1. Float, Liquidity, Speculation, and Stock Prices: Evidence from the Share Structure Reform in China Hwang Chuan Yang Nanyang Business School Zhang Shaojun Nanyang Business School Zhu Yanjian Nanyang Business School 2006 NTU International Conference on Finance December 14, 2006

2. Motivations Internet Bubble. Between early 1998 till Feb. 2000, internet sector prices rose over 1000%, then it collapsed in April 2000. Ofek and Richardson (2003), Cochrane (2003), Hong, Scheinkman and Xiong (2006) offer explanations. Investors have diverse views and the sector tend to have relatively more individual investors. Short-sale constraints (Miller (1977), Chen,Hong and Stein (2002)) Shares are in short supply Lock-up provisions for insiders’ shares Chinese share markets have all of these features and its split share reform provides an ideal setting for conducting out-of- sample and outside-the US market tests.

3. Chinese Split Share Reform Background 1 Features of China Market  Two markets: A- and B-share markets  Split-share structure: 1/3 Tradable and 2/3 non-tradable A-shares mostly owned by state owned enterprises  Undesirable effect of the split share structure are that managers don’t maximize shareholders values and that it makes take-over and merger activities impossible  Share structure reform: On April 29, 2005, the government announced a reform plan to abolish the split-share structure

4. Chinese Split Share Reform Background 2  Making all previous non-tradable shares tradable  Non-tradable shareholders pay a consideration to tradable shareholders to exchange for the liquidity of their shares; an early reform failed in which tradable shareholders were not paid Non-tradable Shareholders Tradable Shareholders Additional value from improved liquidity Consideration received Consideration paid

5. Chinese Split Share Reform Background 2 Steps in implementing the reform:  Bonus shares immediately tradable; lock up period for other shares.

7. Our Contributions to the Literatures Speculative Bubbles Ofek and Richardson (2003), Cochrane (2003), Hong, Scheinkman and Xiong (2006): diverse beliefs, short-sale constraint and limited supply have contributed to the internet bubble.  Would the same factors lead to speculative bubbles in other markets?  It is much harder to detect speculative bubbles without seeing the bubbles collapse. With the data from split share reform, we show there is bubble in the Chinese share market.  We show that split share reform has dampened speculation. Furthermore, we show that price drop and the decrease in speculative activity is larger for more speculative firms.

8. Our Contributions to the Literatures Shape of Demand Curves Scholes (1972): there are perfect substitutes for assets hence demand curve is horizontal (perfectly elastic). Harries Gruel (1996), Shleifer (1996), Lynch and Mendenhall (1997): Prices rise when stocks are added S&P 500 index indicating demand curve is downward sloping. Field and Hanka (2001), Ofek and Richadson (2000): When the IPO lock-up provisions expire, stock price drops indicating demand curve is downward slopping. These results can be contaminated by information.  Our tests are based on a regulatory change which should be free of information content.

9. Our Contributions to the Literatures Liquidity Premium Silber (1991), Longstaff (1995): Restricted shares are traded at price discount relative to unrestricted shares. Amihud and Mendelson (1991), Naik & Radcliffe (1998), Brennen, Chordia and Subrahmanyam (1998): Stocks with better liquidity are traded at higher prices hence lower expected return.  We show that the price difference between tradable and non- tradable is larger for more liquid stocks indicating the liquidity is priced.  We show that firm values increase after the reform due to improved liquidity and the increase in firm value is larger for firms with larger improvement in liquidity.

10. Our Contributions to the Literatures Chinese Stock Markets Allen,Qian and Qian (2006): Law and economic growth. B share discount: Illiquidity (Chen and Xiong (2001)); Market momentum (Karolyi and Li (2003)); Information asymmetry (Chan, Menkveld and Yang (2006)); Speculation (Mei,Scheinkman and Xiong (2005)).  We show that split share reform has dampened speculation and improved liquidity in Chinese stock markets.  B share price discount decreases after the reform: smaller speculation lowers A share prices while B share prices rise due to liquidity improvement.

11. Data Information about share restructuring, ROA and ROE for the fiscal year ending on December 31, 2004: www.cninfo.com.cn www.cninfo.com.cn Stock price and trading volume: Bloomberg Till Mar. 25, 2006, 509 firms started the share structure reform. 31 firms are still in the process of reform. 89 firms adopted a consideration package that is more complex than a simple consideration of bonus shares. IPO firms in the year before Mar. 25, 2006 and those firms whose price data are not available from Bloomberg terminal are also excluded. Final sample: 309 firms.

12. Methodology - Calculation of price premium and wealth gain Relate the price premium of tradable shares relative to non-tradable share to the consideration paid by non- tradable shareholders to tradable shareholders  Equations

13. Methodology - Continued  Model Assumption: Total gain is shared by non-tradable and tradable shareholders in proportion to the number of shares they own after reform

14. Methodology - Continued We use one-year average of the daily dollar trading volume prior to the reform to proxy for the degree of speculative activity. Mei, Scheinkman and Xiong (2005) use daily turnover. We use the proportion of no-price-change days of a stock over one-year period prior to the reform (Lesmond, Ogden and Trzcinka (1999)) as a measure of liquidity. Bekaert, Harvey and Lundbald (2003) has found this measure particularly useful in emerging markets.

15. Table 3: Descriptive Statistics

16. Table 4: Liquidity Premium and Speculation Component in Tradable Share Prices

17. Table 5:Impact on Turnover

18. Table 6: Impact on Speculative Trading

19. Table 7: Impact on Price and the Downward Sloping Demand Curve

20. Table 8: Further Evidence of the Downward Sloping Demand Curve

21. Table 9: Impact on Shareholder Wealth

22. Table 10: Wealth Gain and Liquidity Improvement

23. Table 11: Impact on B Share Market

24. Conclusions There is a speculative bubble in the Chinese stock markets. This is consistent with the explanation for the internet bubble in the NASDAQ market: diverse views of individual investors, short-sale constraint and limited share supply. Chinese split share reform is successful. By increasing the share supply, Chinese split share reform has dampened speculation and improved liquidity. The reduction in speculation is greater for stocks with greater speculation before the reform. The improvement in liquidity is larger for less speculative stocks. B share discount is reduced significantly after the reform; A share price drops while B share price increases even though the reform does not involve B shares. Despite of the price drop of the tradable share, shareholder wealth (firm value) increases after the reform, and the increase is positively related to the liquidity improvement. Demand curve is clearly downward sloping.