk sensitivities should diminish toward zero with
the rule change (d
8
. 0, d
9
, 0 and d
7
, 0). Finally, the asymmetric information
hypothesis suggests that B-shares trade at a discount because foreign investors have
less information than local investors (due to language barriers, different accounting
rules). Following Sun and Tong (2000) and Chen et al. (2001), we would expect that this
disadvantage is smaller for larger ?rms, so g
5
is expected to be negative, but that this
would diminish after the B-share market opens up (d
5
. 0).
JFEP
1,1
88
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Y
U
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A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
The second experiment in our study constructs portfolios of stocks based on the
level of state ownership and the tests for differences in their risk-adjusted returns
performance during the event period. We estimate a system of equations using
Zellner’s (1962) seemingly-unrelated (SUR) model and a multi-index returns generating
model for daily A- and B-share returns, respectively:
R
iPt
¼a
P
þb
PB
R
B
iMt
þb
PA
R
A
iMt
þg
P
D
it
þb
PBD
R
B
iMt
£D
it
þb
PAD
R
A
iMt
£D
it
þ1
it
: ð3Þ
D
it
is a dummyvariable that is equal to one if t is between February 28, 2001 and March 6,
2001 for the period (?rst ?ve trading days) that Chinese residents were allowed to trade
B-shares, and zero, otherwise. R
iPt
is the return on an equally-weighted portfolio of
A-share or B-share stocks in quintile portfolio P sorted according to the level of state
ownership of shares in 2001. Equally-weighted A- and B-share index returns (R
A
iMt
and
R
B
iMt
, respectively) are translated using that day’s prevailing exchange rate into either
Hong Kong or US dollar-denominated returns depending on the ?rm’s traded exchange
for the B-shares. The sample period is the same as that for the cross-sectional regressions
starting from February 1, 2001 and ending on March 31, 2001. We estimate the SUR
model for quintile portfolios by level of state ownership and apply the Gibbons et al.
(1989) test that the intercepts, a
P
, are jointly equal to zero, distributed as an F-statistic, to
measure whether the returns different from each other on a risk-adjusted basis. We also
compute a supplementary test whether the risk-adjusted returns are signi?cantly
different during the period of the rule change by evaluating whether a
P
þ g
P
are equal
across the ?ve portfolios. Finally, the same tests are computed for the extreme (highest
and lowest state-ownership level quintile) portfolios only.
3.3 Results
Table II reports the cross-sectional regression results. The dependent variables for
Panels A, B and C are, respectively, the average B-share discount before and after the
opening of the B-share market and the change in the average discount from the pre- to
post-event period. We report a series of univariate and then one multivariate
speci?cation (always Model 9 in each panel) with coef?cient estimates, associated
t-statistics and the adjusted R
2
.
State ownership is the only ?rm characteristic that signi?cantly affects the discount
levels and changes. Before February 19, 2001 (in Panel A), B-share investors (foreign
investors) penalize by way of a larger B-share discount those ?rms with higher
government ownership. The coef?cient in Model 2 is statistically signi?cant and
positive (0.157) and that in Model 9 with all the control variables is of a similar
magnitude (0.148). To get a sense of the economic importance, a ?rm with 75 percent
state ownership (the highest in our sample) has a 19 percent higher discount than a
?rm with no state ownership. Given the average discount level is 80 percent during this
period, a 19 percent change in discount level is substantial; it is equivalent to 24 percent
higher discounts for ?rms with high state ownership. After February 19, 2001 (Panel
B), the penalty that B-share investors impose on ?rms with high state ownership does
not abate, but even widens further. The coef?cient is 0.268 in Model 2 and 0.274 in
Model 9 with all the controls. A ?rm with 75 percent state ownership now has an even
larger 33 percent higher discount than a ?rm with no state ownership. Given that the
average discount level is 55 percent during this post-February 2001 period, a 33 percent
difference in discount level means that ?rms with high state ownership have almost
Resolution of the
Chinese discount
puzzle
89
D
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a
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d
b
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O
N
D
I
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H
E
R
R
Y
U
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E
R
S
I
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Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
M
o
d
e
l
(
1
)
(
2
)
(
3
)
(
4
)
(
5
)
(
6
)
(
7
)
(
8
)
(
9
)
P
a
n
e
l
A
.
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
C
o
n
s
t
a
n
t
0
.
7
6
4
*
*
*
(
8
7
.
7
1
)
0
.
7
8
0
*
*
*
(
5
1
.
1
6
)
0
.
7
2
4
*
*
*
(
5
4
.
7
3
)
0
.
7
3
3
*
*
*
(
3
2
.
5
3
)
0
.
8
4
3
*
*
*
(
9
.
2
2
)
0
.
7
5
1
*
*
*
(
3
4
.
3
7
)
0
.
7
9
3
*
*
*
(
2
4
.
7
6
)
0
.
7
9
3
*
*
*
(
3
6
.
8
2
)
1
.
0
6
3
*
*
*
(
1
1
.
6
3
)
G
o
v
t
o
w
n
e
r
s
h
i
p
0
.
1
5
7
*
*
*
(
3
.
7
2
)
0
.
1
4
8
*
*
(
2
.
6
3
)
G
o
v
t
o
w
n
d
u
m
m
y
2
0
.
0
9
3
*
*
*
(
2
3
.
8
0
)
2
0
.
0
7
9
*
*
*
(
2
2
.
6
5
)
(
V
O
B
/
V
O
A
þ
B
)
0
.
1
5
3
*
*
*
(
4
.
0
9
)
0
.
1
4
8
*
*
*
(
3
.
2
5
)
(
S
O
B
/
S
O
A
þ
B
)
0
.
1
1
0
(
1
.
4
9
)
2
0
.
0
0
5
(
2
0
.
0
8
)
M
C
A
P
2
0
.
0
1
0
(
2
0
.
8
6
)
2
0
.
0
3
4
*
*
*
(
2
3
.
6
6
)
M
o
m
e
n
t
u
m
2
0
.
1
0
9
(
2
0
.
7
3
)
2
0
.
0
5
1
(
2
0
.
5
5
)
V
o
l
a
t
i
l
i
t
y
r
a
t
i
o
2
0
.
0
2
6
(
2
0
.
8
7
)
2
0
.
0
2
5
(
2
0
.
9
5
)
L
o
c
a
l
b
e
t
a
(
A
)
2
0
.
0
0
6
(
2
0
.
4
7
)
2
0
.
0
1
4
(
2
1
.
3
7
)
W
o
r
l
d
b
e
t
a
(
B
)
0
.
0
4
4
*
(
1
.
8
5
)
0
.
0
1
8
(
1
.
2
2
)
S
h
a
n
g
h
a
i
d
u
m
m
y
2
0
.
0
2
0
(
2
1
.
4
7
)
2
0
.
0
1
7
(
2
1
.
5
1
)
2
0
.
0
7
3
*
*
*
(
2
3
.
8
1
)
2
0
.
0
2
3
(
2
1
.
6
5
)
2
0
.
0
1
8
(
2
1
.
3
9
)
2
0
.
0
1
4
(
2
1
.
0
0
)
2
0
.
0
2
0
(
2
1
.
5
4
)
2
0
.
0
1
9
(
2
1
.
4
7
)
2
0
.
0
6
1
*
*
*
(
2
3
.
2
6
)
A
d
j
u
s
t
e
d
R
2
0
.
0
1
4
7
0
.
1
4
7
1
0
.
2
3
7
7
0
.
0
4
4
2
0
.
0
1
1
2
0
.
0
1
5
2
0
.
0
3
0
6
0
.
0
5
1
7
0
.
4
0
7
1
P
a
n
e
l
B
.
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
a
f
t
e
r
F
e
b
r
u
a
r
y
2
8
,
2
0
0
1
C
o
n
s
t
a
n
t
0
.
5
2
6
*
*
*
(
3
8
.
6
9
)
0
.
5
4
2
*
*
*
(
2
3
.
9
5
)
0
.
4
7
0
*
*
*
(
2
5
.
3
8
)
0
.
4
8
3
*
*
*
(
1
3
.
5
9
)
0
.
5
9
5
*
*
*
(
4
.
4
2
)
0
.
4
9
7
*
*
*
(
1
5
.
8
4
)
0
.
5
6
0
*
*
*
(
1
2
.
8
4
)
0
.
5
8
5
*
*
*
(
1
7
.
6
5
)
0
.
9
1
0
*
*
*
(
6
.
9
3
)
G
o
v
t
o
w
n
e
r
s
h
i
p
0
.
2
6
8
*
*
*
(
4
.
2
9
)
0
.
2
7
4
*
*
*
(
3
.
8
3
)
(
c
o
n
t
i
n
u
e
d
)
Table II.
Regressions of B-share
discounts around the
February 28, 2001
opening of the market to
domestic Chinese
investors
JFEP
1,1
90
D
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D
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R
R
Y
U
N
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E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
M
o
d
e
l
(
1
)
(
2
)
(
3
)
(
4
)
(
5
)
(
6
)
(
7
)
(
8
)
(
9
)
G
o
v
t
o
w
n
d
u
m
m
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2
0
.
1
4
3
*
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(
2
4
.
0
7
)
2
0
.
1
2
8
*
*
*
(
2
3
.
5
9
)
(
V
O
B
/
V
O
A
þ
B
)
0
.
2
1
1
*
*
*
(
4
.
1
6
)
0
.
1
7
7
*
*
*
(
3
.
0
2
)
(
S
O
B
/
S
O
A
þ
B
)
0
.
1
5
1
(
1
.
3
4
)
0
.
0
5
1
(
0
.
5
3
)
M
C
A
P
2
0
.
0
0
8
(
2
0
.
5
2
)
2
0
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0
4
6
*
*
*
(
2
3
.
4
2
)
M
o
m
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t
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m
2
0
.
2
3
4
(
2
0
.
9
7
)
2
0
.
1
7
2
(
2
1
.
1
9
)
V
o
l
a
t
i
l
i
t
y
r
a
t
i
o
2
0
.
0
3
1
(
2
0
.
7
9
)
2
0
.
0
2
7
(
2
0
.
7
5
)
L
o
c
a
l
b
e
t
a
(
A
)
2
0
.
0
2
1
2
0
.
0
3
1
*
(
2
1
.
9
0
)
(
2
1
.
1
6
)
W
o
r
l
d
b
e
t
a
(
B
)
0
.
0
5
8
0
.
0
2
0
(
0
.
7
9
)
(
1
.
5
8
)
S
h
a
n
g
h
a
i
d
u
m
m
y
0
.
0
7
0
*
*
*
(
3
.
5
0
)
0
.
0
7
2
*
*
*
(
3
.
9
9
)
2
0
.
0
0
3
(
2
0
.
1
0
)
0
.
0
6
6
*
*
*
(
3
.
2
0
)
0
.
0
7
2
*
*
*
(
3
.
6
1
)
0
.
0
8
3
*
*
*
(
4
.
0
4
)
0
.
0
7
0
*
*
*
(
3
.
5
0
)
0
.
0
7
3
*
*
*
(
3
.
7
9
)
0
.
0
2
5
(
0
.
9
6
)
A
d
j
u
s
t
e
d
R
2
0
.
1
2
7
2
0
.
2
6
8
9
0
.
2
9
2
5
0
.
1
4
7
6
0
.
1
1
8
3
0
.
1
4
0
6
0
.
1
3
1
4
0
.
1
6
6
5
0
.
4
6
9
3
P
a
n
e
l
C
.
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
c
h
a
n
g
e
f
r
o
m
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
t
o
a
f
t
e
r
F
e
b
r
u
a
r
y
2
8
,
2
0
0
1
C
o
n
s
t
a
n
t
2
0
.
2
3
8
*
*
*
(
2
3
3
.
7
9
)
2
0
.
2
3
9
*
*
*
(
2
2
0
.
2
8
)
2
0
.
2
5
4
*
*
*
(
2
2
8
.
5
3
)
2
0
.
2
5
0
*
*
*
(
2
1
4
.
1
5
)
2
0
.
2
4
7
*
*
*
(
2
4
.
4
5
)
2
0
.
2
5
4
*
*
*
(
2
2
0
.
4
6
)
2
0
.
2
3
3
*
*
*
(
2
1
4
.
4
1
)
2
0
.
2
0
9
*
*
*
(
2
1
2
.
7
4
)
2
0
.
1
5
3
*
*
(
2
2
.
2
6
)
G
o
v
t
o
w
n
e
r
s
h
i
p
0
.
1
1
1
*
*
*
(
3
.
6
2
)
0
.
1
2
6
*
*
*
(
4
.
0
6
)
G
o
v
t
o
w
n
d
u
m
m
y
2
0
.
0
4
9
*
*
*
(
2
2
.
9
3
)
2
0
.
0
5
*
*
*
(
2
3
.
5
7
)
(
V
O
B
/
V
O
A
þ
B
)
0
.
0
5
8
*
*
(
2
.
5
8
)
0
.
0
2
9
(
1
.
2
6
)
(
c
o
n
t
i
n
u
e
d
)
Table II.
Resolution of the
Chinese discount
puzzle
91
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
M
o
d
e
l
(
1
)
(
2
)
(
3
)
(
4
)
(
5
)
(
6
)
(
7
)
(
8
)
(
9
)
(
S
O
B
/
S
O
A
þ
B
)
0
.
0
4
2
(
0
.
7
6
)
0
.
0
5
6
(
1
.
1
5
)
M
C
A
P
0
.
0
0
1
(
0
.
1
7
)
2
0
.
0
1
2
*
(
2
1
.
7
1
)
M
o
m
e
n
t
u
m
2
0
.
1
2
5
(
2
1
.
1
3
)
2
0
.
1
2
0
(
2
1
.
6
1
)
V
o
l
a
t
i
l
i
t
y
r
a
t
i
o
2
0
.
0
0
5
(
2
0
.
4
1
)
2
0
.
0
0
2
(
2
0
.
1
4
)
L
o
c
a
l
b
e
t
a
(
A
)
2
0
.
0
1
6
*
(
2
1
.
8
2
)
2
0
.
0
1
7
(
2
1
.
5
5
)
W
o
r
l
d
b
e
t
a
(
B
)
0
.
0
1
5
(
0
.
8
1
)
0
.
0
0
2
(
0
.
1
4
)
S
h
a
n
g
h
a
i
d
u
m
m
y
0
.
0
9
0
*
*
*
(
9
.
6
2
)
0
.
0
8
9
*
*
*
(
9
.
2
8
)
0
.
0
7
0
*
*
*
(
5
.
7
1
)
0
.
0
8
9
*
*
*
(
9
.
4
8
)
0
.
0
9
0
*
*
*
(
9
.
6
7
)
0
.
0
9
7
*
*
*
(
1
0
.
5
6
)
0
.
0
9
0
*
*
*
(
9
.
5
9
)
0
.
0
9
2
*
*
*
(
1
0
.
5
7
)
0
.
0
8
6
*
*
*
(
6
.
8
9
)
A
d
j
u
s
t
e
d
R
2
0
.
5
4
3
0
0
.
5
9
5
7
0
.
5
6
9
1
0
.
5
4
2
7
0
.
5
3
6
9
0
.
5
5
4
1
0
.
5
3
7
7
0
.
5
6
0
5
0
.
6
3
5
0
N
o
t
e
s
:
A
l
l
p
a
n
e
l
s
s
h
a
r
e
t
h
e
s
a
m
e
i
n
d
e
p
e
n
d
e
n
t
v
a
r
i
a
b
l
e
s
t
h
a
t
a
r
e
c
o
m
p
u
t
e
d
a
s
t
h
e
a
v
e
r
a
g
e
s
o
f
d
a
i
l
y
o
b
s
e
r
v
a
t
i
o
n
s
f
r
o
m
F
e
b
r
u
a
r
y
1
,
2
0
0
1
t
o
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
,
w
h
i
c
h
i
n
c
l
u
d
e
t
h
e
l
e
v
e
l
o
f
g
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
(
g
o
v
t
o
w
n
e
r
s
h
i
p
)
a
s
o
f
2
0
0
1
,
a
g
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
d
u
m
m
y
(
g
o
v
t
o
w
n
d
u
m
m
y
)
t
h
a
t
i
s
e
q
u
a
l
t
o
o
n
e
i
f
t
h
e
?
r
m
h
a
s
n
o
s
t
a
t
e
o
w
n
e
r
s
h
i
p
a
n
d
z
e
r
o
o
t
h
e
r
w
i
s
e
,
r
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
/
S
O
A
þ
B
)
,
m
a
r
k
e
t
c
a
p
i
t
a
l
i
z
a
t
i
o
n
(
M
C
A
P
,
i
n
l
o
g
s
)
,
m
o
m
e
n
t
u
m
c
o
m
p
u
t
e
d
a
s
t
h
e
c
u
m
u
l
a
t
i
v
e
m
o
n
t
h
l
y
A
-
s
h
a
r
e
r
e
t
u
r
n
s
o
v
e
r
t
h
e
p
r
e
c
e
d
i
n
g
m
o
n
t
h
,
t
h
e
v
o
l
a
t
i
l
i
t
y
r
a
t
i
o
(
s
B
/
s
A
)
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
r
a
t
i
o
o
f
t
h
e
t
r
a
i
l
i
n
g
o
n
e
-
m
o
n
t
h
s
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
o
f
d
a
i
l
y
r
e
t
u
r
n
s
o
n
A
a
n
d
B
s
h
a
r
e
s
,
r
e
s
p
e
c
t
i
v
e
l
y
;
V
O
B
/
V
O
A
þ
B
i
s
t
h
e
v
o
l
u
m
e
r
a
t
i
o
o
f
a
v
e
r
a
g
e
d
a
i
l
y
t
r
a
d
i
n
g
v
o
l
u
m
e
o
f
B
s
h
a
r
e
s
(
V
O
B
)
r
e
l
a
t
i
v
e
t
o
a
v
e
r
a
g
e
d
a
i
l
y
t
o
t
a
l
v
o
l
u
m
e
o
f
A
a
n
d
B
s
h
a
r
e
s
(
V
O
A
þ
B
)
.
)
,
l
o
c
a
l
b
e
t
a
s
o
f
A
-
s
h
a
r
e
s
r
e
l
a
t
i
v
e
t
o
t
h
e
e
q
u
a
l
l
y
w
e
i
g
h
t
e
d
l
o
c
a
l
A
-
s
h
a
r
e
m
a
r
k
e
t
p
o
r
t
f
o
l
i
o
,
a
n
d
w
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
r
e
l
a
t
i
v
e
t
o
t
h
e
M
o
r
g
a
n
S
t
a
n
l
e
y
w
o
r
l
d
m
a
r
k
e
t
i
n
d
e
x
;
w
e
a
l
s
o
i
n
c
l
u
d
e
a
d
u
m
m
y
v
a
r
i
a
b
l
e
f
o
r
t
h
o
s
e
s
t
o
c
k
s
t
h
a
t
t
r
a
d
e
o
n
t
h
e
S
H
S
E
(
S
h
a
n
g
h
a
i
d
u
m
m
y
e
q
u
a
l
s
o
n
e
)
;
t
h
e
d
e
p
e
n
d
e
n
t
v
a
r
i
a
b
l
e
f
o
r
P
a
n
e
l
s
A
,
B
a
n
d
C
a
r
e
d
e
?
n
e
d
,
r
e
s
p
e
c
t
i
v
e
l
y
,
a
s
t
h
e
a
v
e
r
a
g
e
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
f
r
o
m
F
e
b
r
u
a
r
y
1
,
2
0
0
1
t
o
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
,
f
r
o
m
F
e
b
r
u
a
r
y
2
8
t
o
M
a
r
c
h
3
1
,
2
0
0
1
,
a
n
d
t
h
e
a
v
e
r
a
g
e
d
i
s
c
o
u
n
t
c
h
a
n
g
e
f
r
o
m
t
h
e
p
r
e
-
p
e
r
i
o
d
t
o
p
o
s
t
-
e
v
e
n
t
p
e
r
i
o
d
;
O
L
S
e
s
t
i
m
a
t
o
r
s
a
r
e
r
e
p
o
r
t
e
d
w
i
t
h
t
-
s
t
a
t
i
s
t
i
c
s
(
i
n
p
a
r
e
n
t
h
e
s
e
s
)
b
a
s
e
d
o
n
s
t
a
n
d
a
r
d
e
r
r
o
r
s
u
s
i
n
g
W
h
i
t
e
(
1
9
8
0
)
m
e
t
h
o
d
s
r
o
b
u
s
t
t
o
h
e
t
e
r
o
s
k
e
d
a
s
t
i
c
i
t
y
;
a
d
j
u
s
t
e
d
R
2
i
s
R
-
s
q
u
a
r
e
d
a
d
j
u
s
t
e
d
f
o
r
d
e
g
r
e
e
s
o
f
f
r
e
e
d
o
m
.
T
h
e
n
u
m
b
e
r
o
f
o
b
s
e
r
v
a
t
i
o
n
s
i
s
7
6
Table II.
JFEP
1,1
92
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
60 percent more discount, ceteris paribus. Comparing pre- and post-event changes in
sensitivities of B-shares valuation to state ownership, we ?nd that when domestic
investors are allowed to hold B-shares, those ?rms with no state ownership or low state
ownership are strongly preferred. This is veri?ed in our key regression model in Panel
C; the coef?cient on government ownership is statistically signi?cant and positive
(0.111). This implies that a ?rm with 75 percent state ownership experiences 14 percent
smaller decrease in its discount than a ?rm with no state ownership. This difference
constitutes about 40 percent of the discount decline of one of the low state ownership
?rms. Overall, this state ownership variable is statistically and economically important
for the B-share discount levels, as previous research by Fernald and Rogers (2002) has
shown. However, it is even more important after the opening of the B-share market,
which is not what we would have expected if, as Fernald and Rogers claim, domestic
residents entering the B-share market revalued the state ownership stakes with a
smaller discount than foreign residents.
Interestingly, few of other ?rm characteristics appear to explain the discount level
and discount changes in a signi?cant way. The relative liquidity variable (relative
volume ratio) has a signi?cantly positive coef?cient in both Panels Aand B for discount
levels, but has no explanatory power in Panel C for discount changes when the state
ownership variable is present in the model. But, even in Panels Aand B, the signs of the
liquidity variable are the opposite of what we would expect according to the liquidity
hypothesis. The market capitalization variable is not signi?cant in either of the
univariate speci?cations (Models 5 in Panels Aand B), but it is statistically signi?cant in
the multivariate speci?cation of Model 9 and with a large negative coef?cient (20.034 in
Panel A, 20.046 in Panel B). This is consistent with the asymmetric information
hypothesis in that the discount is smaller for larger ?rms for which foreign investors are
less likely to be at an information disadvantage. In Panel C, for the discount change, the
sensitivity to size is statistically weak and surprisingly negative (20.012). The
asymmetric information cost to foreigners embedded in the B-share discount should
have diminished, not widened further. All other variables which proxy for differential
demand or differential risk fail to have any signi?cant explanatory power.
Based on the consistent results fromdifferent regressions and the explanatory power
of state ownership, we conclude that state ownership, our proxy for political risk, is a key
factor in explaining the B-share discount. New investors that entered the liberalized
B-share market appeared to be even more averse to ?rms with high state ownership than
the original B-share investors, ceteris paribus. This is a surprising result.
Table III provides further evidence based on portfolio analysis. Panel A shows the
SUR results for A-share quintile portfolios grouped by the level of state ownership.
Panel B is for B-share quintile portfolios. The only signi?cant variables in Panel A are
the A-share market beta (b
PA
), which are all above one. They are positive and
statistically signi?cant for these 76 ?rms during this period from February through
March in 2001. The February 19 regulatory event did not change A-share betas in any
signi?cant way (b
PAD
equals zero for all portfolios). All the risk-adjusted returns on
these A-share quintile portfolios (a
P
) equal zero and they are not signi?cantly different
after the regulatory change (g
P
equals zero for all portfolios). Gibbons, Ross and
Shanken (GRS) tests with associated F-statistics of the joint equality of the g
P
and of
their zero exclusion (g
P
equals zero for each portfolio) con?rm that there were no
changes in the risk-adjusted returns over this period.
Resolution of the
Chinese discount
puzzle
93
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
-
s
h
a
r
e
p
o
r
t
f
o
l
i
o
s
B
-
s
h
a
r
e
p
o
r
t
f
o
l
i
o
s
L
o
w
e
s
t
g
o
v
t
Q
1
Q
2
Q
3
Q
4
H
i
g
h
e
s
t
g
o
v
t
Q
5
L
o
w
e
s
t
g
o
v
t
Q
1
Q
2
Q
3
Q
4
H
i
g
h
e
s
t
g
o
v
t
Q
5
a
P
2
0
.
0
0
1
(
0
.
4
2
)
0
.
0
0
0
(
0
.
2
6
)
0
.
0
0
0
(
0
.
0
1
)
0
.
0
0
1
(
0
.
6
6
)
0
.
0
0
8
(
3
.
0
5
)
*
*
*
0
.
0
0
6
(
2
.
3
5
)
*
*
0
.
0
0
2
(
1
.
8
2
)
*
0
.
0
0
3
(
2
.
5
7
)
*
*
0
.
0
0
8
(
3
.
3
8
)
*
*
*
b
P
B
2
0
.
0
2
7
(
0
.
5
4
)
2
0
.
0
4
4
(
0
.
7
8
)
2
0
.
0
1
0
(
0
.
1
9
)
0
.
0
0
2
(
0
.
0
3
)
2
0
.
0
3
6
(
0
.
5
7
)
0
.
8
6
6
(
8
.
7
3
)
*
*
*
0
.
9
7
4
(
1
1
.
2
)
*
*
*
0
.
9
5
4
(
2
0
.
2
)
*
*
*
0
.
9
5
4
(
2
2
.
5
)
*
*
*
0
.
7
8
3
(
9
.
2
6
)
*
*
*
b
P
A
1
.
6
1
2
(
1
0
.
6
1
)
*
*
*
1
.
7
0
1
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Table III.
SUR models for daily
returns on state
ownership portfolios
around February 19, 2001
JFEP
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E
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I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
The opening-up of the B-share market, however, did affect the B-share market
signi?cantly and in an unequal way. Portfolios with lowest state ownership stocks
experience 7 percent daily risk-adjusted returns after the regulatory change whereas
those with high state ownership stocks experience none. Interestingly, the
risk-adjusted returns on all ?ve portfolios are signi?cantly positive during this
special two-month period of analysis, though not in a signi?cantly different way. We
apply the GRS test to examine whether the February event has an impact and whether
it is a signi?cantly different one across portfolios in Tests 1 and 2, respectively. Indeed,
the effect of the regulatory change on the B-share portfolios is different across
portfolios at the 1 percent signi?cance level (Test 4 F-statistic is 11.29).
4. Tests of alternative hypotheses
Our cross-sectional regressions and portfolio analysis revealed the following facts:
.
before February 2001, foreign investors have lower valuation for ?rms with high
state ownership, ceteris paribus;
.
after February 2001, when domestic investors are allowed to trade in B-share
market, the relative undervaluation for ?rms with high state ownership was
reinforced; and
.
the event has triggered different net buying activity among new investors for
?rms with high and low state ownership.
If we can interpret the relative valuations of A- and B-shares as re?ecting their
perceived political risk, then those new investors who entered the B-share market were
as wary of political risk as the original foreign investors, who, compared to existing
A-share investors, had already priced a substantial political risk premium. We believe
that this regulatory event inspired new domestic resident participants who had a very
different outlook than existing domestic residents participating in the A-share market
and who had a more similar outlook to those of foreign investors. But other
explanations are possible. We will discuss some possible alternative explanations and
provide either direct or circumstantial evidence that leads to our rejection of those
alternatives in favor of our interpretation of the events.
4.1 Anticipation of state share selling?
On June 14, 2001, the Chinese State Council announced a series of long-awaited rules on
how it plans to fund a long-term social welfare shortfall by allowing state-owned
shares to be sold on the stock market. State-owned shares to this point in time belonged
to a special category of equity that could not be traded on the market. Appendix 2,
Table AII details a series of key events related to these rule announcements. If local
investors were anticipating these new policy rules back in February, it is possible that
domestic investors entering the B-share market following February 19 would have
pursued disproportionately the shares of ?rms with lower state ownership stakes not
because of political risk aversion but because of the potential dampening supply effect
on share prices. Local investors may have speculated that prices of these high state
ownership ?rms would drop once the market is ?ooded by the state shares that had
been locked up and untradeable to that point.
If this alternative hypothesis were true, we would also observe a signi?cantly
negative reaction of share prices for those ?rms with relatively higher state ownership
Resolution of the
Chinese discount
puzzle
95
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t
2
1
:
3
5
2
4
J
a
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a
r
y
2
0
1
6
(
P
T
)
stakes on June 14, 2001 when this suspicion would have been con?rmed. To evaluate
this alternative explanation, we perform a supplementary test by estimating the SUR
model of equation (3) again, but with event dates de?ned to be June 14, 2001 to June 20,
2001. We ?nd no statistically signi?cant differences in the risk-adjusted returns across
the quantile portfolios grouped by state ownership[10]. This is consistent with Chen
and Zhou (2005) who study this policy change and who also ?nd no evidence that the
prices of those stocks with heavy state share holdings declined more than those with
no state shares.
October 22, 2001 is another date that we can use to test this alternative hypothesis.
On that day, the CSRC announced the suspension of the sale of shares in state-owned
companies used to fund a national social security in the hope that this would steady its
weakening stock market. See Appendix 2, Table AII for details. We again estimate the
SUR model of equation (3) with event dates now de?ned to be October 22-27, 2001. If
local investors avoided shares of high state ownership ?rms in February due to worries
of future state share selling, we would expect a positive share price reaction in October
among shares of those high state ownership ?rms when the state share selling
program was suspended. However, our test reports no difference in the share price
reactions across quintile portfolios grouped by state ownership.
Finally, a third way to test this hypothesis is to see whether the new investors have
some foresight over the possible reduction in state ownership. We compare the 2002
state ownership levels with those for 2001 for B-share ?rms and ?nd that many ?rms
experienced some reduction in their state ownership. We use the change in the B-share
discount during the February 1, 2001 event as an explanatory variable for the next
year’s change in state ownership. We test whether a greater decline of the B-share
discount during February predicts less state ownership reduction in the future. Our
test shows no such relationship. Thus, we conclude that the evidence does not seem to
support this alternative hypothesis about price pressure from selling state share
holdings.
4.2 New group of foreign investors?
We do not know the identity of B-share investors. Though the policy change allowed
Chinese residents to hold B-shares, it could still be that the investors in the B-share
market were comprised of a new group of foreign investors who entered the B-share
market after February 2001 because they perceived a policy shift in China’s market
development through the signal of the integration of the A- and B-share markets.
Anecdotal and indirect empirical evidence suggests that it is unlikely to be so. First,
we obtain monthly US transactions with foreigners in long-term domestic and foreign
securities from Treasury International Capital (www.treas.gov/tic). Speci?cally, with
respect to Chinese stocks during the three months before and after February 2001, we
compute the monthly difference between the gross sales by foreigners to US residents
and gross purchases by foreigners from US residents to determine the net purchases by
US residents. During the three months before February 2001, US residents were net
buyers of $33 million of Chinese stocks, but were net sellers of $35 million in the three
months following. This activity is not particularly noteworthy as it comprises only a
small fraction (less than 1 percent) of the stock of holdings of US investors in the
Chinese market and, even more importantly, they were exiting the market more than
entering[11].
JFEP
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I
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A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
Second, according to a news report from the Securities Daily (2001) New Agency on
August 17, 2001, the proportion of domestic investors in the B-share market was 90.23
percent after February 19, 2001. It is evident from this fact that foreign investors likely
did not contribute much to the volatility of B-share market prices after liberalization.
Finally, another news report from HuaTai Securities (2001) News Agency on August
28, 2001 reported that foreign shareholders have greatly reduced their shareholdings
after February 19, especially foreign institutional shareholders. Jiangling Motors,
China International Marine, and Guangdong Provincial Expressway Development
Company were speci?cally mentioned to have experienced large foreign ownership
reductions, amounting to more than 5 percent of the total shares within several weeks
around February 19. The foreign ownership of Shanghai Posts and Telecom
Equipment declined to 0.39 percent from an original 6.27 percent during 2001; that of
Jinzhou Port declined from 3.68 to 0.39 percent; and that of Hangzhou STM Turbine
declined from 23.51 to 2.71 percent. According to this report, more than 90 percent of
foreign shareholders have reduced their ownership in Chinese B-shares, with the
average reduction being 40 percent of their original shareholding.
4.3 Some evidence on new local investors
There exists some anecdotal evidence to support our conjecture that it is indeed new
domestic investors who entered the B-share market upon the market’s liberalization.
This possibility would have important economic consequences if the new domestic
investors had different expectations about future growth rates, returns, or future
dividends than existing domestic investors prevalent in the A-share market,
particularly with regard to companies with large state holdings. First, according to a
report, entitled “Regulations governing Chinese nationals who enter the domestic
B-share stock market” and issued on February 26, 2001 by the CSRC and the State
Administration of Foreign Exchange (SAFE), Chinese nationals engaged in B-share
trading were only allowed to use spot exchange deposits and foreign currency cash
deposits which had been deposited in domestic commercial banks before February
19[12]. This restriction was subsequently lifted on June 1, 2001 when Chinese nationals
were allowed to trade B-shares with spot exchange deposits and foreign currency cash
deposits opened after February 19, as well as foreign exchange funds transferred from
overseas[12]. We infer from this fact is that only a special clientele of domestic Chinese
investors would have been able to access the B-shares at the time of the CSRC’s
announcement.
Second, what accompanied the foreign ownership decline in B-shares was an
increase in the number of individual investors. The average number of individual
shareholders in the B-share market had more than doubled since the end of 2000 (CEIC
China Premium database)[13]. HuaTai Securities reported speci?c examples: the
number of individual investors for Hangzhou STM Turbine increased 900 percent,
from 1,198 to 12,306 over this period; the number for Shandong Airlines increased
almost 600 percent from 3,379 to 22,622. The same report also shows that the average
number of shares held by each individual dropped. For example, the average number
of individual shares for Kama B shares dropped from 37,000 to 7,000 between 2000 and
2001 (HuaTai Securities, 2001).
Third, foreign currency deposits of Chinese residents increased signi?cantly before
February 2001 and decreased in the immediate aftermath of the liberalization event[14].
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In the ?rst quarter of 2001, foreign deposits for domestic residents only increased by
$680 million, which was $3.45 billion less than the increase in same quarter of 2000.
According to a news report by Guosen Securities Net (2001), most of the foreign
deposits were transferred to the B-share market during February 2001. What we
surmise from this fact is that there was at least partial anticipation of the policy change
to come in 2001 at least among some clientele of domestic investors.
5. Conclusions
Explaining China’s B-share discount puzzle has been a signi?cant challenge.
Numerous explanations have been put forward, including ones based on differential
liquidity of the two classes of shares, differential risks, differential demand and
asymmetric information effects among local and foreign investors. Our contribution –
which we boldly declare a “resolution” of the puzzle in our title – arises from analyzing
a natural experiment that took place in February 2001 in which the CSRC allowed local
Chinese investors to trade B-shares which were previously restricted to foreign
investors. This policy change represented an important event in China’s capital
markets as the B-share discounts that had been averaging over 80 percent across
almost 80 different stocks declined dramatically to 40 percent on average within
months.
We speci?cally exploit the information in the cross-sectional dispersion of the
discount declines across the stocks. Our simple model can explain 60 percent of the
cross-sectional variation of the discount changes. The most important explanatory
factor is the political risk factor, which we proxy with the fraction of shares owned by
the state. That is, immediately after the opening of the B-share market, Chinese
investors concentrated their efforts in bidding up the B-share prices of low state
ownership ?rms. Just as importantly, we ?nd that other attributes of the stocks such as
the relative liquidity of their B-shares or the relative number of B-shares outstanding
as well as several risk measures (volatility ratios, local and world market betas) are
statistically unimportant in explaining the discount changes that took place.
We interpret our ?nding as evidence consistent with the recent ?ndings that
political risks affect stock valuations. Speci?cally, differences in perceived political
risk can result in difference in security valuation. For researchers, our ?ndings on the
importance of political risk offer reassurance of the basic notions of equilibrium
international asset pricing models relating conditional expectations of asset returns to
expected factor risk premiums and assets’ exposures to those risk factors. For
companies, regulators and decision makers in developing countries, foreign investors
are drawn to stocks only selectively in countries with less transparent reporting and
accounting systems and with weak governance systems that inadequately protect their
interests as minority shareholders. Often, they pay high premiums when their general
demand for international investment is high, as in the case of most markets around the
world for unrestricted over restricted classes of the same shares (Bailey et al., 1999).
Sometimes, as was the case in China before February 2001, they will allow large
discounts to arise and persist, in spite of potentially great demand, simply because of
needed legal or political reforms.
The unique February 2001 event allows us to compare the domestic investors’
valuation of political risk with those of the foreigners. This is the ?rst study to
document the shift of perceived political risk and its valuation due to different groups
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of investors during the event. While foreign investors may have underpriced stocks
with high state ownership, domestic investors who gained access to the shares
previously restricted for trading by foreigners, maybe in?uenced by foreign investors,
turned out to dislike political risks even more, as shown by the case in China after
February 2001. The opening of the B-share market to local Chinese investors was a
positive development, but an incomplete one. This is why we must offer a caution on
our bold title acknowledging only a “partial” resolution of the puzzle. A full integration
of these two markets is ultimately what is desirable for local and global investors alike;
it has still not happened despite a number of false starts and rumors even through
2008[15].
Notes
1. Some important studies in this literature include Hietala (1989), Bailey and Jagtiani (1994),
Stulz and Wasserfallen (1995), Domowitz et al. (1997), and Bailey et al. (1999).
2. See Fisman (2001) and Leuz and Oberholzer-Gee (2006) for studies on the bene?cial effects of
political connections in Indonesia, Johnson and Mitton (2003), for Malaysia, and Ferguson
and Voth (2008), for Germany.
3. Chan et al. (2008) and Ahlgren et al. (2003) focus on differences in the effects of asymmetric
information between the local A- and foreign B-share markets. Chan et al. speci?cally
measures the adverse selection component of the bid-ask spread in the two markets and how
they change around February 2001. Sun et al. (2004) and Lee et al. (2007) focus on information
?ow and the level of market integration between A- and B-share markets.
4. We will associate the level of state share ownership with political risk throughout this paper,
although we acknowledge that this association is debatable. In support of our assumption,
Perotti and van Oijen (2001) present cross-country evidence that progress in privatization of
state share ownership is indeed correlated with improvements in perceived political risk. In
the context of China, in particular, Tian (2001), Xu et al. (2005) and Stouraitis et al. (2008)
show how state share ownership is positively correlated with related party transactions,
such as politically connected director appointments and misappropriation of state funds,
lower labor productivity and poor governance. Of course, as do Fernald and Rogers (2002),
we could interpret that the stronger political connections may ensure better access to ?nance
that translates into better growth prospects and minimized downside risk from bankruptcy,
all attributes deserving of a lower premium.
5. Article 2 of the Securities Law of China stated that “this Law is applicable to the issuing and
trading in China of shares, corporate bonds and such other securities as are lawfully
recognized by the State Council.”
6. Appendix 1, Table AI details the chronology of major events and announcements about the
B-share market during the ?rst half of 2001.
7. Some analysts described the period as one of “B-share frenzy” (see the analyst report by
Yan Dinggong of Shenyin and Wanguo Securities, AFX Asia, February 28, 2001).
8. There has been strong empirical support for this hypothesis in other markets (e.g. Bailey and
Jagtiani, 1994 in Thailand, Bailey et al., 1999 in Mexico).
9. Interestingly, for very similar tests, Sun and Tong (2000) and Chen et al. (2001) ?nd a positive
relationship between the B-share discount and the relative number of B-shares to total shares
outstanding. Sun and Tong (2000) regard the relative number of B-shares outstanding as
being determined by the supply and since more B shares outstanding puts downward
pressure on B-share prices thus increasing the B-share discount, they con?rm the differential
demand hypothesis. Chen et al. (2001), on the other hand, interpret more B-shares
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outstanding as evidence of larger foreign demand which should result in a small B-share
discount and reject the hypothesis.
10. These supplementary results are available upon request.
11. US residents held a stock of $2.33 billion of Chinese stocks as of the end of 2001, according to
the Report on US Holdings of Foreign Securities, as prepared by the Of?ce of the Under
Secretary, International Affairs, Department of the Treasury (www.treas.gov/tic/shc2001r.
pdf, May 2003).
12. www.novexcn.com/chin_nation_trade_b_share.html
13. The CEICDataCompanyLimited(CEIC) supplies real-time Asianeconomic datatoanalysts and
economists at over 800 institutional clients around the world. CEIC Data Company Ltd was
established in 1992 and acquired by ISI Emerging Markets in 2005. See www.ceicdata.com
14. See speech by People Bank of China Deputy Governor, Dr Gui Shiquing, “Management of
capital ?ows in corporate sector; current situation and outlook in China” (October 11, 2002,
www.pbc.gov.cn).
15. In November 2006, the B-share market surged by 73 percent from the beginning of the year
partly on the rumor that the B-share market would close and all B-shares would be converted
into higher priced A-shares. See Finance Asia (2006). In 2008, some companies with
outstanding B-shares were permitted by the CSRC to institute a share buy-back program;
see, for example, Livzon Pharmaceutical Group in June 2008, which bought back HK$160
million worth of B-shares.
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markets: an examination of A and B shares”, Paci?c-Basin Finance Journal, Vol. 16,
pp. 61-77.
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Table AI.
Resolution of the
Chinese discount
puzzle
105
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Appendix 2
Corresponding author
G. Andrew Karolyi can be contacted at: [email protected]
Date Events Source
April 26, 2001 China’s Finance Minister, Xiang Huaicheng, spoke at
a forum in Beijing that it is appropriate for China to
reduce its ownership of listed companies in order to
help fund social security needs
China Press
June 14, 2001 The Chinese State Council announced a series of
long-awaited rules on how it plans to fund a chronic
social welfare shortfall by allowing state-owned
shares to be sold on the stock market. State-owned
shares have hitherto belonged to a special category
of equity that could not be traded on the market. The
new rules permit their sale and stipulate that 10
percent of state companies’ IPO should consist of
state-owned shares and that the proceeds from their
sale should go into a national social security fund.
The new rules also applied to companies planning to
list abroad and existing overseas listed companies
Dow Jones, Reuters
July 24, 2001 The ?rst ?otation of so-called state shares is
announced. They are priced much higher than
expected. Four Chinese companies planning A-share
listings announced they would sell state shares
equivalent to 10 percent of their IPO proceeds and
the state shares will be priced at the same levels as
their IPO shares
Reuters
October 22, 2001 The CSRC announced the suspension of the sale of
shares in state-owned companies used to support the
national social security fund and hoped that this will
steady its weakening stock market
Financial Times
December 18, 2001 China’s multi-billion-dollar Social Security Fund will
be allowed to invest in shares as a way to increase
liquidity in stock markets. Fund Chairman, Liu
Zhongli, said that it would be able to place 40 percent
of its 61 billion Yuan (about HK$57.16 billion) in the
country’s stock markets
South China Morning
Post
Table AII.
Chronology of regulatory
change in trading state
shares, June 2001
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This article has been cited by:
1. Fan Yang, Craig Wilson, Zhenyu Wu. 2014. Investor perceptions of the benefits of political connections.
International Journal of Managerial Finance 10:3, 312-331. [Abstract] [Full Text] [PDF]
2. Mao Liang Li, Chin Man Chui, Chang Qing Li. 2014. Dividend, liquidity and firm valuation: evidence
from China AB share markets. Applied Financial Economics 24, 587-603. [CrossRef]
3. Eric Girardin, Roselyne Joyeux. 2013. Macro fundamentals as a source of stock market volatility in China:
A GARCH-MIDAS approach. Economic Modelling 34, 59-68. [CrossRef]
4. John A. Doukas, Liu Wang. 2013. Information asymmetry, price discovery, and the Chinese B-share
discount puzzle. Pacific-Basin Finance Journal 21, 1116-1135. [CrossRef]
5. Longzhen Fan, Bill Hu, Christine Jiang. 2012. Pricing and information content of block trades on the
Shanghai Stock Exchange. Pacific-Basin Finance Journal 20, 378-397. [CrossRef]
6. Wilson H.S. Tong, Wayne W. Yu. 2012. A corporate governance explanation of the A-B share discount
in China. Journal of International Money and Finance 31, 125-147. [CrossRef]
7. Review of Cross-Listing 39-107. [CrossRef]
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doc_746938612.pdf
The purpose of this paper is to examine the changes in B-share discounts across 76
Chinese stocks around an important regulatory event to understand the importance of political risk in
pricing stocks in emerging markets
Journal of Financial Economic Policy
A (partial) resolution of the Chinese discount puzzle: The 2001 deregulation of the B-
share market
G. Andrew Karolyi Lianfa Li Rose Liao
Article information:
To cite this document:
G. Andrew Karolyi Lianfa Li Rose Liao, (2009),"A (partial) resolution of the Chinese discount puzzle",
J ournal of Financial Economic Policy, Vol. 1 Iss 1 pp. 80 - 106
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Allen N. Berger, Philip Ostromogolsky, (2009),"Effects of banks on “debt-sensitive” small businesses",
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A (partial) resolution
of the Chinese discount puzzle
The 2001 deregulation of the B-share market
G. Andrew Karolyi
Department of Finance, Fisher College of Business, Ohio State University,
Columbus, Ohio, USA
Lianfa Li
Department of Finance, School of Economics, Peking University, Beijing,
People’s Republic of China, and
Rose Liao
Department of Finance, Fisher College of Business, Ohio State University,
Columbus, Ohio, USA, and
Department of Finance and Economics, Rutgers Business School,
Rutgers, The State University of New Jersey, Newark, New Jersey, USA
Abstract
Purpose – The purpose of this paper is to examine the changes in B-share discounts across 76
Chinese stocks around an important regulatory event to understand the importance of political risk in
pricing stocks in emerging markets.
Design/methodology/approach – On February 19, 2001, the Chinese Securities Regulatory
Commission announced that Chinese residents would be allowed to own B-share classes of stocks
traded on both the Shanghai and Shenzhen stock markets. These share classes were previously
restricted to foreign investors while domestic residents were only permitted to hold A-share classes of
stock and were typically priced at a signi?cant discount. This regulatory change triggered a dramatic
decline of prevailing B-share discounts from 80 percent down to 40 percent.
Findings – The paper ?nds that the largest declines in the B-share discounts around this regulatory
event are concentrated in the ?rms with low government ownership stakes and are unrelated to the
?rms’ risks, relative supplies of shares outstanding and liquidity attributes.
Research limitations/implications – This surprising ?nding challenges the current wisdom
about what in?uences the B-share discount and particularly the role of political risk in explaining the
discount puzzle.
Originality/value – The paper offers an alternative interpretation for the B-share discount puzzle.
The ?ndings have important implications for China’s future ?nancial liberalization policies.
Keywords China, Political risk, Market segmentation, Stocks
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – F30, G32, G15
The authors thank Bai DongMing of the Asset Management Division of WanGuo Securities
for extensive discussions about the markets in China during February 2001. Comments from
Yakov Amihud, Warren Bailey, Cheol Eun, Roger Loh, Albert Menkveld, Asani Sarkar,
Ann Sherman, and Rene´ Stulz greatly improved the paper. The Dice Center for Financial
Economics provided ?nancial support. All remaining errors are the authors’ own.
JFEP
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Journal of Financial Economic Policy
Vol. 1 No. 1, 2009
pp. 80-106
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576380910962394
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1. Introduction
Interest in foreign equity markets, especially in emerging economies, has continued to
expand over the past decade. Even recent crises have not stopped global investors from
seeking higher returns and international diversi?cation opportunities in foreign stock
markets. In many markets, foreign investors still have to contend with investment
barriers in the form of restrictions on foreign equity ownership. Such barriers are of
particular interest because the limits they impose can induce a form of capital market
segmentation in which foreigners can trade local equities among themselves at a price
premium (or discount) relative to those shares traded by local investors. Segmentation
in the form of premiums and discounts on shares around the world with foreign
ownership restrictions has received considerable attention in the ?nance and
economics literature because it helps to understand what drives the demand for
cross-border investments in the ?rst place[1]. Researchers have rationalized the
existence of these premiums/discounts with hypotheses about differences in risk,
turnover and liquidity, differences in general supply and demand conditions of
restricted and unrestricted shares, as well as the asymmetry of information or risk
tolerances between foreign and local investors.
Foreign ownership restrictions in China’s stock market have been especially
perplexing for researchers because large and persistent price discounts, rather than the
usual premiums, have continued to exist for those shares restricted to foreign investors
(B-shares) relative to those only available to domestic residents (A-shares). Researchers
have rationalized the Chinese B-share discount (on average 80 percent) with
hypotheses about differences in risk (Bailey, 1994; Eun et al., 2001), in turnover and
liquidity (Chen et al., 2001), in general supply and demand conditions of restricted and
unrestricted shares (Sun and Tong, 2000), in the asymmetry of information between
foreign and local investors (Chan et al., 2008; Chakravarty et al., 1998; Chen et al., 2004),
as well as in behaviors (Mei et al., 2004). However, a consensus has not yet emerged.
As puzzling as is China’s B-share discount, another mystery has attracted more
attention; namely, how China has experienced the fastest economic growth with such a
weak legal and institutional environment. Allen et al. (2005) argue that China’s fast
economic growth is driven mainly by the private sector rather than through the
activities of the larger state-owned enterprises (SOEs). Indeed, considerable research
has focused on the economic effects of the dominance of state-ownership in the A-share
market. Contrary to research in other countries that shows how ?rms bene?t from
political connections, most of these papers on the A-share market unambiguously point
out the detrimental effect of government ownership in China[2]. Firms with high state
ownership have lower Tobin’s q ratios (Tian, 2001; Bai et al., 2004; Wei and Varela,
2003) and worse ?nancial operating performance (Qi et al., 2000). Firms with high state
ownership experience signi?cantly negative returns around the announcement of
related-party transactions with controlling interests in SOEs (Cheung et al., 2008).
Firms with higher state ownership and legal entity ownership are more likely to be
accused of fraud (Chen et al., 2006). Firms with politically-connected CEOs experience
signi?cantly worse post-initial public offerings (IPO) long-termstock returns (Fan et al.,
2007).
Undoubtedly, state ownership plays an important, if not paramount, role in
explaining Chinese ?rms’ valuations. A natural question arises whether the level of
state ownership can explain the B-share discount. If investors in the B- and A-share
Resolution of the
Chinese discount
puzzle
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markets have different perceived bene?ts (costs) of state ownership, the answer would
be yes. In fact, Fernald and Rogers (2002) study a panel of ?rms that have both A- and
B-shares from 1993 to 1997 and ?nd that foreign investors did pay relatively less for
stocks with high state ownership. One limitation of their study is that it is dif?cult to
ascertain just how economically important state ownership is for the discount puzzle.
Their study focuses on a period in which the level of state ownership did not change
and, more importantly, there was little temporal variation in the B-share discounts. As
a result, endogeneity problems likely inhibit analysis of the economic effects; do
investors choose to price a bigger discount for B-shares of ?rms with higher levels of
share ownership or has the state chosen to relinquish its stake in those ?rms with
lower discounts? One way to circumvent these limitations is by means of an exogenous
event that induces a signi?cant change in the B-share discount and one that we could,
in turn, use to identify whether the consequences were different for ?rms with different
levels of state ownership.
This paper exploits one such unique event which took place in 2001. On February
19, 2001, the Chinese Securities and Regulatory Commission (CSRC) announced that
Chinese residents would be allowed to own B-shares previously restricted to foreign
investors. The elimination of the foreign ownership restriction in China would have
predictably reduced the B-share discount and the consequence of this impact would
have been greater for those Chinese ?rms in which the foreign investors priced in the
larger premium for the level of state ownership. Indeed, we ?nd that the average
B-share discount declined from 80 percent before the event to 40 percent by the end of
2001, but strikingly the “new” investors intensively pursued B-shares of those ?rms
with lower, not higher, levels of state ownership. On average, ?rms with no state
ownership experienced a 15 percent larger discount decline than those with higher
state ownership. Furthermore, portfolios of B-shares with lower levels of state
ownership experienced a statistically signi?cant and economically large 7 percent
abnormal return around this two-week period relative to those with higher state
ownership.
Our cross-sectional regression analysis before and after the regulatory change
con?rms that B-share investors before the rule change undervalued stocks with higher
state ownership on a relative basis (the discount difference between the highest
state-ownership ?rms and lowest state ownership ?rms is 20 percent), but also shows
that B-share investors after the event undervalued stocks with higher state ownership
with even greater intensity (the average discount difference between the highest
state-ownership ?rms and lowest state ownership ?rms grew to 35 percent). What we
can infer is that those investors that took advantage of the new opportunity to enter
the B-share market after February 2001 appear to be just as wary of state ownership as
the previous foreign investors, and even more so at the margin. Existing studies
indicate that foreign investors command a higher premium for state ownership than
domestic investors, so we might expect that opening up the B-share market would
dissipate the higher premium for B-shares. We provide evidence that these investors
were mostly comprised of domestic Chinese residents – rather than new or existing
foreign investors – and that they priced the B-shares with high levels of state
ownership at a discount similar in magnitude to that by foreign investors. We explore
several alternative hypotheses later in the paper to sharpen this inference.
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Our paper is not the only study that has exploited the February 2001 event to examine
the B-share discount. The other studies, however, focus on other potential drivers of the
discount change around the event[3]. Our paper, however, is the ?rst to document a shift
of perceived political risk and its valuation consequences due to the participation of
different groups of investors during the event[4]. Indeed, this contribution is important
as we ?nd that the level of state ownership is the only statistically signi?cant variable in
the cross-sectional regression explaining discount changes. In terms of explanatory
power, it can explain 60 percent of the cross-sectional variation in discount changes. Our
paper also contributes importantly to the large existing literature on the B-share
discount puzzle in China, to the broader literature on foreign ownership restrictions and
equity price premiums, and ?nally to the newer burgeoning literature on the pricing of
political risk, privatizations and stock market development in emerging economies.
The next section provides a brief description of China’s stock exchanges and offers
institutional details about the CSRC announcement in 2001. Section 3 describes the
data, research design and results. Section 4 discusses several alternative hypotheses
and some anecdotal evidence along with our interpretation of the ?ndings. Section 5
summarizes the paper. We speci?cally discuss why we title our paper only a “partial”
resolution of the B-share puzzle and outline the institutional developments in this
market since 2001.
2. CSRC’s opening of the B-share market in 2001
Prior to 1992, foreign investors were not allowed to trade China’s stock. In 1992, the
CSRC allowed companies to issue so-called “special shares” that were restricted for
trading by foreign investors, denominated in either Hong Kong dollars (traded in
Shenzhen) or US dollars (traded in Shanghai). While these “special shares” later were
designated B-shares, the shares tradable by domestic residents were called A-shares.
The Securities Law of China (passed on July 1, 1999) explicitly recognized the equal
status of shareholders of both A- and B-shares[5]. Among over 1,250 A-shares, there
are only 86 stocks with simultaneous A- and B-share listings as of 2006 (Financial
Times, 2006). Overall, the B-share market has constituted a smaller proportion of the
total market capitalization and has been much less actively traded during the past
decade (Table 1 of Chen et al., 2001).
In a surprise announcement by the CSRC on February 19, 2001 (with the of?cial
approval of the State Council as of 11 a.m. of that day), domestic investors were
allowed to open trading accounts for B-shares. Immediately, both the Shanghai and
Shenzhen Stock Exchanges (the two major exchanges in China) suspended trading in
B-shares from February 20 through 23. Brokerages in China were inundated with so
many applications to open accounts (with minimum fund requirement of US$1,000)
that the CSRC extended the trading suspension imposed on B-shares for two more days
until February 28[6]. On February 28, 2001, the Shanghai and Shenzhen B-share
markets opened and many stocks hit their 10 percent daily price limits within hours
restraining potential trading volumes. Eventually, by early March 2001, B-share prices
increased dramatically and trading volumes were unusually high[7].
Figure 1 shows the distribution of the price ratio of A- to B-shares for our sample of
76 Shanghai and Shenzhen stocks during this period and demonstrates a dramatic
decline in the B-share discount. The median A-to-B share price ratio ?uctuated around
6-to-1 through much of 2000 and fell to below 4-to-1 at the end of 2000. Following the
Resolution of the
Chinese discount
puzzle
83
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
market closure in the last ten days of February 2001, the median A-to-B price ratio
declined to just above 1-to-1 and remained until the end of 2001. We will present more
formal statistics of the magnitude of this B-share discount decline in the next section.
3. Data, research design and results
3.1 Data
To conduct our study, we require data on share prices as well as ?rm characteristics.
Datastream International is used to collect daily closing prices, trading volumes and
the numbers of shares outstanding data for 76 Chinese stocks listing both A- and
B-shares. These 76 stocks are evenly split between the Shanghai Stock Exchange
(SHSE) and the Shenzhen Stock Exchange (SZSE). We also obtain the foreign exchange
rates of the Chinese renminbi (Rmb.) yuan relative to the US dollar and Hong Kong
dollar, the local A-share index return, the local B-share index return and the Morgan
Stanley Capital International World Market Index (MSCI index) returns. China’s Wind
Info Company (www.wind.com.cn) has an equity database with ?nancial statement
data and is our source for the levels of state ownership as of 2001. We also checked
these data by hand with the of?cial websites of SHSE and SZSE.
Table I presents univariate tests of the changes in the B-share discounts around the
opening of the B-share market in February 2001. We examine average daily discounts
for each stock during the periods before and after February 2001 and test whether the
differences were signi?cantly different from zero. We also report similar tests for the
ratio of shares outstanding (denoted as SO
B
/(SO
A
þ SO
B
) where SO
i
is the shares
outstanding for share class i ), market cap, relative volatility (denoted as s
B
/s
A
, where s
i
is the standard deviation of the returns for share class i ), the volume ratio (or VO
B
/(VO
A
þ VO
B
) where VO
i
is the shares traded for share class i ), the cumulative past-one-month
returns performance on the A-shares (or Momentum), and for two market betas
from market model regressions of the A-shares on an equally weighted-index of
all A-share stocks (b
M
A
) and of the B-shares on the MSCI index (b
W
B
), respectively.
Figure 1.
Relative prices of A- to
B-shares for Chinese
stocks on Shenzhen and
Shanghai exchanges
0
5
10
15
20
25
01/1999 04/1999 07/1999 10/1999 01/2000 04/2000 07/2000 10/2000 01/2001 04/2001 07/2001 10/2001
C
u
r
r
e
n
c
y
-
a
d
j
u
s
t
e
d
r
a
t
i
o
o
f
A
-
s
h
a
r
e
t
o
B
-
s
h
a
r
e
p
r
i
c
e
s
(
M
e
d
i
a
n
s
h
a
r
e
,
h
e
a
v
y
l
i
n
e
;
r
a
n
g
e
,
g
r
a
y
s
h
a
d
e
)
JFEP
1,1
84
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
v
e
r
a
g
e
d
i
s
c
o
u
n
t
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
a
s
o
f
2
0
0
1
M
a
r
k
e
t
c
a
p
(
R
m
b
,
m
i
l
l
i
o
n
s
)
V
o
l
u
m
e
r
a
t
i
o
(
V
O
B
/
V
O
A
þ
B
)
R
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
/
S
O
A
þ
B
)
R
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
(
s
B
/
s
A
)
M
o
m
e
n
t
u
m
L
o
c
a
l
m
a
r
k
e
t
b
e
t
a
s
o
f
A
-
s
h
a
r
e
s
W
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
s
P
a
n
e
l
A
.
S
u
m
m
a
r
y
s
t
a
t
i
s
t
i
c
s
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
,
2
0
0
1
M
e
a
n
0
.
7
9
5
0
.
3
6
6
8
.
1
2
7
0
.
3
2
3
0
.
3
0
2
1
.
4
4
4
0
.
0
4
0
1
.
0
0
7
2
0
.
0
4
6
S
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
0
.
0
6
9
0
.
2
2
8
0
.
6
5
2
0
.
2
6
3
0
.
1
1
2
0
.
6
7
1
0
.
1
1
3
0
.
6
1
5
0
.
8
3
2
S
k
e
w
n
e
s
s
2
0
.
5
3
1
2
0
.
4
2
7
0
.
3
4
8
0
.
6
4
2
0
.
4
4
3
1
.
5
1
4
1
.
6
7
6
2
0
.
5
9
4
0
.
9
5
1
K
u
r
t
o
s
i
s
0
.
4
1
7
2
1
.
0
5
5
0
.
2
7
1
2
0
.
7
7
0
0
.
7
2
7
3
.
8
0
9
8
.
1
6
4
2
.
8
9
7
3
.
2
3
4
P
a
n
e
l
B
.
S
u
m
m
a
r
y
s
t
a
t
i
s
t
i
c
s
a
f
t
e
r
A
p
r
i
l
1
,
2
0
0
1
M
e
a
n
0
.
4
3
4
0
.
3
6
6
8
.
4
1
6
0
.
6
6
8
0
.
3
0
3
1
.
6
9
3
2
0
.
0
2
5
1
.
0
6
3
0
.
1
4
0
S
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
0
.
1
2
3
0
.
2
2
8
0
.
5
8
8
0
.
2
2
9
0
.
1
1
3
2
.
7
7
3
0
.
0
9
2
0
.
4
9
3
0
.
5
6
0
S
k
e
w
n
e
s
s
2
0
.
6
5
2
2
0
.
4
2
7
0
.
6
9
7
2
0
.
7
1
9
0
.
4
2
3
2
3
.
6
6
6
2
0
.
0
9
0
2
0
.
1
6
7
0
.
7
0
2
K
u
r
t
o
s
i
s
1
.
2
5
2
2
1
.
0
5
5
0
.
7
4
7
2
0
.
3
5
2
0
.
7
3
0
6
0
1
.
9
5
8
0
.
5
7
3
1
.
8
7
5
2
.
3
4
0
B
e
f
o
r
e
v
s
a
f
t
e
r
t
-
s
t
a
t
i
s
t
i
c
2
5
.
4
8
N
A
2
2
.
9
8
2
1
2
.
8
0
2
0
.
0
4
2
1
.
8
8
2
1
.
9
7
2
1
.
1
9
2
6
.
5
8
(
p
-
v
a
l
u
e
)
(
0
.
0
0
)
N
A
(
0
.
0
0
)
(
0
.
0
0
)
(
0
.
9
7
)
(
0
.
0
6
)
(
0
.
0
0
)
(
0
.
2
3
)
(
0
.
0
0
)
P
a
n
e
l
C
.
C
o
r
r
e
l
a
t
i
o
n
s
(
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
,
2
0
0
1
b
e
l
o
w
d
i
a
g
o
n
a
l
,
a
f
t
e
r
A
p
r
i
l
1
,
2
0
0
1
a
b
o
v
e
d
i
a
g
o
n
a
l
)
A
v
e
r
a
g
e
d
i
s
c
o
u
n
t
1
.
0
0
0
0
.
0
8
5
0
.
0
3
0
0
.
5
9
4
0
.
3
5
9
0
.
1
5
3
0
.
1
9
3
2
0
.
1
3
6
0
.
0
6
8
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
0
.
2
0
3
1
.
0
0
0
0
.
3
0
7
0
.
2
0
5
2
0
.
3
7
2
0
.
1
1
0
2
0
.
0
6
4
2
0
.
0
8
0
2
0
.
0
3
0
M
a
r
k
e
t
c
a
p
2
0
.
2
0
3
0
.
3
3
2
1
.
0
0
0
0
.
2
2
7
2
0
.
2
4
9
2
0
.
0
6
3
2
0
.
1
4
5
2
0
.
1
1
2
2
0
.
0
5
8
V
o
l
u
m
e
r
a
t
i
o
0
.
4
8
8
0
.
1
7
7
0
.
1
7
1
1
.
0
0
0
0
.
3
9
9
0
.
0
8
5
2
0
.
0
3
0
2
0
.
0
3
3
0
.
0
0
9
(
c
o
n
t
i
n
u
e
d
)
Table I.
Summary statistics of
Chinese B-share
discounts and other
attributes before and
after February 19, 2001
Resolution of the
Chinese discount
puzzle
85
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
v
e
r
a
g
e
d
i
s
c
o
u
n
t
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
a
s
o
f
2
0
0
1
M
a
r
k
e
t
c
a
p
(
R
m
b
,
m
i
l
l
i
o
n
s
)
V
o
l
u
m
e
r
a
t
i
o
(
V
O
B
/
V
O
A
þ
B
)
R
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
/
S
O
A
þ
B
)
R
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
(
s
B
/
s
A
)
M
o
m
e
n
t
u
m
L
o
c
a
l
m
a
r
k
e
t
b
e
t
a
s
o
f
A
-
s
h
a
r
e
s
W
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
s
R
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
0
.
1
2
1
2
0
.
3
5
7
2
0
.
3
0
2
0
.
3
6
5
1
.
0
0
0
2
0
.
0
8
6
0
.
0
4
3
0
.
1
3
7
2
0
.
0
7
6
R
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
0
.
1
1
5
0
.
2
3
6
0
.
1
9
9
0
.
6
0
6
0
.
0
8
4
1
.
0
0
0
2
0
.
0
1
7
2
0
.
5
0
7
2
0
.
0
4
6
M
o
m
e
n
t
u
m
0
.
4
1
2
2
0
.
0
9
1
2
0
.
2
3
3
0
.
0
0
3
0
.
0
3
5
2
0
.
2
4
2
1
.
0
0
0
0
.
1
3
4
0
.
1
6
1
L
o
c
a
l
m
a
r
k
e
t
B
e
t
a
s
o
f
A
-
s
h
a
r
e
s
2
0
.
2
3
6
2
0
.
1
2
7
0
.
0
2
1
2
0
.
2
6
2
2
0
.
0
2
2
2
0
.
1
9
1
2
0
.
2
1
8
1
.
0
0
0
0
.
2
2
4
W
o
r
l
d
m
a
r
k
e
t
B
e
t
a
s
o
f
B
-
s
h
a
r
e
s
0
.
2
6
4
2
0
.
1
5
2
2
0
.
2
8
4
0
.
0
9
7
0
.
1
1
9
0
.
0
8
4
0
.
1
9
5
2
0
.
0
6
4
1
.
0
0
0
N
o
t
e
s
:
T
h
e
d
i
s
c
o
u
n
t
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
d
i
f
f
e
r
e
n
c
e
b
e
t
w
e
e
n
t
h
e
c
l
o
s
i
n
g
A
-
s
h
a
r
e
s
t
o
c
k
p
r
i
c
e
(
P
A
)
a
n
d
c
l
o
s
i
n
g
B
-
s
h
a
r
e
s
t
o
c
k
p
r
i
c
e
(
P
B
)
o
n
a
c
u
r
r
e
n
c
y
-
a
d
j
u
s
t
e
d
b
a
s
i
s
d
i
v
i
d
e
d
b
y
A
-
s
h
a
r
e
p
r
i
c
e
a
s
(
(
P
A
2
P
B
)
/
P
A
)
;
n
u
m
b
e
r
o
f
d
a
y
s
i
s
t
h
e
d
a
i
l
y
o
b
s
e
r
v
a
t
i
o
n
s
a
v
a
i
l
a
b
l
e
f
r
o
m
J
a
n
u
a
r
y
2
,
2
0
0
0
t
h
r
o
u
g
h
D
e
c
e
m
b
e
r
3
1
,
2
0
0
1
;
t
h
e
p
e
r
i
o
d
f
r
o
m
F
e
b
r
u
a
r
y
1
,
2
0
0
1
t
o
M
a
r
c
h
3
1
,
2
0
0
1
i
s
e
x
c
l
u
d
e
d
;
g
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
i
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
C
h
i
n
e
s
e
G
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
i
n
t
h
e
e
n
t
e
r
p
r
i
s
e
;
S
O
B
/
S
O
A
þ
B
i
s
t
h
e
f
r
a
c
t
i
o
n
o
f
B
-
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
)
t
o
t
o
t
a
l
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
A
þ
B
)
;
r
e
l
a
t
i
v
e
v
o
l
a
t
i
l
i
t
y
(
s
B
/
s
A
)
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
r
a
t
i
o
o
f
t
h
e
t
r
a
i
l
i
n
g
o
n
e
-
m
o
n
t
h
s
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
o
f
d
a
i
l
y
r
e
t
u
r
n
s
o
n
A
a
n
d
B
s
h
a
r
e
s
,
r
e
s
p
e
c
t
i
v
e
l
y
;
V
O
B
/
V
O
A
þ
B
i
s
v
o
l
u
m
e
r
a
t
i
o
o
f
a
v
e
r
a
g
e
d
a
i
l
y
t
r
a
d
i
n
g
v
o
l
u
m
e
o
f
B
s
h
a
r
e
s
(
V
O
B
)
r
e
l
a
t
i
v
e
t
o
a
v
e
r
a
g
e
d
a
i
l
y
t
o
t
a
l
v
o
l
u
m
e
o
f
A
a
n
d
B
s
h
a
r
e
s
(
V
O
A
þ
B
)
;
m
a
r
k
e
t
c
a
p
i
s
i
n
l
o
g
s
a
n
d
d
e
n
o
m
i
n
a
t
e
d
i
n
y
u
a
n
;
m
o
m
e
n
t
u
m
i
s
t
h
e
c
u
m
u
l
a
t
i
v
e
p
a
s
t
-
o
n
e
-
m
o
n
t
h
r
e
t
u
r
n
s
o
n
A
s
h
a
r
e
s
;
l
o
c
a
l
m
a
r
k
e
t
B
e
t
a
s
o
f
A
-
s
h
a
r
e
s
i
s
c
o
m
p
u
t
e
d
u
s
i
n
g
O
L
S
w
i
t
h
d
a
i
l
y
r
e
t
u
r
n
s
o
v
e
r
t
h
e
t
r
a
i
l
i
n
g
m
o
n
t
h
o
f
A
-
s
h
a
r
e
s
o
n
a
n
e
q
u
a
l
l
y
-
w
e
i
g
h
t
e
d
i
n
d
e
x
o
f
a
l
l
A
-
s
h
a
r
e
s
a
n
d
w
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
s
i
s
c
o
m
p
u
t
e
d
u
s
i
n
g
O
L
S
w
i
t
h
d
a
i
l
y
r
e
t
u
r
n
s
o
v
e
r
t
h
e
t
r
a
i
l
i
n
g
m
o
n
t
h
o
f
B
-
s
h
a
r
e
s
o
n
t
h
e
M
S
C
I
i
n
d
e
x
;
t
w
o
c
o
r
r
e
l
a
t
i
o
n
t
a
b
l
e
s
f
o
r
e
a
c
h
s
u
b
s
a
m
p
l
e
(
p
r
e
-
a
n
d
p
o
s
t
-
e
v
e
n
t
)
a
r
e
r
e
p
o
r
t
e
d
i
n
P
a
n
e
l
C
;
n
u
m
b
e
r
o
f
o
b
s
e
r
v
a
t
i
o
n
s
i
s
7
6
Table I.
JFEP
1,1
86
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a
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d
b
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P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
Other statistics reported include the sample standard deviation, skewness, kurtosis, as
well as t-statistic associated with the null hypothesis that the variable of interest is equal
across the two subperiods. Panel C presents the correlations among these variables
before February 2001 (belowthe diagonal) and after February 2001 (above the diagonal).
The average B-share discount declines from 79.5 to 43.4 percent around February
2001, and this change is statistically signi?cantly different from zero (t-statistic of
25.5). There is greater cross-sectional dispersion in the discounts after the rule change.
We also observe statistically signi?cant increases in the B-share volume ratio, market
cap (though the magnitude is small), and in world market betas of the B-shares. The
statistically signi?cant but economically modest 4 percent A-share momentum
observed in the month before February 2001 is reversed in the month after the rule
change. The correlation between the discount and the government ownership stake is
positive (0.203) before B-share market opened up, but it declines signi?cantly
afterward (0.085). The other variables with noteworthy correlations include the volume
ratio, which is positively correlated with the discount before (0.489) and after the rule
change (0.594), and the ratio of shares outstanding, which is large and positive after
February 2001 (0.359), but smaller before that date (0.129).
3.2 Estimation methods
We estimate multivariate regression models of the B-share discounts computed before the
B-share market opened upandafterward, as well as of the change inthe B-share discounts
over this period. One important concern is that we measure as accurately as possible the
immediate impact of the rule change on the markets, but with as little statistical noise due
to imprecise measurement as possible. The tradeoff concerns the period over which to
measure the B-share discounts before and after the event as well as a number of the
control variables. We attempted various sample periods but report the results using
the “Before” period from February 1, 2001 through February 19, 2001 and the “After”
period from February 28 to April 1, 2001. All estimation is with ordinary least squares
(OLS) using t-statistics based on standard errors robust to heteroscedasticity using
White (1980).
The following regression models are estimated:
Discount
it
¼ g
0
þg
1
Govt ownership
it
þg
2
D_own
it
þg
3
VO
B
VO
AþB
it21
þg
4
SO
B
SO
AþB
it21
þg
5
MCAP
it21
þg
6
ðMomentumÞ
it21
þg
7
sA
sB
it21
þg
8
b
M
Ait21
þg
9
b
W
Bit21
þg
10
I
Shanghai;i
þ1
it
;
ð1Þ
DDiscount
it
¼ d
0
þd
1
Govt ownership
it
þd
2
D_own
it
þd
3
VO
B
VO
AþB
it21
þd
4
SO
B
SO
AþB
it21
þd
5
MCAP
it21
þd
6
ðMomentumÞ
it21
þd
7
sA
sB
it21
þd
8
b
M
Ait21
þd
9
b
W
Bit21
þd
10
I
Shanghai;i
þ1
it
;
ð2Þ
Resolution of the
Chinese discount
puzzle
87
D
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b
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O
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D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
where Discount
it
and DDiscount
it
denotes the pre- and post-event discount (a positive
value denotes a discount) and the change in the discount for ?rm i. The subscript t
denotes the period after the event and t 2 1 denotes that before the event. Govt
ownership
it
denotes the state ownership level in 2001 and D_own
it
is a dummy variable
that is equal to one if the ?rm’s government ownership in 2001 is equal to zero. We also
introduce a dummy variable for those stocks traded on the SHSE (I
Shanghai
). The rest of
the variables are as de?ned above.
Our central hypothesis outlines what we expect for the government ownership in
the B-share discount regression models in equations (1) and (2). Based on Fernald and
Rogers (2002), we expect a positive relationship (g
1
. 0) before the rule change and that
this relationship should weaken after the B-share market opened up (d
1
, 0). The dummy
variable for ?rms with no state ownership stakes are designed to capture potential
non-linearity in this relationship; we expect that the discount should be smaller for these
?rms (g
2
, 0) and that this difference should decline after the rule change (d
2
, 0).
We have expectations about the control variables in these equations. The volume
ratio is a (inverse) proxy for the relative liquidity in the A- and B-share markets, which
studies by Chen et al. (2001) have found to be important for the B-share discount puzzle.
If the liquidity hypothesis is correct, more liquid and thus more actively traded
B-shares should be associated with a smaller discount (g
3
, 0) and this should weaken
toward zero if the B-share market opens up (d
3
. 0). The differential demand
hypothesis is based on a model by Stulz and Wasserfallen (1995). They propose that
demand functions for domestic and foreign investors differ in terms of price elasticity.
Their model would predict that the B-share discount is smaller as foreign demand
increases[8]. As an empirical proxy, we use the ratio of outstanding B-shares to total
outstanding shares. In equilibrium, of course, the distinction between measures of
supply and demand may not be clear. If outstanding shares are primarily determined
by supply of shares by ?rms rather than demand by investors, we may observe the
discount across ?rms as a positive function of the ratio of B-shares to total shares
outstanding (g
4
. 0)[9]. After the rule change, the discount should decline more for
?rms with greater excess supply (d
4
, 0).
The differential risk hypothesis – ?rst delineated by Bailey (1994) for China and
later tested by Ma (1996) and Eun et al. (2001) – proposes that price differences are
in?uenced by investors’ attitudes toward risk. Since Chinese investors cannot readily
diversify overseas, the B-share discount will be greater the lower the systematic
exposures of the A-shares relative to other A-shares traded in China (g
8
, 0) and the
higher the systematic exposures of the B-shares relative to world market returns
(g
9
. 0). Sun and Tong (2000), Chen et al. (2001) and Eun et al. (2001) test the
hypothesis between the discount and these risks, but they uncover mixed evidence. We
also consider the volatility ratio as a proxy for relative risks and would predict that
higher relative total risk of B-shares should be associated with a larger B-share
discount (g
7
. 0). All three of these risk sensitivities should diminish toward zero with
the rule change (d
8
. 0, d
9
, 0 and d
7
, 0). Finally, the asymmetric information
hypothesis suggests that B-shares trade at a discount because foreign investors have
less information than local investors (due to language barriers, different accounting
rules). Following Sun and Tong (2000) and Chen et al. (2001), we would expect that this
disadvantage is smaller for larger ?rms, so g
5
is expected to be negative, but that this
would diminish after the B-share market opens up (d
5
. 0).
JFEP
1,1
88
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a
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d
b
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O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
The second experiment in our study constructs portfolios of stocks based on the
level of state ownership and the tests for differences in their risk-adjusted returns
performance during the event period. We estimate a system of equations using
Zellner’s (1962) seemingly-unrelated (SUR) model and a multi-index returns generating
model for daily A- and B-share returns, respectively:
R
iPt
¼a
P
þb
PB
R
B
iMt
þb
PA
R
A
iMt
þg
P
D
it
þb
PBD
R
B
iMt
£D
it
þb
PAD
R
A
iMt
£D
it
þ1
it
: ð3Þ
D
it
is a dummyvariable that is equal to one if t is between February 28, 2001 and March 6,
2001 for the period (?rst ?ve trading days) that Chinese residents were allowed to trade
B-shares, and zero, otherwise. R
iPt
is the return on an equally-weighted portfolio of
A-share or B-share stocks in quintile portfolio P sorted according to the level of state
ownership of shares in 2001. Equally-weighted A- and B-share index returns (R
A
iMt
and
R
B
iMt
, respectively) are translated using that day’s prevailing exchange rate into either
Hong Kong or US dollar-denominated returns depending on the ?rm’s traded exchange
for the B-shares. The sample period is the same as that for the cross-sectional regressions
starting from February 1, 2001 and ending on March 31, 2001. We estimate the SUR
model for quintile portfolios by level of state ownership and apply the Gibbons et al.
(1989) test that the intercepts, a
P
, are jointly equal to zero, distributed as an F-statistic, to
measure whether the returns different from each other on a risk-adjusted basis. We also
compute a supplementary test whether the risk-adjusted returns are signi?cantly
different during the period of the rule change by evaluating whether a
P
þ g
P
are equal
across the ?ve portfolios. Finally, the same tests are computed for the extreme (highest
and lowest state-ownership level quintile) portfolios only.
3.3 Results
Table II reports the cross-sectional regression results. The dependent variables for
Panels A, B and C are, respectively, the average B-share discount before and after the
opening of the B-share market and the change in the average discount from the pre- to
post-event period. We report a series of univariate and then one multivariate
speci?cation (always Model 9 in each panel) with coef?cient estimates, associated
t-statistics and the adjusted R
2
.
State ownership is the only ?rm characteristic that signi?cantly affects the discount
levels and changes. Before February 19, 2001 (in Panel A), B-share investors (foreign
investors) penalize by way of a larger B-share discount those ?rms with higher
government ownership. The coef?cient in Model 2 is statistically signi?cant and
positive (0.157) and that in Model 9 with all the control variables is of a similar
magnitude (0.148). To get a sense of the economic importance, a ?rm with 75 percent
state ownership (the highest in our sample) has a 19 percent higher discount than a
?rm with no state ownership. Given the average discount level is 80 percent during this
period, a 19 percent change in discount level is substantial; it is equivalent to 24 percent
higher discounts for ?rms with high state ownership. After February 19, 2001 (Panel
B), the penalty that B-share investors impose on ?rms with high state ownership does
not abate, but even widens further. The coef?cient is 0.268 in Model 2 and 0.274 in
Model 9 with all the controls. A ?rm with 75 percent state ownership now has an even
larger 33 percent higher discount than a ?rm with no state ownership. Given that the
average discount level is 55 percent during this post-February 2001 period, a 33 percent
difference in discount level means that ?rms with high state ownership have almost
Resolution of the
Chinese discount
puzzle
89
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
M
o
d
e
l
(
1
)
(
2
)
(
3
)
(
4
)
(
5
)
(
6
)
(
7
)
(
8
)
(
9
)
P
a
n
e
l
A
.
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
C
o
n
s
t
a
n
t
0
.
7
6
4
*
*
*
(
8
7
.
7
1
)
0
.
7
8
0
*
*
*
(
5
1
.
1
6
)
0
.
7
2
4
*
*
*
(
5
4
.
7
3
)
0
.
7
3
3
*
*
*
(
3
2
.
5
3
)
0
.
8
4
3
*
*
*
(
9
.
2
2
)
0
.
7
5
1
*
*
*
(
3
4
.
3
7
)
0
.
7
9
3
*
*
*
(
2
4
.
7
6
)
0
.
7
9
3
*
*
*
(
3
6
.
8
2
)
1
.
0
6
3
*
*
*
(
1
1
.
6
3
)
G
o
v
t
o
w
n
e
r
s
h
i
p
0
.
1
5
7
*
*
*
(
3
.
7
2
)
0
.
1
4
8
*
*
(
2
.
6
3
)
G
o
v
t
o
w
n
d
u
m
m
y
2
0
.
0
9
3
*
*
*
(
2
3
.
8
0
)
2
0
.
0
7
9
*
*
*
(
2
2
.
6
5
)
(
V
O
B
/
V
O
A
þ
B
)
0
.
1
5
3
*
*
*
(
4
.
0
9
)
0
.
1
4
8
*
*
*
(
3
.
2
5
)
(
S
O
B
/
S
O
A
þ
B
)
0
.
1
1
0
(
1
.
4
9
)
2
0
.
0
0
5
(
2
0
.
0
8
)
M
C
A
P
2
0
.
0
1
0
(
2
0
.
8
6
)
2
0
.
0
3
4
*
*
*
(
2
3
.
6
6
)
M
o
m
e
n
t
u
m
2
0
.
1
0
9
(
2
0
.
7
3
)
2
0
.
0
5
1
(
2
0
.
5
5
)
V
o
l
a
t
i
l
i
t
y
r
a
t
i
o
2
0
.
0
2
6
(
2
0
.
8
7
)
2
0
.
0
2
5
(
2
0
.
9
5
)
L
o
c
a
l
b
e
t
a
(
A
)
2
0
.
0
0
6
(
2
0
.
4
7
)
2
0
.
0
1
4
(
2
1
.
3
7
)
W
o
r
l
d
b
e
t
a
(
B
)
0
.
0
4
4
*
(
1
.
8
5
)
0
.
0
1
8
(
1
.
2
2
)
S
h
a
n
g
h
a
i
d
u
m
m
y
2
0
.
0
2
0
(
2
1
.
4
7
)
2
0
.
0
1
7
(
2
1
.
5
1
)
2
0
.
0
7
3
*
*
*
(
2
3
.
8
1
)
2
0
.
0
2
3
(
2
1
.
6
5
)
2
0
.
0
1
8
(
2
1
.
3
9
)
2
0
.
0
1
4
(
2
1
.
0
0
)
2
0
.
0
2
0
(
2
1
.
5
4
)
2
0
.
0
1
9
(
2
1
.
4
7
)
2
0
.
0
6
1
*
*
*
(
2
3
.
2
6
)
A
d
j
u
s
t
e
d
R
2
0
.
0
1
4
7
0
.
1
4
7
1
0
.
2
3
7
7
0
.
0
4
4
2
0
.
0
1
1
2
0
.
0
1
5
2
0
.
0
3
0
6
0
.
0
5
1
7
0
.
4
0
7
1
P
a
n
e
l
B
.
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
a
f
t
e
r
F
e
b
r
u
a
r
y
2
8
,
2
0
0
1
C
o
n
s
t
a
n
t
0
.
5
2
6
*
*
*
(
3
8
.
6
9
)
0
.
5
4
2
*
*
*
(
2
3
.
9
5
)
0
.
4
7
0
*
*
*
(
2
5
.
3
8
)
0
.
4
8
3
*
*
*
(
1
3
.
5
9
)
0
.
5
9
5
*
*
*
(
4
.
4
2
)
0
.
4
9
7
*
*
*
(
1
5
.
8
4
)
0
.
5
6
0
*
*
*
(
1
2
.
8
4
)
0
.
5
8
5
*
*
*
(
1
7
.
6
5
)
0
.
9
1
0
*
*
*
(
6
.
9
3
)
G
o
v
t
o
w
n
e
r
s
h
i
p
0
.
2
6
8
*
*
*
(
4
.
2
9
)
0
.
2
7
4
*
*
*
(
3
.
8
3
)
(
c
o
n
t
i
n
u
e
d
)
Table II.
Regressions of B-share
discounts around the
February 28, 2001
opening of the market to
domestic Chinese
investors
JFEP
1,1
90
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
M
o
d
e
l
(
1
)
(
2
)
(
3
)
(
4
)
(
5
)
(
6
)
(
7
)
(
8
)
(
9
)
G
o
v
t
o
w
n
d
u
m
m
y
2
0
.
1
4
3
*
*
*
(
2
4
.
0
7
)
2
0
.
1
2
8
*
*
*
(
2
3
.
5
9
)
(
V
O
B
/
V
O
A
þ
B
)
0
.
2
1
1
*
*
*
(
4
.
1
6
)
0
.
1
7
7
*
*
*
(
3
.
0
2
)
(
S
O
B
/
S
O
A
þ
B
)
0
.
1
5
1
(
1
.
3
4
)
0
.
0
5
1
(
0
.
5
3
)
M
C
A
P
2
0
.
0
0
8
(
2
0
.
5
2
)
2
0
.
0
4
6
*
*
*
(
2
3
.
4
2
)
M
o
m
e
n
t
u
m
2
0
.
2
3
4
(
2
0
.
9
7
)
2
0
.
1
7
2
(
2
1
.
1
9
)
V
o
l
a
t
i
l
i
t
y
r
a
t
i
o
2
0
.
0
3
1
(
2
0
.
7
9
)
2
0
.
0
2
7
(
2
0
.
7
5
)
L
o
c
a
l
b
e
t
a
(
A
)
2
0
.
0
2
1
2
0
.
0
3
1
*
(
2
1
.
9
0
)
(
2
1
.
1
6
)
W
o
r
l
d
b
e
t
a
(
B
)
0
.
0
5
8
0
.
0
2
0
(
0
.
7
9
)
(
1
.
5
8
)
S
h
a
n
g
h
a
i
d
u
m
m
y
0
.
0
7
0
*
*
*
(
3
.
5
0
)
0
.
0
7
2
*
*
*
(
3
.
9
9
)
2
0
.
0
0
3
(
2
0
.
1
0
)
0
.
0
6
6
*
*
*
(
3
.
2
0
)
0
.
0
7
2
*
*
*
(
3
.
6
1
)
0
.
0
8
3
*
*
*
(
4
.
0
4
)
0
.
0
7
0
*
*
*
(
3
.
5
0
)
0
.
0
7
3
*
*
*
(
3
.
7
9
)
0
.
0
2
5
(
0
.
9
6
)
A
d
j
u
s
t
e
d
R
2
0
.
1
2
7
2
0
.
2
6
8
9
0
.
2
9
2
5
0
.
1
4
7
6
0
.
1
1
8
3
0
.
1
4
0
6
0
.
1
3
1
4
0
.
1
6
6
5
0
.
4
6
9
3
P
a
n
e
l
C
.
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
c
h
a
n
g
e
f
r
o
m
b
e
f
o
r
e
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
t
o
a
f
t
e
r
F
e
b
r
u
a
r
y
2
8
,
2
0
0
1
C
o
n
s
t
a
n
t
2
0
.
2
3
8
*
*
*
(
2
3
3
.
7
9
)
2
0
.
2
3
9
*
*
*
(
2
2
0
.
2
8
)
2
0
.
2
5
4
*
*
*
(
2
2
8
.
5
3
)
2
0
.
2
5
0
*
*
*
(
2
1
4
.
1
5
)
2
0
.
2
4
7
*
*
*
(
2
4
.
4
5
)
2
0
.
2
5
4
*
*
*
(
2
2
0
.
4
6
)
2
0
.
2
3
3
*
*
*
(
2
1
4
.
4
1
)
2
0
.
2
0
9
*
*
*
(
2
1
2
.
7
4
)
2
0
.
1
5
3
*
*
(
2
2
.
2
6
)
G
o
v
t
o
w
n
e
r
s
h
i
p
0
.
1
1
1
*
*
*
(
3
.
6
2
)
0
.
1
2
6
*
*
*
(
4
.
0
6
)
G
o
v
t
o
w
n
d
u
m
m
y
2
0
.
0
4
9
*
*
*
(
2
2
.
9
3
)
2
0
.
0
5
*
*
*
(
2
3
.
5
7
)
(
V
O
B
/
V
O
A
þ
B
)
0
.
0
5
8
*
*
(
2
.
5
8
)
0
.
0
2
9
(
1
.
2
6
)
(
c
o
n
t
i
n
u
e
d
)
Table II.
Resolution of the
Chinese discount
puzzle
91
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
M
o
d
e
l
(
1
)
(
2
)
(
3
)
(
4
)
(
5
)
(
6
)
(
7
)
(
8
)
(
9
)
(
S
O
B
/
S
O
A
þ
B
)
0
.
0
4
2
(
0
.
7
6
)
0
.
0
5
6
(
1
.
1
5
)
M
C
A
P
0
.
0
0
1
(
0
.
1
7
)
2
0
.
0
1
2
*
(
2
1
.
7
1
)
M
o
m
e
n
t
u
m
2
0
.
1
2
5
(
2
1
.
1
3
)
2
0
.
1
2
0
(
2
1
.
6
1
)
V
o
l
a
t
i
l
i
t
y
r
a
t
i
o
2
0
.
0
0
5
(
2
0
.
4
1
)
2
0
.
0
0
2
(
2
0
.
1
4
)
L
o
c
a
l
b
e
t
a
(
A
)
2
0
.
0
1
6
*
(
2
1
.
8
2
)
2
0
.
0
1
7
(
2
1
.
5
5
)
W
o
r
l
d
b
e
t
a
(
B
)
0
.
0
1
5
(
0
.
8
1
)
0
.
0
0
2
(
0
.
1
4
)
S
h
a
n
g
h
a
i
d
u
m
m
y
0
.
0
9
0
*
*
*
(
9
.
6
2
)
0
.
0
8
9
*
*
*
(
9
.
2
8
)
0
.
0
7
0
*
*
*
(
5
.
7
1
)
0
.
0
8
9
*
*
*
(
9
.
4
8
)
0
.
0
9
0
*
*
*
(
9
.
6
7
)
0
.
0
9
7
*
*
*
(
1
0
.
5
6
)
0
.
0
9
0
*
*
*
(
9
.
5
9
)
0
.
0
9
2
*
*
*
(
1
0
.
5
7
)
0
.
0
8
6
*
*
*
(
6
.
8
9
)
A
d
j
u
s
t
e
d
R
2
0
.
5
4
3
0
0
.
5
9
5
7
0
.
5
6
9
1
0
.
5
4
2
7
0
.
5
3
6
9
0
.
5
5
4
1
0
.
5
3
7
7
0
.
5
6
0
5
0
.
6
3
5
0
N
o
t
e
s
:
A
l
l
p
a
n
e
l
s
s
h
a
r
e
t
h
e
s
a
m
e
i
n
d
e
p
e
n
d
e
n
t
v
a
r
i
a
b
l
e
s
t
h
a
t
a
r
e
c
o
m
p
u
t
e
d
a
s
t
h
e
a
v
e
r
a
g
e
s
o
f
d
a
i
l
y
o
b
s
e
r
v
a
t
i
o
n
s
f
r
o
m
F
e
b
r
u
a
r
y
1
,
2
0
0
1
t
o
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
,
w
h
i
c
h
i
n
c
l
u
d
e
t
h
e
l
e
v
e
l
o
f
g
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
(
g
o
v
t
o
w
n
e
r
s
h
i
p
)
a
s
o
f
2
0
0
1
,
a
g
o
v
e
r
n
m
e
n
t
o
w
n
e
r
s
h
i
p
d
u
m
m
y
(
g
o
v
t
o
w
n
d
u
m
m
y
)
t
h
a
t
i
s
e
q
u
a
l
t
o
o
n
e
i
f
t
h
e
?
r
m
h
a
s
n
o
s
t
a
t
e
o
w
n
e
r
s
h
i
p
a
n
d
z
e
r
o
o
t
h
e
r
w
i
s
e
,
r
a
t
i
o
o
f
s
h
a
r
e
s
o
u
t
s
t
a
n
d
i
n
g
(
S
O
B
/
S
O
A
þ
B
)
,
m
a
r
k
e
t
c
a
p
i
t
a
l
i
z
a
t
i
o
n
(
M
C
A
P
,
i
n
l
o
g
s
)
,
m
o
m
e
n
t
u
m
c
o
m
p
u
t
e
d
a
s
t
h
e
c
u
m
u
l
a
t
i
v
e
m
o
n
t
h
l
y
A
-
s
h
a
r
e
r
e
t
u
r
n
s
o
v
e
r
t
h
e
p
r
e
c
e
d
i
n
g
m
o
n
t
h
,
t
h
e
v
o
l
a
t
i
l
i
t
y
r
a
t
i
o
(
s
B
/
s
A
)
i
s
c
o
m
p
u
t
e
d
a
s
t
h
e
r
a
t
i
o
o
f
t
h
e
t
r
a
i
l
i
n
g
o
n
e
-
m
o
n
t
h
s
t
a
n
d
a
r
d
d
e
v
i
a
t
i
o
n
o
f
d
a
i
l
y
r
e
t
u
r
n
s
o
n
A
a
n
d
B
s
h
a
r
e
s
,
r
e
s
p
e
c
t
i
v
e
l
y
;
V
O
B
/
V
O
A
þ
B
i
s
t
h
e
v
o
l
u
m
e
r
a
t
i
o
o
f
a
v
e
r
a
g
e
d
a
i
l
y
t
r
a
d
i
n
g
v
o
l
u
m
e
o
f
B
s
h
a
r
e
s
(
V
O
B
)
r
e
l
a
t
i
v
e
t
o
a
v
e
r
a
g
e
d
a
i
l
y
t
o
t
a
l
v
o
l
u
m
e
o
f
A
a
n
d
B
s
h
a
r
e
s
(
V
O
A
þ
B
)
.
)
,
l
o
c
a
l
b
e
t
a
s
o
f
A
-
s
h
a
r
e
s
r
e
l
a
t
i
v
e
t
o
t
h
e
e
q
u
a
l
l
y
w
e
i
g
h
t
e
d
l
o
c
a
l
A
-
s
h
a
r
e
m
a
r
k
e
t
p
o
r
t
f
o
l
i
o
,
a
n
d
w
o
r
l
d
m
a
r
k
e
t
b
e
t
a
s
o
f
B
-
s
h
a
r
e
r
e
l
a
t
i
v
e
t
o
t
h
e
M
o
r
g
a
n
S
t
a
n
l
e
y
w
o
r
l
d
m
a
r
k
e
t
i
n
d
e
x
;
w
e
a
l
s
o
i
n
c
l
u
d
e
a
d
u
m
m
y
v
a
r
i
a
b
l
e
f
o
r
t
h
o
s
e
s
t
o
c
k
s
t
h
a
t
t
r
a
d
e
o
n
t
h
e
S
H
S
E
(
S
h
a
n
g
h
a
i
d
u
m
m
y
e
q
u
a
l
s
o
n
e
)
;
t
h
e
d
e
p
e
n
d
e
n
t
v
a
r
i
a
b
l
e
f
o
r
P
a
n
e
l
s
A
,
B
a
n
d
C
a
r
e
d
e
?
n
e
d
,
r
e
s
p
e
c
t
i
v
e
l
y
,
a
s
t
h
e
a
v
e
r
a
g
e
B
-
s
h
a
r
e
d
i
s
c
o
u
n
t
f
r
o
m
F
e
b
r
u
a
r
y
1
,
2
0
0
1
t
o
F
e
b
r
u
a
r
y
1
9
,
2
0
0
1
,
f
r
o
m
F
e
b
r
u
a
r
y
2
8
t
o
M
a
r
c
h
3
1
,
2
0
0
1
,
a
n
d
t
h
e
a
v
e
r
a
g
e
d
i
s
c
o
u
n
t
c
h
a
n
g
e
f
r
o
m
t
h
e
p
r
e
-
p
e
r
i
o
d
t
o
p
o
s
t
-
e
v
e
n
t
p
e
r
i
o
d
;
O
L
S
e
s
t
i
m
a
t
o
r
s
a
r
e
r
e
p
o
r
t
e
d
w
i
t
h
t
-
s
t
a
t
i
s
t
i
c
s
(
i
n
p
a
r
e
n
t
h
e
s
e
s
)
b
a
s
e
d
o
n
s
t
a
n
d
a
r
d
e
r
r
o
r
s
u
s
i
n
g
W
h
i
t
e
(
1
9
8
0
)
m
e
t
h
o
d
s
r
o
b
u
s
t
t
o
h
e
t
e
r
o
s
k
e
d
a
s
t
i
c
i
t
y
;
a
d
j
u
s
t
e
d
R
2
i
s
R
-
s
q
u
a
r
e
d
a
d
j
u
s
t
e
d
f
o
r
d
e
g
r
e
e
s
o
f
f
r
e
e
d
o
m
.
T
h
e
n
u
m
b
e
r
o
f
o
b
s
e
r
v
a
t
i
o
n
s
i
s
7
6
Table II.
JFEP
1,1
92
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
60 percent more discount, ceteris paribus. Comparing pre- and post-event changes in
sensitivities of B-shares valuation to state ownership, we ?nd that when domestic
investors are allowed to hold B-shares, those ?rms with no state ownership or low state
ownership are strongly preferred. This is veri?ed in our key regression model in Panel
C; the coef?cient on government ownership is statistically signi?cant and positive
(0.111). This implies that a ?rm with 75 percent state ownership experiences 14 percent
smaller decrease in its discount than a ?rm with no state ownership. This difference
constitutes about 40 percent of the discount decline of one of the low state ownership
?rms. Overall, this state ownership variable is statistically and economically important
for the B-share discount levels, as previous research by Fernald and Rogers (2002) has
shown. However, it is even more important after the opening of the B-share market,
which is not what we would have expected if, as Fernald and Rogers claim, domestic
residents entering the B-share market revalued the state ownership stakes with a
smaller discount than foreign residents.
Interestingly, few of other ?rm characteristics appear to explain the discount level
and discount changes in a signi?cant way. The relative liquidity variable (relative
volume ratio) has a signi?cantly positive coef?cient in both Panels Aand B for discount
levels, but has no explanatory power in Panel C for discount changes when the state
ownership variable is present in the model. But, even in Panels Aand B, the signs of the
liquidity variable are the opposite of what we would expect according to the liquidity
hypothesis. The market capitalization variable is not signi?cant in either of the
univariate speci?cations (Models 5 in Panels Aand B), but it is statistically signi?cant in
the multivariate speci?cation of Model 9 and with a large negative coef?cient (20.034 in
Panel A, 20.046 in Panel B). This is consistent with the asymmetric information
hypothesis in that the discount is smaller for larger ?rms for which foreign investors are
less likely to be at an information disadvantage. In Panel C, for the discount change, the
sensitivity to size is statistically weak and surprisingly negative (20.012). The
asymmetric information cost to foreigners embedded in the B-share discount should
have diminished, not widened further. All other variables which proxy for differential
demand or differential risk fail to have any signi?cant explanatory power.
Based on the consistent results fromdifferent regressions and the explanatory power
of state ownership, we conclude that state ownership, our proxy for political risk, is a key
factor in explaining the B-share discount. New investors that entered the liberalized
B-share market appeared to be even more averse to ?rms with high state ownership than
the original B-share investors, ceteris paribus. This is a surprising result.
Table III provides further evidence based on portfolio analysis. Panel A shows the
SUR results for A-share quintile portfolios grouped by the level of state ownership.
Panel B is for B-share quintile portfolios. The only signi?cant variables in Panel A are
the A-share market beta (b
PA
), which are all above one. They are positive and
statistically signi?cant for these 76 ?rms during this period from February through
March in 2001. The February 19 regulatory event did not change A-share betas in any
signi?cant way (b
PAD
equals zero for all portfolios). All the risk-adjusted returns on
these A-share quintile portfolios (a
P
) equal zero and they are not signi?cantly different
after the regulatory change (g
P
equals zero for all portfolios). Gibbons, Ross and
Shanken (GRS) tests with associated F-statistics of the joint equality of the g
P
and of
their zero exclusion (g
P
equals zero for each portfolio) con?rm that there were no
changes in the risk-adjusted returns over this period.
Resolution of the
Chinese discount
puzzle
93
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
3
5
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
-
s
h
a
r
e
p
o
r
t
f
o
l
i
o
s
B
-
s
h
a
r
e
p
o
r
t
f
o
l
i
o
s
L
o
w
e
s
t
g
o
v
t
Q
1
Q
2
Q
3
Q
4
H
i
g
h
e
s
t
g
o
v
t
Q
5
L
o
w
e
s
t
g
o
v
t
Q
1
Q
2
Q
3
Q
4
H
i
g
h
e
s
t
g
o
v
t
Q
5
a
P
2
0
.
0
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1
(
0
.
4
2
)
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(
0
.
2
6
)
0
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0
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(
0
.
0
1
)
0
.
0
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1
(
0
.
6
6
)
0
.
0
0
8
(
3
.
0
5
)
*
*
*
0
.
0
0
6
(
2
.
3
5
)
*
*
0
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0
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2
(
1
.
8
2
)
*
0
.
0
0
3
(
2
.
5
7
)
*
*
0
.
0
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8
(
3
.
3
8
)
*
*
*
b
P
B
2
0
.
0
2
7
(
0
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5
4
)
2
0
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0
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4
(
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7
8
)
2
0
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0
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0
(
0
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1
9
)
0
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0
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2
(
0
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0
3
)
2
0
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0
3
6
(
0
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5
7
)
0
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8
6
6
(
8
.
7
3
)
*
*
*
0
.
9
7
4
(
1
1
.
2
)
*
*
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.
9
5
4
(
2
0
.
2
)
*
*
*
0
.
9
5
4
(
2
2
.
5
)
*
*
*
0
.
7
8
3
(
9
.
2
6
)
*
*
*
b
P
A
1
.
6
1
2
(
1
0
.
6
1
)
*
*
*
1
.
7
0
1
(
9
.
7
6
)
*
*
*
1
.
3
6
1
(
8
.
9
5
)
*
*
*
1
.
6
2
7
(
7
.
9
7
)
*
*
*
1
.
4
3
8
(
7
.
3
0
)
*
*
*
0
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4
2
6
(
1
.
4
0
)
0
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4
0
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(
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.
5
0
)
0
.
2
4
3
(
1
.
6
7
)
*
0
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7
4
(
1
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3
3
)
0
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7
(
1
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5
7
)
g
P
2
0
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0
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(
0
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1
5
)
2
0
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(
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1
4
)
2
0
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5
(
0
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3
2
)
2
0
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9
(
0
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3
9
)
0
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0
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(
0
.
3
7
)
0
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0
7
0
(
2
.
0
5
)
*
*
0
.
0
6
0
(
2
.
0
0
)
*
*
0
.
0
1
1
(
0
.
6
8
)
0
.
0
1
2
(
0
.
8
0
)
0
.
0
1
9
(
0
.
6
4
)
b
P
B
D
0
.
0
9
0
(
0
.
1
0
)
2
0
.
1
3
7
(
0
.
1
4
)
2
0
.
5
2
6
(
0
.
6
1
)
2
0
.
1
4
3
(
0
.
1
2
)
2
0
.
9
9
1
(
0
.
8
9
)
2
0
.
7
2
1
(
1
.
8
0
)
*
2
0
.
6
5
3
(
1
.
8
6
)
*
2
0
.
1
0
6
(
0
.
5
5
)
2
0
.
1
6
9
(
0
.
9
8
)
2
0
.
1
7
2
(
0
.
5
0
)
b
P
A
D
2
0
.
0
1
7
(
0
.
0
9
)
0
.
0
2
2
(
0
.
0
9
)
0
.
0
6
8
(
0
.
3
4
)
2
0
.
0
0
1
(
0
.
0
0
)
2
0
.
0
4
7
(
0
.
1
8
)
2
0
.
4
0
7
(
0
.
2
4
)
2
0
.
5
5
1
(
0
.
3
6
)
2
0
.
3
2
2
(
0
.
3
9
)
0
.
0
7
4
(
0
.
1
0
)
2
0
.
4
2
2
(
0
.
2
9
)
A
d
j
u
s
t
e
d
R
2
0
.
8
1
2
0
.
7
7
8
0
.
7
5
6
0
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7
2
2
0
.
6
5
9
0
.
8
6
7
0
.
9
0
9
0
.
9
6
8
0
.
9
7
3
0
.
8
7
7
T
e
s
t
1
H
o
:
g
i
¼
0
1
.
1
0
(
0
.
9
5
)
T
e
s
t
1
H
o
:
g
i
¼
0
1
2
.
8
9
(
0
.
0
2
)
T
e
s
t
2
H
o
:
g
1
¼
g
2
¼
.
.
.
¼
g
5
1
.
1
0
(
0
.
8
9
)
T
e
s
t
2
H
o
:
g
1
¼
g
2
¼
.
.
.
¼
g
5
1
2
.
8
7
(
0
.
0
1
)
T
e
s
t
3
H
o
:
g
1
¼
g
5
0
.
4
6
(
0
.
4
9
)
T
e
s
t
3
H
o
:
g
1
¼
g
5
1
1
.
0
2
(
,
0
.
0
1
)
T
e
s
t
4
H
o
:
a
1
þ
g
1
¼
a
5
þ
g
5
0
.
4
8
(
0
.
4
8
)
T
e
s
t
4
H
o
:
a
1
þ
g
1
¼
a
5
þ
g
5
1
1
.
2
9
(
,
0
.
0
1
)
N
o
t
e
s
:
S
i
g
n
i
?
c
a
n
c
e
a
t
t
h
e
*
1
0
;
*
*
5
;
*
*
*
1
p
e
r
c
e
n
t
l
e
v
e
l
s
;
r
e
g
r
e
s
s
i
o
n
r
e
s
u
l
t
s
f
o
r
A
a
n
d
B
s
h
a
r
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p
o
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f
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b
a
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d
o
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s
h
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p
q
u
i
n
t
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a
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p
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;
w
e
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t
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m
a
t
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m
a
r
k
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m
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r
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p
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f
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,
R
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,
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a
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a
P
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t
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R
A
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t
a
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o
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q
u
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t
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(
2
)
;
t
h
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m
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t
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m
a
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d
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;
w
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(
1
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2
)
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b
b
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a
l
.
(
1
9
8
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Table III.
SUR models for daily
returns on state
ownership portfolios
around February 19, 2001
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The opening-up of the B-share market, however, did affect the B-share market
signi?cantly and in an unequal way. Portfolios with lowest state ownership stocks
experience 7 percent daily risk-adjusted returns after the regulatory change whereas
those with high state ownership stocks experience none. Interestingly, the
risk-adjusted returns on all ?ve portfolios are signi?cantly positive during this
special two-month period of analysis, though not in a signi?cantly different way. We
apply the GRS test to examine whether the February event has an impact and whether
it is a signi?cantly different one across portfolios in Tests 1 and 2, respectively. Indeed,
the effect of the regulatory change on the B-share portfolios is different across
portfolios at the 1 percent signi?cance level (Test 4 F-statistic is 11.29).
4. Tests of alternative hypotheses
Our cross-sectional regressions and portfolio analysis revealed the following facts:
.
before February 2001, foreign investors have lower valuation for ?rms with high
state ownership, ceteris paribus;
.
after February 2001, when domestic investors are allowed to trade in B-share
market, the relative undervaluation for ?rms with high state ownership was
reinforced; and
.
the event has triggered different net buying activity among new investors for
?rms with high and low state ownership.
If we can interpret the relative valuations of A- and B-shares as re?ecting their
perceived political risk, then those new investors who entered the B-share market were
as wary of political risk as the original foreign investors, who, compared to existing
A-share investors, had already priced a substantial political risk premium. We believe
that this regulatory event inspired new domestic resident participants who had a very
different outlook than existing domestic residents participating in the A-share market
and who had a more similar outlook to those of foreign investors. But other
explanations are possible. We will discuss some possible alternative explanations and
provide either direct or circumstantial evidence that leads to our rejection of those
alternatives in favor of our interpretation of the events.
4.1 Anticipation of state share selling?
On June 14, 2001, the Chinese State Council announced a series of long-awaited rules on
how it plans to fund a long-term social welfare shortfall by allowing state-owned
shares to be sold on the stock market. State-owned shares to this point in time belonged
to a special category of equity that could not be traded on the market. Appendix 2,
Table AII details a series of key events related to these rule announcements. If local
investors were anticipating these new policy rules back in February, it is possible that
domestic investors entering the B-share market following February 19 would have
pursued disproportionately the shares of ?rms with lower state ownership stakes not
because of political risk aversion but because of the potential dampening supply effect
on share prices. Local investors may have speculated that prices of these high state
ownership ?rms would drop once the market is ?ooded by the state shares that had
been locked up and untradeable to that point.
If this alternative hypothesis were true, we would also observe a signi?cantly
negative reaction of share prices for those ?rms with relatively higher state ownership
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stakes on June 14, 2001 when this suspicion would have been con?rmed. To evaluate
this alternative explanation, we perform a supplementary test by estimating the SUR
model of equation (3) again, but with event dates de?ned to be June 14, 2001 to June 20,
2001. We ?nd no statistically signi?cant differences in the risk-adjusted returns across
the quantile portfolios grouped by state ownership[10]. This is consistent with Chen
and Zhou (2005) who study this policy change and who also ?nd no evidence that the
prices of those stocks with heavy state share holdings declined more than those with
no state shares.
October 22, 2001 is another date that we can use to test this alternative hypothesis.
On that day, the CSRC announced the suspension of the sale of shares in state-owned
companies used to fund a national social security in the hope that this would steady its
weakening stock market. See Appendix 2, Table AII for details. We again estimate the
SUR model of equation (3) with event dates now de?ned to be October 22-27, 2001. If
local investors avoided shares of high state ownership ?rms in February due to worries
of future state share selling, we would expect a positive share price reaction in October
among shares of those high state ownership ?rms when the state share selling
program was suspended. However, our test reports no difference in the share price
reactions across quintile portfolios grouped by state ownership.
Finally, a third way to test this hypothesis is to see whether the new investors have
some foresight over the possible reduction in state ownership. We compare the 2002
state ownership levels with those for 2001 for B-share ?rms and ?nd that many ?rms
experienced some reduction in their state ownership. We use the change in the B-share
discount during the February 1, 2001 event as an explanatory variable for the next
year’s change in state ownership. We test whether a greater decline of the B-share
discount during February predicts less state ownership reduction in the future. Our
test shows no such relationship. Thus, we conclude that the evidence does not seem to
support this alternative hypothesis about price pressure from selling state share
holdings.
4.2 New group of foreign investors?
We do not know the identity of B-share investors. Though the policy change allowed
Chinese residents to hold B-shares, it could still be that the investors in the B-share
market were comprised of a new group of foreign investors who entered the B-share
market after February 2001 because they perceived a policy shift in China’s market
development through the signal of the integration of the A- and B-share markets.
Anecdotal and indirect empirical evidence suggests that it is unlikely to be so. First,
we obtain monthly US transactions with foreigners in long-term domestic and foreign
securities from Treasury International Capital (www.treas.gov/tic). Speci?cally, with
respect to Chinese stocks during the three months before and after February 2001, we
compute the monthly difference between the gross sales by foreigners to US residents
and gross purchases by foreigners from US residents to determine the net purchases by
US residents. During the three months before February 2001, US residents were net
buyers of $33 million of Chinese stocks, but were net sellers of $35 million in the three
months following. This activity is not particularly noteworthy as it comprises only a
small fraction (less than 1 percent) of the stock of holdings of US investors in the
Chinese market and, even more importantly, they were exiting the market more than
entering[11].
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Second, according to a news report from the Securities Daily (2001) New Agency on
August 17, 2001, the proportion of domestic investors in the B-share market was 90.23
percent after February 19, 2001. It is evident from this fact that foreign investors likely
did not contribute much to the volatility of B-share market prices after liberalization.
Finally, another news report from HuaTai Securities (2001) News Agency on August
28, 2001 reported that foreign shareholders have greatly reduced their shareholdings
after February 19, especially foreign institutional shareholders. Jiangling Motors,
China International Marine, and Guangdong Provincial Expressway Development
Company were speci?cally mentioned to have experienced large foreign ownership
reductions, amounting to more than 5 percent of the total shares within several weeks
around February 19. The foreign ownership of Shanghai Posts and Telecom
Equipment declined to 0.39 percent from an original 6.27 percent during 2001; that of
Jinzhou Port declined from 3.68 to 0.39 percent; and that of Hangzhou STM Turbine
declined from 23.51 to 2.71 percent. According to this report, more than 90 percent of
foreign shareholders have reduced their ownership in Chinese B-shares, with the
average reduction being 40 percent of their original shareholding.
4.3 Some evidence on new local investors
There exists some anecdotal evidence to support our conjecture that it is indeed new
domestic investors who entered the B-share market upon the market’s liberalization.
This possibility would have important economic consequences if the new domestic
investors had different expectations about future growth rates, returns, or future
dividends than existing domestic investors prevalent in the A-share market,
particularly with regard to companies with large state holdings. First, according to a
report, entitled “Regulations governing Chinese nationals who enter the domestic
B-share stock market” and issued on February 26, 2001 by the CSRC and the State
Administration of Foreign Exchange (SAFE), Chinese nationals engaged in B-share
trading were only allowed to use spot exchange deposits and foreign currency cash
deposits which had been deposited in domestic commercial banks before February
19[12]. This restriction was subsequently lifted on June 1, 2001 when Chinese nationals
were allowed to trade B-shares with spot exchange deposits and foreign currency cash
deposits opened after February 19, as well as foreign exchange funds transferred from
overseas[12]. We infer from this fact is that only a special clientele of domestic Chinese
investors would have been able to access the B-shares at the time of the CSRC’s
announcement.
Second, what accompanied the foreign ownership decline in B-shares was an
increase in the number of individual investors. The average number of individual
shareholders in the B-share market had more than doubled since the end of 2000 (CEIC
China Premium database)[13]. HuaTai Securities reported speci?c examples: the
number of individual investors for Hangzhou STM Turbine increased 900 percent,
from 1,198 to 12,306 over this period; the number for Shandong Airlines increased
almost 600 percent from 3,379 to 22,622. The same report also shows that the average
number of shares held by each individual dropped. For example, the average number
of individual shares for Kama B shares dropped from 37,000 to 7,000 between 2000 and
2001 (HuaTai Securities, 2001).
Third, foreign currency deposits of Chinese residents increased signi?cantly before
February 2001 and decreased in the immediate aftermath of the liberalization event[14].
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In the ?rst quarter of 2001, foreign deposits for domestic residents only increased by
$680 million, which was $3.45 billion less than the increase in same quarter of 2000.
According to a news report by Guosen Securities Net (2001), most of the foreign
deposits were transferred to the B-share market during February 2001. What we
surmise from this fact is that there was at least partial anticipation of the policy change
to come in 2001 at least among some clientele of domestic investors.
5. Conclusions
Explaining China’s B-share discount puzzle has been a signi?cant challenge.
Numerous explanations have been put forward, including ones based on differential
liquidity of the two classes of shares, differential risks, differential demand and
asymmetric information effects among local and foreign investors. Our contribution –
which we boldly declare a “resolution” of the puzzle in our title – arises from analyzing
a natural experiment that took place in February 2001 in which the CSRC allowed local
Chinese investors to trade B-shares which were previously restricted to foreign
investors. This policy change represented an important event in China’s capital
markets as the B-share discounts that had been averaging over 80 percent across
almost 80 different stocks declined dramatically to 40 percent on average within
months.
We speci?cally exploit the information in the cross-sectional dispersion of the
discount declines across the stocks. Our simple model can explain 60 percent of the
cross-sectional variation of the discount changes. The most important explanatory
factor is the political risk factor, which we proxy with the fraction of shares owned by
the state. That is, immediately after the opening of the B-share market, Chinese
investors concentrated their efforts in bidding up the B-share prices of low state
ownership ?rms. Just as importantly, we ?nd that other attributes of the stocks such as
the relative liquidity of their B-shares or the relative number of B-shares outstanding
as well as several risk measures (volatility ratios, local and world market betas) are
statistically unimportant in explaining the discount changes that took place.
We interpret our ?nding as evidence consistent with the recent ?ndings that
political risks affect stock valuations. Speci?cally, differences in perceived political
risk can result in difference in security valuation. For researchers, our ?ndings on the
importance of political risk offer reassurance of the basic notions of equilibrium
international asset pricing models relating conditional expectations of asset returns to
expected factor risk premiums and assets’ exposures to those risk factors. For
companies, regulators and decision makers in developing countries, foreign investors
are drawn to stocks only selectively in countries with less transparent reporting and
accounting systems and with weak governance systems that inadequately protect their
interests as minority shareholders. Often, they pay high premiums when their general
demand for international investment is high, as in the case of most markets around the
world for unrestricted over restricted classes of the same shares (Bailey et al., 1999).
Sometimes, as was the case in China before February 2001, they will allow large
discounts to arise and persist, in spite of potentially great demand, simply because of
needed legal or political reforms.
The unique February 2001 event allows us to compare the domestic investors’
valuation of political risk with those of the foreigners. This is the ?rst study to
document the shift of perceived political risk and its valuation due to different groups
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of investors during the event. While foreign investors may have underpriced stocks
with high state ownership, domestic investors who gained access to the shares
previously restricted for trading by foreigners, maybe in?uenced by foreign investors,
turned out to dislike political risks even more, as shown by the case in China after
February 2001. The opening of the B-share market to local Chinese investors was a
positive development, but an incomplete one. This is why we must offer a caution on
our bold title acknowledging only a “partial” resolution of the puzzle. A full integration
of these two markets is ultimately what is desirable for local and global investors alike;
it has still not happened despite a number of false starts and rumors even through
2008[15].
Notes
1. Some important studies in this literature include Hietala (1989), Bailey and Jagtiani (1994),
Stulz and Wasserfallen (1995), Domowitz et al. (1997), and Bailey et al. (1999).
2. See Fisman (2001) and Leuz and Oberholzer-Gee (2006) for studies on the bene?cial effects of
political connections in Indonesia, Johnson and Mitton (2003), for Malaysia, and Ferguson
and Voth (2008), for Germany.
3. Chan et al. (2008) and Ahlgren et al. (2003) focus on differences in the effects of asymmetric
information between the local A- and foreign B-share markets. Chan et al. speci?cally
measures the adverse selection component of the bid-ask spread in the two markets and how
they change around February 2001. Sun et al. (2004) and Lee et al. (2007) focus on information
?ow and the level of market integration between A- and B-share markets.
4. We will associate the level of state share ownership with political risk throughout this paper,
although we acknowledge that this association is debatable. In support of our assumption,
Perotti and van Oijen (2001) present cross-country evidence that progress in privatization of
state share ownership is indeed correlated with improvements in perceived political risk. In
the context of China, in particular, Tian (2001), Xu et al. (2005) and Stouraitis et al. (2008)
show how state share ownership is positively correlated with related party transactions,
such as politically connected director appointments and misappropriation of state funds,
lower labor productivity and poor governance. Of course, as do Fernald and Rogers (2002),
we could interpret that the stronger political connections may ensure better access to ?nance
that translates into better growth prospects and minimized downside risk from bankruptcy,
all attributes deserving of a lower premium.
5. Article 2 of the Securities Law of China stated that “this Law is applicable to the issuing and
trading in China of shares, corporate bonds and such other securities as are lawfully
recognized by the State Council.”
6. Appendix 1, Table AI details the chronology of major events and announcements about the
B-share market during the ?rst half of 2001.
7. Some analysts described the period as one of “B-share frenzy” (see the analyst report by
Yan Dinggong of Shenyin and Wanguo Securities, AFX Asia, February 28, 2001).
8. There has been strong empirical support for this hypothesis in other markets (e.g. Bailey and
Jagtiani, 1994 in Thailand, Bailey et al., 1999 in Mexico).
9. Interestingly, for very similar tests, Sun and Tong (2000) and Chen et al. (2001) ?nd a positive
relationship between the B-share discount and the relative number of B-shares to total shares
outstanding. Sun and Tong (2000) regard the relative number of B-shares outstanding as
being determined by the supply and since more B shares outstanding puts downward
pressure on B-share prices thus increasing the B-share discount, they con?rm the differential
demand hypothesis. Chen et al. (2001), on the other hand, interpret more B-shares
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outstanding as evidence of larger foreign demand which should result in a small B-share
discount and reject the hypothesis.
10. These supplementary results are available upon request.
11. US residents held a stock of $2.33 billion of Chinese stocks as of the end of 2001, according to
the Report on US Holdings of Foreign Securities, as prepared by the Of?ce of the Under
Secretary, International Affairs, Department of the Treasury (www.treas.gov/tic/shc2001r.
pdf, May 2003).
12. www.novexcn.com/chin_nation_trade_b_share.html
13. The CEICDataCompanyLimited(CEIC) supplies real-time Asianeconomic datatoanalysts and
economists at over 800 institutional clients around the world. CEIC Data Company Ltd was
established in 1992 and acquired by ISI Emerging Markets in 2005. See www.ceicdata.com
14. See speech by People Bank of China Deputy Governor, Dr Gui Shiquing, “Management of
capital ?ows in corporate sector; current situation and outlook in China” (October 11, 2002,
www.pbc.gov.cn).
15. In November 2006, the B-share market surged by 73 percent from the beginning of the year
partly on the rumor that the B-share market would close and all B-shares would be converted
into higher priced A-shares. See Finance Asia (2006). In 2008, some companies with
outstanding B-shares were permitted by the CSRC to institute a share buy-back program;
see, for example, Livzon Pharmaceutical Group in June 2008, which bought back HK$160
million worth of B-shares.
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5
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4
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n
u
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r
y
2
0
1
6
(
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Qi, D., Wu, W. and Zhang, H. (2000), “Shareholding structure and corporate performance of
partially privatized ?rms: evidence from listed Chinese companies”, Paci?c-Basin Finance
Journal, Vol. 8, pp. 587-610.
Securities Daily (2001), “Bene?ts and losses of B-share liberalization”, Securities Daily, available
at:http://?nance.sina.com.cn/t/20010817/97114.html (accessed August 17, 2001).
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Sun, Q. and Tong, W.H.S. (2000), “The effect of market segmentation on stock prices: the China
syndrome”, Journal of Banking & Finance, Vol. 24, pp. 1875-902.
Sun, Q., Tong, W.H.S. and Yan, Y. (2004), “Market liberalization within a country”, working
paper, Nanyang Technological University, Singapore.
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paper, Peking University, Beijing.
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from China’s newly privatized ?rms”, Global Finance Journal, Vol. 14, pp. 65-82.
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Further reading
Amihud, Y. and Mendelson, H. (1986), “Asset pricing and the bid-ask spread”, Journal of
Financial Economics, Vol. 17, pp. 223-49.
Brennan, M. and Cao, H.H. (1997), “International portfolio investment ?ows”, Journal of Finance,
Vol. 52, pp. 57-82.
Errunza, V. and Losq, E. (1985), “International asset pricing under mild segmentation: theory and
test”, The Journal of Finance, Vol. 40, pp. 105-24.
Eun, C.S. and Janakiramanan, S. (1986), “A model of international asset pricing with a constraint
on the foreign equity ownership”, The Journal of Finance, Vol. 41, pp. 897-914.
Goriaev, A. and Sonin, K. (2005), “Is political risk company-speci?c? The market side of the
Yukos affair”, working paper, New Economic School, Moscow.
Kang, J.-K. and Stulz, R.M. (1997), “Why is there a home bias? An analysis of foreign portfolio
equity ownership in Japan”, Journal of Financial Economics, Vol. 46, pp. 3-28.
Rui, O.M., Wu, W. and Lee, B.-S. (2007), “Market segmentation and stock prices discount in the
Chinese stock market: revisiting B-share discounts in the Chinese stock market”, SSRN
Working Paper.
Tan, L., Chiang, T.C., Mason, J.R. and Nelling, E. (2008), “Herding behavior in Chinese stock
markets: an examination of A and B shares”, Paci?c-Basin Finance Journal, Vol. 16,
pp. 61-77.
JFEP
1,1
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Resolution of the
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Table AI.
JFEP
1,1
104
D
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Table AI.
Resolution of the
Chinese discount
puzzle
105
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Appendix 2
Corresponding author
G. Andrew Karolyi can be contacted at: [email protected]
Date Events Source
April 26, 2001 China’s Finance Minister, Xiang Huaicheng, spoke at
a forum in Beijing that it is appropriate for China to
reduce its ownership of listed companies in order to
help fund social security needs
China Press
June 14, 2001 The Chinese State Council announced a series of
long-awaited rules on how it plans to fund a chronic
social welfare shortfall by allowing state-owned
shares to be sold on the stock market. State-owned
shares have hitherto belonged to a special category
of equity that could not be traded on the market. The
new rules permit their sale and stipulate that 10
percent of state companies’ IPO should consist of
state-owned shares and that the proceeds from their
sale should go into a national social security fund.
The new rules also applied to companies planning to
list abroad and existing overseas listed companies
Dow Jones, Reuters
July 24, 2001 The ?rst ?otation of so-called state shares is
announced. They are priced much higher than
expected. Four Chinese companies planning A-share
listings announced they would sell state shares
equivalent to 10 percent of their IPO proceeds and
the state shares will be priced at the same levels as
their IPO shares
Reuters
October 22, 2001 The CSRC announced the suspension of the sale of
shares in state-owned companies used to support the
national social security fund and hoped that this will
steady its weakening stock market
Financial Times
December 18, 2001 China’s multi-billion-dollar Social Security Fund will
be allowed to invest in shares as a way to increase
liquidity in stock markets. Fund Chairman, Liu
Zhongli, said that it would be able to place 40 percent
of its 61 billion Yuan (about HK$57.16 billion) in the
country’s stock markets
South China Morning
Post
Table AII.
Chronology of regulatory
change in trading state
shares, June 2001
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
JFEP
1,1
106
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doc_746938612.pdf