Have You Ever Bought New Shares from China's Stock Market?

Attraction of China's Stock Market

Most people in Hong Kong are familiar with the stock market. Many have a stake in it, and most regard the Hang Seng index as a barometer of the local economy.

China's stock market is relatively new. It is small, but has a huge potential; it is immature, yet is developing rapidly; the public has a limited understanding and there is little institutional presence to provide a stabilizing force. Precisely because it is so different, it is an interesting subject for academic study. Economic and behavioural theories can be tested in new domains.

But China's stock market is of more than academic interest. It is a symbol of market socialism and a developing private sector, and as such a barometer of China's economic reform, with obvious social and political ramifications. It is not just a tool for companies to raise capital for growth, but also a crucial element in the drive to modernize the teetering state enterprises and transform the whole fabric of Chinese society.

For these reasons, China's stock market has become an important subject of research by economists and business academics. The Business Administration Faculty, as the largest and best-known business school in Hong Kong, has launched a broad-based research effort to investigate the subject, an effort that is underpinned by CUHK's unique access to China's stock market databases. The Shanghai Stock Exchange, the Shanghai International Securities Co., and the Shenzhen Stock Exchange have all agreed to provide stock data and company information of their respective markets to CUHK researchers. With these advantages, CUHK is emerging as a world leader in this area of research.

One such project is undertaken by Dr. Henry M.K. Mok of the Department of Decision Sciences and Managerial Economics at CUHK, in collaboration with Dr. Y.V. Hui of the City Polytechnic of Hong Kong. The project examines the underpricing of new issues and their volatility in China's stock markets, and won an earmarked grant of HK$150,000 from the Research Grants Council in 1993.

One of the most striking phenomena that cries out for examination and theoretical understanding is the underpricing of initial public offerings (IPO), and the huge volatility that it generates.

When a private company goes public, the original proprietors will offer shares in the company for sale to the public. There are several advantages to such share offerings. From the point of view of society as a whole, the stock market helps to divert savings from consumption to long-term investment. For the original proprietors, it offers access to capital and hence the opportunity to grow. It also allows start-up entrepreneurs to recoup their investments on the basis of expected rather than realized profits. When state-owned enterprises are converted into share-holding companies, their management and operations become market-driven and market-responsive. The investors on the other hand get the opportunity of achieving a somewhat higher rate of return than is available from the bank — at the cost of some financial risk. Society as a whole also gains by spreading financial risk around.

Economic theory holds that each party in any transaction acts to maximize his own benefits. Thus the issuers, as the seller, would want to set the price of IPOs as high as the market will bear — especially since there is always a limit to the number of shares to allot, one need not suppress price to drive up volume. If IPOs are priced at close to eventual market valuation, the offering would see only a very small rise (possibly even a small fall) soon after the offering, with longer-term gains driven by the success of the enterprise. Yet IPOs are often underpriced, as evidenced by sharp rises very soon after public offer. In developed markets, the underpricing ranges from a few per cent to nearly 50 per cent. Why should the issuers in effect sell below market price? This poses a challenge to economic theory, and has been cited (Brealey and Myers, 1991) as one of the ten puzzles in capital market research.

The problem is magnified in the Chinese stock market. Underpricing is systematic and substantial. The IPOs of A-shares were underpriced by as much as 400 per cent on average. For certain new issues, the average closing price on day one aftermarket was as high as 17 times of their offering prices (see Fig. 1). The gross underpricing and the resultant expectation of a sure way to get rich led to tremendous oversubscription, and half a million people pouring into Shenzhen to purchase `application forms for share lottery' in 1992, which culminated in a riot on 11th August 1992.

Dr. Henry Mok's project will examine the IPO phenomenon in China, in three phases.

First, the extent of underpricing and volatility will be tracked for China's two stock markets in Shenzhen and Shanghai, for both A and B shares, over the period 1990_93. Measures of market return, namely the average price relatives, cumulative average return in excess of the market effect etc. will be used in the analysis. The institutional arrangements of underwriting IPOs will also be studied, with a focus on their impact on the extent of underpricing. Specifically, the speculative bubble hypothesis is tested.

With data on 101 unseasoned A-share and 22 B-share new issues in Shanghai, Dr. Mok has found that the A-shares were grossly underpriced by about 400 per cent on average. The underpricing of B-share IPOs, however, was not supported. After excluding the effects of price limits and market co-movements, the fad or the speculative bubble explanation of aftermarket inefficiency was supported for the bear issues and not for the bull issues and the B issues.

A very large percentage of shares outstanding is found to have changed hands on the first few aftermarket days. Although it is rational to take profit when the returns are high on unseasoned stocks in an emerging market, it suggests immediate profit-taking by flippers. This gross underpricing of A-share IPOs also resulted in an overheated primary market and misled the Chinese public to speculate and to overlook risk.

The second phase of the research will analyse the risk-return relation of IPOs in China. Financial theory postulates that there should be a correlation between risk and return — prices will only equilibrate at a point where higher risks are compensated by higher expected returns. Researchers will also examine the non-trading, intraday and interday volatility. A Capital Asset Pricing Model (CAPM) which provides a simple yet powerful tool to estimate the relation between risk and return will be used to estimate the risk-return relationship. Findings will be gauged against statistics from other stock markets such as Hong Kong and the US. The purpose is to investigate whether the returns over-reward the risks — and if so, why. It is expected that as the market develops and rationality returns after the initial subscription frenzy, the underpricing and volatility will decline over time.

Thirdly, China's stock markets have unique features which require special hypotheses to explain the IPO phenomenon. The relationships among different parameters such as institutional arrangements, volatility and the state of the market will be examined empirically. The analysis will help to examine two hypotheses. First, the information asymmetry hypothesis of Baron (1982) and Rock (1986), which states that investors, especially small investors, do not have as much information as other parties such as the management and the underwriter, and must be `lured' by deliberate underpricing. Secondly, Masulis (1987) and Affleck-Graves (1989) have proposed that regulation of the stock market reduces the information asymmetry, and should therefore reduce the underpricing. However, the reverse seems to be true in China: new issues are tightly regulated and centrally allocated, yet investors with little experience in investing have little access to information on new issues. Is this a cause of the severe underpricing?

This study has important implications for the pricing of IPOs in China, and policy on disclosure of company information. The findings will be important for the market's healthy development, for understanding the risks involved in IPOs, and will help shape policy for stock market regulators in mainland China.