Understanding the Chinese Stock Market: Long-term Performance and Institutional Reforms

Franklin Allen, Jun Qian, Chenyu Shan, Lei Zhu
Jul 05, 2017



The Chinese economy had spectacular growth in the past three decades, however the Chinese stock market had the worst performance among the major stock markets. Professor Franklin Allen from Imperial College, Professor Jun Qian from Fanhai International School of Finance, Fudan University, and coauthors offer their explanation of this puzzling divergence.

In many developed economies, such as the US, Japan, Germany and France, the stock market is a leading indicator for the economy, as shown by a positive and significant correlation between (e.g., three-year or five-year) stock market returns and (future) GDP growth rates. The correlation is also positive in many large emerging economies, such as India, Russia, Brazil, and South Africa. The correlation for China’s domestic stock market, however, is less than 2% and statistically insignificant. This “disconnection” from the overall economic growth presents an interesting and defining characteristic of the Chinese stock market.

The Chinese economy has performed extraordinarily well in the past thirty-five years. In 1980, China’s GDP was less than 10% of that of the US; at the end of 2014, according to World Bank, China has overtaken the US and become the largest economy in the world as measured in Purchasing Power Parity (PPP) terms. In PPP terms, it will have double the US GDP around 2035 as long as it maintains an average growth rate that is at least twice as high as that of the US. The impressive growth of such a large economy has far exceeded expectations of investors and pundits worldwide.

The Chinese stock market started in 1990 with the establishment of two domestic stock exchanges (the “A share” market): the Shanghai Stock Exchange (SSE hereafter) and the Shenzhen Stock Exchange (SZSE). Each listed firm must be approved by the China Securities Regulation Commission (CSRC, equivalent to the SEC in the US). The market has been growing fast since its inception with now more than 2,300 firms listed and traded in the two exchanges. As of the end of 2014, the Chinese A share market is the second largest in the world in terms of total market capitalization, trailing only the US equity markets. However, the performance of the market has been disappointing, especially in comparison with the growth of the economy. If we start from December 31, 1991 the real GDP of China has grown by more than a factor of eight since then, and the growth eclipses that of a number of other large developed (e.g., the U.S. and Japan) and emerging economies (e.g., Brazil and India) over the period 1992-2014. By contrast, the Shanghai Composite has been one of the worst performing indexes in the world; only the Nikkei from Japan has performed worse.

The Shanghai Composite rose after its establishment but fell dramatically in real terms subsequently; this was in part due to high inflation in the early 1990s. Moreover, many of the securities laws and regulations were introduced and implemented after 2000, and the pace of adding new firms to the exchanges slowed down after 2000. For these reasons, we focus on the period from January 1, 2000 to the end of 2014. The Chinese economy was 3.7 times larger in real terms over this period, a growth performance still much better than the rest of the large economies, including India and Brazil. In terms of the cumulative, ‘buy and hold’ returns, the performance of the Chinese market is the worst of the group of large countries, including Japan over the period 2000-2014. Investors in the market earned zero return in real terms, and the cumulative return is much lower than that of five-year bank deposits or three- and five-year government bonds in China. By contrast, there is little difference in stock returns between the Chinese firms listed overseas, mostly in Hong Kong, and listed firms from other emerging countries such as India and Brazil and they significantly outperform developed countries’ stocks such as US ones. The correlation between the stock returns of Chinese firms listed in Hong Kong and China’s future GDP growth rates is positive and significant, similar to that for the other large developed and developing countries.

Prior research (e.g., Morck, Yeung and Yu (2000), Jin and Myers (2006), Xiong and Yu (2011)) examines the movements of stock prices and their relationship with firm fundamentals and features of the markets including investors, and much evidence indicates inefficiency in the formation of asset prices in the Chinese market. We ask some new questions in this paper. What are the factors contributing to the disconnection between the world’s largest and fastest growing economy and the world’s second largest stock market? What can explain the difference between the performance of Chinese firms listed in the domestic exchanges and those listed overseas? We address these questions through examining the institutional features of the markets in a working paper (Allen, Qian, Shan and Zhu, hereafter AQSZ, 2017). In particular, we compare the performance of the Chinese market and listed firms with those of the other large developing economies—India and Brazil, and large developed economies (US and Japan), among others. In addition, we compare Chinese firms listed in the domestic A-share market and those listed overseas, as well as unlisted firms in China.

AQSZ (2017)’s first hypothesis to explain the Chinese market’s divergence from its economic growth is that problematic listing and delisting processes, under the control of CSRC, worsen the adverse selection of listed firms. Arguably the three most well-known Chinese companies worldwide are privately owned internet giants ‘BAT’—Baidu, Alibaba and Tencent; they are all publicly listed but none of them is listed in the domestic market. Each IPO must be approved by the CSRC, and in earlier years this took on the form of explicit quotas every year allocated to different regions across the nation. Firms must also show profits in three consecutive years leading up to the IPO application year, among other explicit financial requirements, to satisfy listing standards set by the CSRC. Moreover, one of the stated purposes of establishing the stock market back in 1990 was to promote the privatization of state-owned enterprises (SOEs) by helping them raise funds through markets—i.e., selling shares to the public via an IPO. Hence, SOEs and firms from mature industries and those with connections to the regulators and relevant government branches are more likely to be listed, whereas privately owned firms, especially from growth industries without high, current profitability find it very difficult to list.

It is well known that firms ‘time’ the IPO in the US and other countries, and the corroborating evidence is that both ROA (return on assets) and ROS (return on sales) drop during the post-IPO period from the highest levels in the IPO year or the year before the IPO. But IPO firms in China’s A share market have by far the largest post-IPO drop compared to firms from the other four countries and Chinese firms listed overseas. We also find Chinese firms use earnings boosting activities more prior to IPO than US firms and Chinese firms listed overseas. In addition, we find that the average ROA, ROE and the growth rates of net income are all lower than those of matched (by industry and asset) unlisted firms for the period 2000-2014. These results suggest that the best-performing firms within an industry are not always selected to enter the A share market.

Once listed, firms are rarely delisted in China and the ‘shell’ of a listed firm is very valuable given the difficult listing process. After two consecutive years of losses, listed firms in China are labeled “ST” (special treatment), but most of them go through multiple rounds of asset restructuring while remaining listed. The fact that poor-performing firms are not dropped from the market also worsens the adverse selection of the listed firms in the A share market.

AQSZ (2017)’s second hypothesis in explaining the disconnection between stock market performance and economic growth is that listed firms have low investment efficiency after IPO. Listed firms in China have much higher levels of investment than their counterparts in the US, Japan, India and Brazil after IPO. We measure returns on investment by firms’ net cash flows ( = EBITDA – Income Taxes – Changes in Working Capital – Capex) scaled by assets. The annual net cash flows of Chinese firms are lower than that of firms from the other four countries and those of Chinese firms listed overseas. Lower net cash flows are associated with more related-party transactions for Chinese firms, a proxy for tunneling by the controlling shareholders. Therefore, poor investment returns can be attributed to deficiencies in corporate governance.

In summary, by focusing on firms’ cash flows AQSZ (2017) show that a significant part of the poor long-run performance of the Chinese stock market, relative to the overall economy and markets from both developed and developing countries, can be attributed to suboptimal regulations regarding firms’ entry into (IPO) and exit from (delisting) the market. The current IPO procedure is an administrative process with high performance hurdles and one in which SOEs and firms from mature industries ‘crowd out’ privately owned firms and firms from new industries. This is despite the fact that these firms have been contributing most of the GDP growth and their role in the economy will only strengthen in the years ahead.  The other important factor is the poor investment decisions and the apparent tunneling of resources from listed firms to unlisted firms.

The implication is that CSRC should reform the IPO procedure and move toward a market-oriented process, and encourage the listing of privately owned firms and those from growth industries. Such reform, along with better enforcement of the delisting process and continuing effort in enhancing corporate governance, can improve the mixture of firms in the market and resource allocation, and increase returns to (minority) shareholders.

The stock market has not played a role as prominent as the banking sector in providing financing for firms and promoting economic growth in China (Allen, Qian and Qian, 2005). However, the importance of this market has been growing: without a stock market that is a viable investment alternative too many resources go into other saving vehicles, such as the real estate sector, and this has led to many costly distortions in the economy. Moreover, the stock market provides a vital source of funding for China’s growing consumption and services as well as hi-tech sectors, the main driver for China’s continuing economic growth. Hence, further development of the stock market, especially solving the structural problems outlined here represents one of the key tasks for China’s financial system going forward.

(Franklin Allen, Imperial College London; Jun "QJ" Qian, Fanhai International School of Finance, Fudan University; Susan Chenyu Shan, Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University; Julie Lei Zhu, Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University.)


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