Currency Expectation and A-H Share Disparity of China and Hong Kong Author: Tian Tan Persistent link: http://hdl.handle.net/2345/3076 This work is posted on eScholarship@BC, Boston College University Libraries. Boston College Electronic Thesis or Dissertation, 2013 Copyright is held by the author, with all rights reserved, unless otherwise noted. A THESIS Currency Expectation and A-H Share Disparity of China and Hong Kong Tian Tan 5/1/2013 Advisor Eyal Dvir* ABSTRACT. This research studies the effect of exchange rate expectations on A-H share discount in China and Hong Kong. The A-H class listing of Chinese stocks offers an interesting framework to examine asset price in segmented markets. This research wants to contribute to the existing literatures by adding other currencies into the exchange rate model and verify their effect, introducing and controlling for company specific information, such as earnings. I find that the effect of both Euro and US dollar to be significant in explaining the share price disparity, and companies in different sector and with different market capitalization react to currency information differently. * I would like to thank Professor Dvir for his help throughout the process of writing this thesis. 1. Introduction Cross-Listing and Price Disparity Cross listing is not a new phenomenon. With the invention of ADR and other similar types of securities, many companies have cross-listed all over the world. Currently, many Chinese and Hong Kong companies have cross listings in Shanghai/Shenzhen and Hong Kong/New York. Among them, there are 70 companies (Berg (2012)) that have cross-listed in Mainland China and Hong Kong. The shares traded in Hong Kong (H share) and shares traded in Mainland China (A share) represent the same ownership and cash flow, and thus represent the same rights over the assets and future cash flows. One would expect these two classes of shares to have the same value. This is not the case if we examine the actual data. The figure on the left shows the chart of Hang Seng China AH Premium Index (HSAHP). This index is calculated by taking the weighted average of the premium of A (class) shares over H (class) share of 48 most liquid and most traded cross-listed companies in China and Hong Kong. If the index is higher than 100, A shares are traded with a premium over H shares. We can see from the figure that Mainland shares are traded in a premium for most of the past 5 years, and the premium has been as high as 100%. Interestingly, the current value of the index shows that there is almost no H share discount; for some time the index has been smaller than 100, meaning that there is now a premium for H shares. This paper will attempt to explore and explain the reason behind this phenomenon at the macro level. First, I will explain the nature of these two markets and their restrictions. The A share is the typical common stock for the investors in Mainland China, and they are nominated in Chinese currency, the Renminbi (RMB). This class of share is only open to the Mainland investors. The H class share is the common stock for the same company after it went public in the Hong Kong Stock Exchange. H shares are denominated in Hong Kong Dollars (HKD). This class of share is only open to the investors who are eligible to invest in Hong Kong. Since Hong Kong is a free capital market, those investors are typically Hong Kong investors and international investors. An investor from Mainland China will not be able to invest in H shares. Therefore, A shares and H shares create a good opportunity to study the price of the same capital asset in segmented markets. Capital Control and Exchange Rate The segmentation is one of the consequences of China’s capital controls. As background, the trilemma of international finance is shown on the left. To maintain a stable financial system, an economy must choose only one side of the triangle, that is, two out of the three goals: free capital flows, fixed/managed exchange rate and sovereign monetary policy. The U.S., along with other major developed economies is currently operating their financial system on side b, which implies a floating exchange rate, free capital flow and an independent monetary policy. Hong Kong stands on side “a” of the triangle, having a fixed exchange rate (HKD pegs to USD) and free capital flows. On the other hand, China still operates on side c, which combines strict capital controls with independent monetary policy. It is worth noting that the triangle only shows the extremes; sometimes a country can have some control of the exchange rate while maintain free capital flows or independent monetary policy. Hence, a Chinese investor will not be able to invest in H shares both because he is unable to obtain the necessary currency, and he is restrained by the policy. The same applies to an international investor who wants to get exposure to China. The only way will be purchasing H shares in Hong Kong. Even if the H share is cheaper than the A share, or vice versa, there will be no artitrage opportunity, given the fact that these two shares are not interchangble across markets. Research Goals Even if investors in one market cannot purchase the shares from the other market, there is little reason investors in these two markets will price the same asset differently. There should be connections between the disparity of share price and the market level factors, as some studies have shown. I will give detailed summary of those studies in the second part of this paper: firstly, the opportunity to invest in the stock market has been relatively limited for Chinese investors due to the slow process of IPO under CSRC. Secondly, H shares are nominated in HKD while mainland shares are nominated in RMB. As most of the companies operate in Mainland China, the uncertainty on future RMB exchange rate may lead to a risk discount on the cash flows of these companies, eventually causing a discount in the Hong Kong market. Thirdly, although corporate governance has improved among Chinese public companies, the transparency of mostly state owned companies remains a concern. Information asymmetry may leads to risk discount from Hong Kong as well. This study emphasizes on one of those explanations: the effect of exchange rate expectations. According to past studies, there is a relationship between the expected appreciation of RMB and the A share premium over H shares. This study will verify this possible relationship, using the data from 2008 to 2013, and will test the following hypotheses: Hypothesis 1: The change in expected RMB exchange rate against major international currencies, such as USD and EUR, will partially explain the change in relative price of A shares and H shares. Hypothesis 2: Business specific information will have an impact on how companies react to the change in exchange rate expectations Hypothesis 3: Specific news will have an impact on the price disparity of A and H shares 2. Literature Review The phenomenon of A-H share disparity has potentially many possible explanations. Moreover, the asset price disparity also happens in other markets. In this session, I will examine the various theories explaining this phenomenal, and summarize the recent studies on this topic†. Information Asymmetry One explanation of the A share premium is information asymmetry. Charkravarty et al. (1998) studied the relative price between A share and B share, a class of shares that is denominated in US dollars, and is limited to foreign investors. There is a premium of A share over its corresponding B shares. They reported that on average B shares traded at 60% of the price of A shares. They argued that one reason that this discount existed is because foreign investors have less information about the local firms. They found that A share returns are more likely to lead B share returns, but not the reverse; also B share price discount on a shock is negatively related to its † See Lee (2009) coverage to English media. This information asymmetry explains partially the discount between A and B shares. Gao (2004) provides evidence that A share investors have quicker access to information than other investors. Gao conducted an event study and found that market reaction is more intensive in the A-share market and takes place much earlier before the public release of information. Gao further reports abnormal trading volumes without price changes in advance of the public disclosure, which implies that there may exist an informal information environment in the A-share market. Gao attributes his study to insider trading, speculation and over-optimistic prospects for the economy in the A-share market. Liquidity Hypothesis There is a possible liquidity difference between H shares and A shares. Pastor et al (2001) show that market-wide liquidity is a state variable important for asset pricing. They found that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Lee (2009) examines the price premium between A and H share using intraday data in 2004, and found that Chinese A-shares on average provide better market liquidity than their Hong Kong H-share counterparties. Second, after controlling for traditional liquidity measures, the percentage difference in quoted spread and depth between A and H share still explain significantly the price premium. Different Risk Attitude Those who follow the Chinese stock market may note the risk taking tendency of Chinese investors, especially during the early years of Chinese capital market. It is therefore possible that the Chinese investor simply assign a lower price for risk. Eun et al. (1986) provides a theoretical asset pricing model with a constraint on the foreign equity ownership. If there is barrier for international investment in an economy, i.e. the domestic investor is only able to own at most a fraction of a company, there will be a premium offered by the domestic investors over the price under no constraints and the discount demanded by the foreign investors. This means domestic investors facing ownership restriction will pay a higher price than foreign investors. Ma (1996) studies the expected return of A and B share in China, and argues that the B share discount is due to the risk taking attitude of Chinese investors in the A share market. A similar argument can be found in Sun et al. (2000), when they partially attribute the B share discount to speculation of Chinese investors. Demand-Supply of Security There are a number of papers studying the relationship between foreign demand for securities and the price disparity. Sun et al (2000) report that the B-share discount increases with the increase of investing opportunity in Hong Kong (H share). They argue that the existence of the H-share and red-chip markets in Hong Kong provides good substitutes for the B-share market; therefore, the increase of supply will lead to a lower price of the security, which they find from B- share discount. The other aspect of this problem is the supply of securities in China. Fernald and Rogers (2002) did an early study on the relationship between A-H price disparity and the supply of securities in China. They attribute low Chinese expected returns to the limited alternative investments available in China. Chan and Kwok (2005) report that the premium for domestic shares is determined by the limited alternative investment opportunities available for retail investors. Their evidence indicates that cross-sectional variation in the premiums for A-shares is negatively related to the relative supply of A-shares, and positively related to the relative supply of foreign shares. I note that these studies were investigating pre-2008 period of Chinese stock market. Given their empirical evidence, it is plausible that the shortage of securities has caused the A share premium historically. However, after the crisis in 2008, the Chinese stock market has experienced supply and demand equilibrium, if not an excess in supply, given the decline of A share price. This paper will not consider the supply of securities due to the limitation of data, and also due to the fact that both markets have experienced little shortage of security supply after the crisis. Exchange Rate Regime Frankel (2009) tests the nature of China’s new exchange rate regime since 2005, which is relevant to my study. In 2005, China announced a move away from the dollar peg; however, the question remained: what is China’s exchange rate regime now? China has claimed that the exchange rate regime is a managed float against a “basket of currencies”. However, China did not publicize the weight of each currency, making it difficult to predict RMB’s exchange rate. J. Frankel (2009) developed a new technique to find out both the weight and flexibility of China’s new exchange rate regime. He introduced a new variable, Market Pressure, expressed as the percentage increase in the value of the currency plus the increase in reserves. The coefficient of this variable is used to test to what extent the exchange rate changes due to the change in market demand of RMB. In other words, to what extent the exchange rate is fixed. His new estimation consists of the following equation: Where w(j) is the weight and X(j) is the exchange rate of currency j; emp is the market pressure, or the demand for RMB in the international market. The regression result is the following: Figure 6