Analysis of the Chinese Stock Markets

Risks in Chinese Stock Exchange

The Chinese stock market (CSM) has generated a lot of interest in the international investor community. This is hardly surprising given the fact that China is currently the fastest growing economy on earth and consequently receives more direct foreign investment than even the United States.

However this intense interest is tempered by the many serious risks that are associated with the Chinese stock market. Indeed the CSM is widely recognised as the worst performing stock exchange in Asia. Identifying and explaining these risks in the wider context of the Chinese economy and peculiar reform process constitute the core objectives of this study.

This research paper is divided into five sections. The first section provides an overview of the Chinese stock market; effectively outlining its origins, brief history and defining structures. The following section introduces some of the best materials and sources of information on the CSM. The third section provides information and analysis on the wider Chinese economy, especially on areas that directly impact on the performance of the CSM.

The rationale here is that the Chinese stock markets (and the risks associated with them) cannot be fully understood without a broader assessment of Chinese commercial practices and economic structures. The fourth section introduces the concept of “Efficiency Market Hypothesis” (EMH) and assesses the performance of the Chinese stock markets accordingly. Its argued here that the widely held consensus that CSM conforms to weak-form efficiency status, is correct. The final section briefly discusses some of the best research methods for gaining primary and quality information on the CSM and its associated risks.

The last section also contains an interview with a China analyst at leading commercial consultancy in London. The questions contained in the survey are designed to give the student an insight into the kind of difficult questions that need to be put to leading experts. Whilst questions relating to EMH, risks and WTO accession are properly addressed in the latter sections of this study, consistent references to these themes are made throughout this research paper.

The core premise of this research paper is that the Chinese stock exchanges reflect some of the worst features of Chinese commercial practices and economic structures and very few of the decent ones. Consequently the CSM is not a representative of the broader Chinese economy, which despite many of its structural flaws, is now generally recognised as one of the most dynamic in the world.

Chinese Stock Markets

Contrary to widespread belief, the Chinese stock markets predate their official formation in Shanghai in 1990 by several years. In fact informal markets in company stocks were prevalent in the early 1980’s. In January 1985 Shanghai Yanzhong made the first public offering of standardised corporate equity in China. The following yearning-markers were established in Shanghai and Shenyang, but they lacked the power to restrain rogue speculation and curb trading. Given the sheer scale of the problem, it is possible to hypothesize that black markets in Chinese stocks may have become prevalent at least 10 years prior to this development.

The first decisive move towards establishing a formal and centralised stock market was made in early 1990, when the reformist leader DEng Xiaoping inaugurated the Shanghai stock exchange. In fact the Shanghai and Shenzhen stock markets formally began operations in December 1990. By all standards of comparison the formal establishments of stock markets in China came very late in the day. Even developing countries like Pakistan and Indonesia had set up stock markets decades before the Chinese. Nonetheless the very fact of a nominally socialist country establishing stock exchanges, were in itself a remarkable event and attested to the serious resolve on the part of the senior echelons of the communist party, to reform the Chinese economy.

Any serious discussion on the structural flaws and shortcomings of them must be set in the context of its brief 14 year history. But even this history is misleading, since the Chinese stock markets(essentially composed of the Shanghai and Shenzhen stock exchanges) did not begin to assume real regulatory powers until the middle of the1990’s. Indeed in their early years both markets were beset by extraordinarily high levels of uncertainty and volatility.

The main problems in the early years were the markets’ vulnerability vies-à-virtue government’s economic policies. For instance the markets boomed and consequently suffered badly in the period 1993-1995, at the height of the government’s anti-inflationary campaigns. Moreover the central government regularly intervened in the early years to limit the issuance of stocks.

In the early years the Chinese government seemed to have been less than convinced of the importance of vibrant and dynamic stock markets to a liberalising economy. The government was more preoccupied with managing the privatisation process and developing free trade areas, than thinking strategically about the role of the embryonic stock markets. Indeed the markets’ economic value was dismissed on the grounds that they were purely speculative in nature.

The initial configuration and categorisation of shares—which persists to this day almost unchanged—reflect the central government’s preference for control and over-regulation. Indeed one of the distinctive features of CSM is that shares are defined and limited by their categorisation. In other words once a share has been categorised, it is very difficult to transform it into another share type. This can only be done with the explicit permission of the “China Securities Regulatory Commission” (CSRC). The share types that were devised by the central government in the early 1990’s fall into six categories. These are: A-shares, B-shares, Legal person shares, State shares, H-shares and Red Chips.

The most important shares are the A and B categories. Broadly speaking the former category are reserved for Chinese citizens(i.e. foreigners cannot—as a general rule—acquire these shares) and conversely the latter are designed for foreign ownership. The terms “legal person shares” and “state shares” are essentially designed to determine the private-public balance of share ownership. This is also advice employed by the Chinese government to deny that its stock markets legitimise wholesale privatisation. Of course in real terms, these idiosyncrasies constrain free commerce and make it difficult to fully identify asset ownership. H-shares refers to mainland registered companies listed in Hong Kong and Red-Chips belong to companies registered and listed abroad but which nonetheless have substantial Chinese interests and are at least partly controlled by the Chinese government.

The complexity of this share-categorisation system is, first and foremost, driven by the peculiar characteristics of the Chinese economy and the central government’s strategic policy of reforming it incrementally. In short it is a form of control, but nonetheless—given the overall configuration of the Chinese economy—it is difficult to imagine viable Chinese stock markets without at least some of these controls, in the foreseeable future. This system reflects the fact that even to this day many of the companies listed on CSM are classed as “State Owned Enterprises” (SOE’s) and are thus ultimately controlled either by the regional governments or the central government in Beijing.

This is not to deny that the Chinese authorities have taken steps to enhance the “private” dimension of CSM, but merely to state that taking into account “private” interests was not a major consideration for those who initially planned and constructed Chinese stock markets. Andes it has been argued already, many of the foundational structures offs (for instance the rigid forms of share categorisation) persist to this day.

Moreover it is interesting to note that the Chinese authorities only embarked upon greater privatisation or “corporatisation” of CSM once it became clear that SOE managers were seriously undermining the stock exchanges. In fact what has occurred from 1996-1997 onwards is a form of “part-privatisation” where state control of companies is balanced by independent or “private “management. However, these half-measures have failed to significantly improve corporate governance and thus indicate that Chinese stock markets are exposed to unacceptably high levels of risk (more on this in the economy section).

Aside from its complex share-categorisation, the Chinese stock market is also defined by its core mission. Whereas in fully capitalist economies, stock markets facilitate companies’ access to capital and provide an effective forum for ordinary citizens to acquire a stake in the private economy, in China the stock exchanges are primarily designed to refinance the SOE sector. In other words, in China private capital is absorbed by state entities that are characterised by inefficiency, lack of transparency and accountability.

Moreover the Chinese authorities have—for the past 8 years at least—relied on the stock markets to force the SOE’s to improve their antiquated and secretive corporate governance culture. Whilst there is a debate in the west as to whether stock markets can engender better corporate governance, there is little doubt that they cannot be expected to transform deep-rooted corporate and commercial practices. Therefore the core mission of the CSM is not only in conflict with the values and functions of conventional stock markets but–given the inherent limitations of stock markets—the Chinese authorities are unlikely to meet their own objectives.

In conventional stock markets, the existence of a level playing field enabling firms to compete for capital is taken for granted. Indeed it is universally assumed that this system is the essential component of dynamic capital market. But the Chinese system is clearly different, insofar as SOE’s enjoy a conspicuous advantage over other forms of economic/commercial entities. Moreover capital markets grow out of socio-economic systems that sanctify private property and establish powerful mechanisms and sanctions to safeguard this institution.

Whilst the Chinese communist party has long grudgingly accepted the legitimacy of private property, this acceptance has yet to fully penetrate into the cultural and legal edifices of Chinese institutions. As far as Chinese stock markets are concerned the absence of the unquestioned rule of law has had a marked psychological impact, effectively acting as a barrier against the natural evolution of the CSM into conventional capital markets.

Notwithstanding these limitations, the CSM has grown rapidly since the late 1990’s. In the first six years of their existence Chinese stock markets listed only 323 companies, valued at around $11.6 billion. Byte end of 1999 the total number of listed companies stood at 923,valued at around $53.9 billion. Interestingly, since 1997 Chinese stock markets have recorded annual capitalisation growth rates averaging at around 45%. On its own these growth rates represent truly impressive trends. However it must be noted that the massive growth in capitalisation largely stems from the sheer size of the companies that are listed in Chinese stock markets. Therefore it would require significant leap of analytical faith to explain the growth rates on the basis of investor confidence or any other meaningful indicator of stock market dynamism.

The last few years have been marked by the growing liberalisation of the CSM. The establishment of a “second board” exchange in Shenzhen in2001 was a truly landmark event. Initially conceived as a forum for high-tech companies, it is now referred to as the Change Ban (or Growth Enterprise Market “GEM”) and is primarily designed to finance small and medium sized enterprises. Since its inception the GEM has functioned more akin to western stock markets than the main boards of Shanghai and Shenzhen. Moreover since 2001 the differences between the stock exchanges of Shanghai and Shenzhen have become more pronounced.

Broadly speaking boards belonging to the former still largely lassie’s and their subsidiaries, whilst Shenzhen exchanges are increasingly listing private entities (especially small and medium sized enterprises). Whether this development evolves into a permanent dichotomisation of the Chinese stock markets remains to be seen. However it is interesting to note that the Chinese political-economic elites have historically shown a preference for operating different systems to reconcile divergent or conflicting interests. The absorption of Hong Kong in 1997 under the “one country: two systems” banner and the establishments of free trade zones in the south east are testament to this unique policy.

Notwithstanding these promising signs, the main boards of CSM have yet to mature into markets of property rights. Indeed the main boards are still characterised by the domination of the SOE’s, restricted access to the market, lack of corporate transparency and legal redress and the absence of a culture of long-term ownership. These problems will only be overcome once the CSM is allowed to operate solely on the basis of market principles. As it stands, Chinese stock markets are essentially mechanism to maintain the financial viability of SOE’s. Consequently any move to break this foundational functionality is likely to meet massive political resistance. Therefore it is unlikely that there will be significant institutional changes to the CSM in the foreseeable future.

Finally, one other feature of the CSM that needs to be outlined and explained is its regulatory framework. Regulatory powers for the Chinese stock markets were initially invested on the municipal and national governments, even though a central regulatory authority, namely the “China Securities Regulatory Commission” (CSRC) had been formed in the early years. The CSRC was established in 1992, but it remained weak until 1997. A combination of factors coincided to consolidate the centrality of the CSRC.

First and foremost banks and their bond trading were banished from the stock markets. Secondly growing rivalry between municipal and national governments inevitably had a negative impact on the performance of the CSM, thus forcing the financial authorities to consider strengthening the CSRC. These factors were accentuated by the Asian financial crisis of the 1990’s, which finally convinced the authorities to invest all regulatory powers on the CSRC. In fact the CSRC quickly assumed a level of prestige that went beyond its status as a securities market controller. Indeed the CSRC was subordinated to the state council and a senior ally of the then prime minister was appointed as its chairman.

Broadly speaking, the CSRC has proven to be an effective regulator. There cent growth of the Chinese stock markets would have been inconceivable without the efficient regulatory oversight of the CSRC. Nonetheless, there are areas in which the CSRC tends to over-regulate and hence unnecessarily manipulate the system. The main problems revolve around the primary listing of firms on Chinese stock markets.

The CSRC operates an elaborate “approval” system, in stark contrast to western regulators, in particular the U.S. “Securities and Exchange Commission” (SEC) which operates a “registration” system. The “approval” system has led to charges that the whole listing process is tainted with preferential treatment and corruption. This is all the more likely, given the fact that SOE’s continue to dominate Chinese stock markets.

Literature Review

The purpose of this section is to introduce the student to some of the best sources on the CSM, particularly in areas of risk, EMH and the implications of WTO accession. Not surprisingly there is now a wealth of information on Chinese stock markets and broader economic and commercial issues on specialist publications, in book form and freely available on the internet. Selecting the most suitable material and conversely avoiding sources that are at best irrelevant and at worst downright misleading, requires careful and patient research.

This section is effectively the product of this research. Whilst this research paper makes use of material produced by a specialist business consultancy in London in latter sections, this section will mostly concentrate on material that are either in book form or freely available on the internet. Aside from introducing these sources, there will be a critical discussion of their contents.

As far as generic material on risk is concerned, the student is advised to refer to a piece of mini-research by the Chinese University of Hong Kong. This article (which effectively highlights the main points of research paper) correctly identifies CSM as a crucial device in the campaign to modernise China’s struggling state enterprises. The article points towards the under-pricing of initial public offerings (IPO), and the inevitable volatility it generates, as one of the primary risks facing investors. It provides some interesting information on under-pricing, for instance the IPO’s of A-shares are under-priced by as much as 400% on average. While the student is not advised to read the research piece in its entirety, S/he is advised to take note of the highlights, not least because they draw attention to a feature of CSM that is rarely covered elsewhere (namely the under-pricing of IPO’s).

In regards to the “Efficiency Market Hypothesis”, the student is advised to read a report published by Princeton University. This paper is a very useful source on the EMH and its complexities. While it is not focussed on China, it is still a must-read for anyone who wishes to discuss EMH in any context. This report—in its own words—examines the attacks on the EMH and the relationship between predictability and efficiency. The report charts the evolution of EMH as a key theory in finance and argues that a generation ago it was widely accepted as infallible. However it argues that today the intellectual dominance of the theory has diminished considerably. While the central argument of this report is that markets are far more efficient than most people realise, it still critiques the opposite argument both fairly and comprehensively.

The report is written in a remarkably concise and intelligible style and moreover describes key financial terms in a very insightful manner. For instance it describes the term “efficiency” as a financial phenomenon that does not allow investors to earn above-average returns without incurring above-average risks. In this regard the author makes the controversial claim that markets can be efficient even in the absence of rational agents. Therefore markets are still efficient even if the volatility associated with them confounds the “fundamentals” of the capital markets, such as earnings and dividends. Furthermore the author adopts an “informational” stance on the debate; in other words he argues that markets are efficient because they are remarkable devices for reflecting new information rapidly and accurately.

Aside from looking at “efficiency” and “predictability” from different angles, this report also looks at other interesting and unique perspectives, in particular behavioural finance. The author argues that behavioural finance has now become an important tool for understanding the dynamics of the financial markets. By not ruling out behavioural or “psychological” influences on the dynamics of the capital markets, the author is effectively conceding that the stock markets are not efficient to the point of perfection.

In regards to accessing sources that discuss EMH in relation to the Chinese stock markets, the student is strongly advised to read discussion paper by Adelaide University entitled: “Are China’s Stock Markets Really Weak-Form Efficient?” This research project tests the weak-form efficiency hypothesis for both the Shanghai and Shenzhen stock markets, using serial correlation, runs and variance ratio tests applied to index and individual share data for daily, weekly and monthly frequencies. The authors claim that while the literature on the EMH is extensive, most studies are parochial, insofar as they focus on one frequency of data or either individual share or index data.

Moreover the authors argue that determining the extent of the Chinese markets efficiency can only be done by using the largest possible sample sizes and subjecting these to comprehensive and concurrent standard tests. Furthermore the authors propose running “comparative “tests; in other words comparing the results of the Chinese samples to those of other countries, and thus arriving at definitive conclusions regarding the relative efficiency of CSM. Whilst these arguments maybe dismissed as patently obvious, they nonetheless indicate that testing of this kind on the Chinese stock markets had not been seriously attempted before.

What makes this report interesting is that it consistently strives to offer a “comparative” analysis; i.e. it looks at numerous other studies on weak-form efficiency and considers other stock markets apart from the Chinese. However what makes it truly unique are the conclusions that it makes. The authors—having conducted their tests—make the bold conclusion that Chinese stock markets are not weak-form efficient. They claim that Chinese stock markets are relatively more efficient than their western counterparts.

In fact the authors are only willing to concede that individual A-shares and overall individual shares for the Shenzhen market might be weak-form efficient. In a final indication of conceptual innovation the authors even turn the structural flaws of the CSM and the country’s poor reporting and accounting standards to their advantage, effectively arguing that bad information may be making the Chinese capital markets less efficient than they really are.

Although the research methodology and conclusions of this report may not be altogether conventional, the piece still constitutes one of the more important studies into EMH in relation to the CSM. Consequently it provides students and researchers with an important benchmark for critically appraising more conventional studies.

A more conventional—and specific—study is a doctoral programme conducted at the University of Tsukuba. In its own words, the paper investigates the weak-form efficient market hypothesis in the Shanghai stock exchange using data from April 1996 to April 2002. This paper also essentially concludes that there is no evidence that the Shanghai stock exchange is a weak-form efficient market.

However it only arrives at this conclusion as a result of the inherent limitations of its sample data. In other words it is not striving to prove that the market is not weak-form efficient. Moreover it does not make the bold claim that Shanghai is as efficient as its western counterparts. In fact it acknowledges that it has not even attempted to ascertain whether the Shanghai stock exchange resembles a semi-strong EMH market. In its own modest words it merely concludes that the study found no existence of appositive trade-off between return and risk, measured from the viewpoint of individual security. Finally this report is rich in technical terms, concepts and methodologies and is thus a great resource and reference point.

As far as China’s accession to the WTO is concerned, a report by theta Secretariat provides a general overview of relevant issues. This report also provides comprehensive information on the WTO, focussing in particular on its organisational structure, vision and objectives. Airport presented at Tufts University in 2003, is also another excellent source for accessing general information relating to China’s accession to the WTO. The report claims that China’s decision to join the WTO demonstrates “long-term vision, commitment to reform, belief in multilateralism and willingness to confront domestic interest groups who were opposed.”

Although this report is arguably over-optimistic, it does nonetheless consider all the relevant factors and comments on most of the implications of WTO accession. Finally a report by the World Bank in 2000 provides a comprehensive evaluation of the impact fought accession on the liberalisation of the Chinese economy. This paper does not consider risk in any great length and essentially argues tattoo accession is likely to accelerate the liberalisation of the Chinese economy.

Finally, in regards to material on the wider Chinese economy, and particularly on the reform process since the late 1970’s, most of the best sources are in book form. In terms of tracking the nature and pace of the overall economic reform process, Neil Hughes’ “China’s Economic Challenge” constitutes an excellent resource. Raphael Sheen’s “China’s Economic Reform” is a particularly good source on financial reforms in the People’s Republic. Moreover P.J. Lloyd and Xiao-gang Zhang’s “China in the Global Economy” provides in-depth coverage on the stranglehold of SOE’s on the Chinese economy. Furthermore “The Dragon Millennium”, edited by Frank-Jürgen Richter discusses the Chinese stock markets in the context of the wider financial sector.

The Chinese Economy

The purpose of this section is to explore the wider environment within which the Chinese stock markets have to operate. This requires an examination of different aspects of the Chinese economy. The information and analysis presented here will be further developed in the final section of this report to provide a conclusion. This section looks at four different areas of the Chinese economy, commerce and financial sector and analyses their characteristics in the context of the CSM. The analysis begins with an overview of the reform process in China since the late 1970’s and subsequently discusses the Banking and Accounting/ Financial Reporting sectors. Finally it assesses the impact of WTO accession in late 2001 on the economy in general and the CSM in particular.

Overview of Reforms

Economic reforms in China began in earnest in the late 1970’s. The demise of Chairman Mao in 1976 and the rise of the pragmatic DEng Xiaoping to the position of paramount leader in 1978 marked the official commencement of the peculiarly Chinese style of reform. Broadly speaking the Chinese model divorces financial and economic reforms from political liberalisation. Consequently, despite the fact that the Chinese have significantly liberalised their Socialist command economy over the decades, the political system is still entirely dominated by the communist party.

While macroeconomic and other structural reforms began in the late1970’s, it was not until the early 1980’s that the financial sector was exposed to tentative liberalisation. Although the Chinese style of reform has been widely trumpeted as a success around the world–not least because it has engendered massive change without undermining social stability and cohesion—the near complete absence of any meaningful political reform causes profound underlying tensions. These tensions are evident in all sectors of the Chinese economy.

First and foremost the Chinese economy remains dominated by State Owned Enterprises (SOE’s) that stifle competition and prevent the emergence of large and powerful private enterprises. Indeed Chinese-style reforms have given rise to a peculiar system that can be best characterised as “semi-privatisation”, where companies with powerful government backing and control can easily outmanoeuvre wholly private enterprises.

The fact that the communist party continues to enjoy complete monopoly over political power, inevitably provides ample opportunities for state interference in the economy, regardless of how serious the Chinese authorities are about liberalising their economy. This innate need for control and manipulation is particularly evident in the patterns of financial sector reform in China over the last two decades. Not surprisingly—given the sensitive nature of the financial sector and its central importance to communist ideology—the Chinese authorities only began to reform the financial sector after consolidating reforms another areas of the economy.

For a long time the Chinese authorities resisted doing any serious business with the International Monetary Fund (IMF) and prevented this influential institution from getting involved in the country’s reform process. Moreover the Chinese authorities rationalised that they could compensate for the lack of meaningful financial reforms by attracting massive flows of foreign capital. They have been largely successful insofar as foreign investment is concerned, especially since China is currently the largest recipient of direct foreign investment in the world. But this success is tempered by the fact that most of this investment is absorbed directly by Chinese industry and is not injected into the country’s financial sector and capital markets.

The peculiarities of the Chinese system have led some analysts to conclude that many of the structural problems of the financial sector(and in particular the stock markets) persist only because the political will to resolve them is lacking. In other words powerful political interests in the country are against greater liberalisation. This entails an enormous amount of risk as far as the CSM is concerned, for it basically means that the Chinese stock exchanges are not ruled according to the dynamics of the market.


Banks in China continue to operate under the legal umbrella of four directives issued by the communist party in December 1978. In 1995 the Chinese State Council, while endorsing these four directives, tried to widen the operational scope of commercial banks in the country. For instance it provided ample leeway for commercial banks to accommodate all types of borrowing, including consumer and mortgage loans. Currently the Chinese banking sector is dominated by the “Big Four “state banks; namely Bank of China (Bloc), China Construction Bank (CCB),Industrial and Commercial Bank of
China (ICBC) and Agricultural Bank of China, which together account for
Just over 60% of total bank lending.

Broadly speaking China’s banking sector constitutes one of the biggest and intractable structural problems for the economy, as the financial system prepares to open up fully to foreign competition in late 2006,in line with WTO requirements. A major—and seemingly perennial—problem revolves around the misallocation of capital. Indeed decisions on lending are often influenced by political considerations rather than financial risk.

A major problem is that Banks make massive loans thunder-performing SOE’s in order to keep them on life-support. This is, first and foremost, a political decision since the government relies nose’s to keep millions in employment, and hence maintain social stability. However these loans constitute a massive waste in capital, which could otherwise be absorbed by efficient and deserving entities.

The Chinese authorities are making genuine efforts at improving the credit allocation facilities and procedures, but are apparently meeting institutional resistance. In particular the authorities are striving to improve transparency and risk management. They are hoping that greater transparency will reduce lending based on political considerations or downright fraudulent practices (which is apparently widespread in China). Moreover they expect that improved risk management will decrease loans that are unlikely to be recouped.

More broadly the authorities seem keen on modernising the entire apparatus of the Chinese Banking system. A key element in this strategy is to increase the involvement of foreign banks in the sector. They are hoping that the presence of foreign banks will lead to the adoption of western-style banking practices by local banks and other lending entities.

But this is a risky strategy,


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