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Analysis of the Chinese Stock Markets

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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, not least because in the short-term the disparity between foreign and local banks will likely marginalize the latter. Moreover any significant banking reforms—particularly if they are implemented too quickly—will have massive economic and political consequences. This is because truly efficient banks will likely cease lending to SOE’s, and this will almost certainly lead to many of them folding immediately. Consequently this will cause unemployment and alienate influential players in the Chinese economy and government.

In sum the Chinese authorities are facing a real challenge in their efforts at balancing banking reform with maintaining economic and social stability. They recognise the urgency of significant banking reforms, especially in light of their looming WTO obligations, but at the same time—like every other aspect of the reform and liberalisation process in China—they are obstructed by extremely powerful political and institutional interests.

Thus far the result of this delicate balancing act has been incremental reform, but this is no longer tenable—again especially in light of the country’s WTO obligations. It remains to be seen whether the authorities are capable of making risky—albeit necessary—decisions, but failure to act decisively will likely have very negative consequences in the mid to long term. Another words a measure of short-term discomfort may be necessary to avoid far more serious problems further down the line.

As far as the Chinese stock markets are concerned, banking reform is crucial to their long-term viability. The issue is not one of direct involvement, but rather of massive indirect influence. Chinese banks were barred from overt trading in the stock exchanges a long time ago, but there is little doubt that they exert massive indirect influence on the process. First and foremost they are largely responsible for lending credit to the SOE’s that dominate Chinese stock markets.

Therefore a more efficient banking system in the country is likely to boost the fortunes of private enterprises in the CSM. This will in turn impact positively on many of the structural flaws of the Chinese capital markets and help curtail many of the unacceptably high risks that bedevil today’s investors. In due course banking reform—arguably more than any other reforming sector—will be the key to overcoming many of the weak-form characteristics of the Chinese capital markets and enable them to acquire western-style semi-strong efficient features.

Accounting/Financial Reporting

China is widely regarded as maintaining poor accounting and financial reporting standards. Indeed the country only adopted internationally accepted accounting standards in 1993 and state enterprises were given until 1995 to integrate these into their own accounting practices. However there is ample evidence that the adoption of internationally accepted accounting and financial reporting standards has largely been matter of form rather than substance.

For instance preparation of financial statements continues to be viewed as a perfunctory reporting exercise to a higher authority, and not an indispensable auditing and risk management exercise. Consequently financial and other data is often manipulated to depict a financial picture that best serves the interests of the entity.

The very fact that Chinese accounting culture and practices cannot be trusted entails an enormous amount of risk as far as investing in Chinese shares is concerned. Financial reporting information—and the core accounting data that underpins them—is often the only available information on listed companies. Consequently investors rely on this information to make key investment decisions. This entire process operates on trust—i.e. trusting the information presented in financial statements—and if trust is lacking, then the whole apparatus collapses.

Whilst studies into a direct relationship between CSM under-performance and the country’s poor accounting and financial reporting standards have yet to take place, nonetheless it is safe to assume that a strong relationship likely exists. This is particularly the case insofar as foreign investment in Chinese shares is concerned.

In many respects, reforming Chinese accounting and financial reporting and ensuring compliance with western standards, requires a broader reform of the country’s corporate governance culture. The reform of corporate governance culture and practices in China has long revolved around improving the management and efficiency of SOE’s. In fact the listing of SOE’s in the stock markets was essentially designed to improve their corporate governance. Moreover it was hoped that exposure to the markets would lead to the diversification of these enterprises’ ownership.

In other words, whilst the government was determined to retain dominant control over SOE’s it was willing to concede a measure of ownership to private interests—both domestic and foreign. In reality however many SOE’s remained fully in government hands, but they acquired the status of legal entities and were, for all intents and purposes, treated as private enterprises.

However because ownership ultimately resides in the corridors of power (whether at the local or national government levels), and thus subject to political control and manipulation, real corporate governance reform is proving hard to achieve. Moreover by complicating the ownership structure offset’s, the authorities may have inadvertently made corporate governance reform even more difficult, since in many cases ascertaining ownership and control is extremely difficult. This has a marked negative impact on investor confidence as well, since investors are unlikely to allocate capital to companies whose ownership structure is not immediately apparent.

As with banking, the Chinese authorities are serious about reforming corporate governance. One idea that is currently being debated is widening the scope for institutional investment in Chinese companies. It is hoped that institutional investment can stabilise the highly volatile stock markets, primarily because institutional investors are seen as strategic investors pursuing long-term returns rather than short-term profits.

Accordingly their participation and impact is seen as likely leading to a reduction in short-term trading activities, thus engendering more stable capital markets. But of course the positive impact of institutional investors is diminished (and perhaps even reversed) if they—like the companies they are investing in—are also part of the government. Thus reform of corporate governance—in particular attempts at overhauling ownership structures—is also hostage to powerful political and institutional interests.

WTO Accession

China joined the World Trade Organisation (WTO) in December 2001 and has apparently been making steady progress in meeting its WTO commitments. Nevertheless China is still regarded as a “non-market “economy by many of its major trading partners at the WTO. Scanning the available literature, it seems clear that few are complaining that the Chinese are not meeting their WTO obligations. Indeed the general consensus seems to be that China is adapting well to the conditions fought membership and gradually integrating itself with the global economy.

However the U.S. government has occasionally complained that China has not been keeping some of its commitments, especially in the area of intellectual property and the reduction of market barriers. But these complaints are to be expected, as the Americans have a variety of motives for pressurising China—not least the fear the Chinese will likely displace the U.S. as the world’s pre-eminent power sometime in this century.

Notwithstanding the general consensus that China has coped well withstood accession, there is one important point that has been entirely overlooked by analysts. The key question regarding the risks posed byte accession do not revolve around sluggish adaptation to WTO standards, but rather concern an over-zealousness on the part of the Chinese authorities to meet their obligations. After all adapting well to WTO standards and in due course securing an influential position in that organization has enormous prestige value for the Chinese.

In fact this is a core objective of Chinese foreign policy—and unlike the wider reform process which is seen as a primarily domestic issue—the government is determined to make progress at a very rapid pace. And herein lies the danger; rapid integration into the global economy can have destabilising implications for the Chinese economy, not least because it is still a non-market economy.

Rapid integration into the global economy would be good news if the Chinese were liberalising all aspects of their economy at a quick rate as well. However this is clearly not happening and it remains to be seen whether serious risks are incurred as a result of rapid integration in the decisive years ahead. Insofar as the Chinese stock markets are concerned, the risks are obvious. Indeed if the Chinese economy is undermined as a result of rapid globalisation, then the CSM stands to reap the repercussions.

EMH & the Chinese Stock Markets

The Efficiency Market Hypothesis (EMH) was first formulated in the1960’s and for a long while constituted the dominant theory insofar as understanding the fundamental dynamics of capital markets is concerned. In very simple terms, the EMH theory contends that capital markets are efficient because they behave consistently. Moreover the theory contends that stock prices accurately reflect all known information and consequently it is impossible to accurately predict the value of stocks in the future. This is because news and information which affect stock prices are impossible to predict. In practical terms, according to EMH theory it is extremely difficult (and next to impossible) to make above-average returns in the stock markets, except through unconventional means, in particular luck and/or access to inside information.

There are essentially three forms of EMH; namely weak-form, semi-strong and strong form efficiency. Clearly a stronger level of efficiency entails a more consistent and hence low-risk capital market. While comprehensive analysis of all these three forms is beyond the scope of this study, it is important to stress that most (if not all) western capital markets generally conform to the semi-string form type.

Moreover it is widely believed that the strong-form efficiency type does not really exist since capital markets (like the human beings that create and run them) are not altogether 100% rational. In fact the practical non-existence of the strong-form type has led many people to question the validity of the EMH theory in its entirety. Indeed in recent years alternative theories have emerged to challenge the primacy of EMH. The most important of these is “behavioural finance” which challenges the notion that the markets are efficient and rational on the basis that the markets reflect the beliefs and emotions of those who administer them.

Insofar as the CSM is concerned, most of the available literature indicates that they are weak-form efficient. However some studies (two of which were discussed earlier) have challenged this notion on the basis of consistent empirical testing. However no matter what form efficiency the Chinese capital markets are, it is not altogether clear whether this classification enables us to identify and assess the risks associated with the country’s stock exchanges.

While stronger form efficiency generally indicates a lower level of risk, this does not necessarily help in identifying and understanding the specific constellation of risks that pertain to specific markets. This is especially the case with the Chinese stock markets, not least because they are subsumed in an economy and polity that is exceptionally eccentric and complex.

While ascertaining the EMH characteristics of the Chinese stock markets is a useful exercise insofar as it provides a general comparative context (especially in relation to the capital markets of the western nations), it can in no way be relied upon as a risk assessment tool. The Chinese socio-economic and political system (and the stock markets that have grown out of them) is far too complex to be explained away by the EMH theory. Consequently a proper risk assessment exercise needs tube multi-dimensional and focus on broader structural dynamics.

Risk Analysis

There are three components to this section. Firstly there is discussion on the optimum research methods for gathering information on the CSM and its associated risks. Secondly there is a presentation of survey completed by a China analyst at a leading business consultancy in London. The responses of the analyst are analysed in the context of the findings and arguments of this research paper. The main purpose of this exercise is to introduce the student to the kid of questions that constitute quality “primary” research on this subject. Finally this paper will present its conclusions.

Research Methodologies

The selection of research methods is dependent on a number of key factors. The most important factors are the scope and functions of the research. In other words what matters most is the length/quality and purpose of the research project. If the research is intended to be a major project into the structural dynamics of Chinese stock markets and the risks associated with them, then the core focus will need to be on accessing primary quality information directly from the stock markets over an extended period. Indeed most of the research projects carried out by major academic and financial research institutes into the CSM revolve around accessing and analysing vast amounts of historical and contemporaneous data.

However, if the research project is far more limited in scope and is intended to form the basis of a BSc or MSc dissertation into the Chinese capital markets, then clearly both the structure and informational/analytical depth of the research piece will be markedly different. In short it will prove very difficult to conduct painstaking research for essentially two reasons: namely time and funding.

Over the past 5 years a number of high quality research projects on the CSM have been commissioned by academic and other research institutions. A number of these projects have been introduced and critically discussed in this research paper. These research projects almost invariably take many months (and perhaps even years) to complete.

This is because the task of identifying, collecting, assessing and analysing primary data is very arduous and time consuming. Moreover it requires significant amount of funding to cover the various expenses that are incurred during the research process. Cleary in the case of a BSc or MSc research project, both the time and the funding is lacking. The most consequential—and obvious—implication is that the research proposal will have to be far less ambitious in scope and function.

This, however, does not mean that a BSc or MSc dissertation cannot make a unique contribution to on-going efforts to understand the Chinese stock markets. Arguably the best way to make an impact is to identify and approach people who can shed some light on the complexities of the Chinese capital markets. In effect “interviewing “or having the subject complete a comprehensive and well-planned survey, is the best way to incorporate their information and insights into the dissertation.


The following survey was completed by a China analyst at “Business Monitor International”, a leading London-based commercial consultancy:

1) What in your view are the defining features of the Chinese Stock Market? (Discuss with particular reference to the Shanghai Composite Index)

Most trading is done in the Shanghai stock market. There is separate Shanghai B index, but I am not altogether sure how influential it is. Clearly the benchmark index is the Shanghai Composite Index. In regards to the Shenzhen index, they have recently launched a new board for small and medium sized enterprises, which the Chinese hope will in due course develop into a NASDAQ style board.

2) Do you anticipate the bubble of the Chinese Stock market bursting in the next few years? (Discuss in relation to the Morgan Stanley Capital International posting a 23 per cent gain in Sterling terms over the past 3 years, effectively outstripping the FTSE All Share Index and FTSE World index)

It already HAS burst. In April 2004 the Shanghai Composite was at a2½-year high; it recently fell to a 5¾-year low, taking overall losses to 500 points, or around 30%. It was Asia’s worst performing stock market last year. Over the very long term, it may have bright prospects, but for now it is looking decidedly weak.

3) What are the best forms of stock in the CSM? (Discuss in relation to oil & Commodities, Mining etc…)

China desperately needs more commodities to drive its economic growth, so those companies should benefit from on-going rapid GDP expansion. Also, the electricity sector is being rapidly expanded and upgraded to cope with demand. China’s electricity needs rise in tandem with the economy, and power companies could be a key beneficiary. I imagine that infrastructure-related stocks should gain, since China has a lot to dote boost its roads, railways, airports, etc… as it becomes a modern economy.

4) Conversely what are the worst forms of stock in investment terms?

Right now, with credit controls on many key sectors such as property, steel, etc., those types of companies may not be such a good bet.

5) What are the primary risks associated with doing business in them? (Discuss primarily in relation to its infancy and volatility)

It is unclear how open and transparent accounting practices are. There also is said to be a lot of corruption in China. The overall market is still quite regulated.

6) How can the Chinese authorities minimize these risks?

They need to introduce more reforms to make it more ‘Western-style’ in terms of accounting practices and business and financial operations. For example, two Chinese state-owned banks are supposedly planning to avoid a New York listing, because of a tightening of standards there following corporate US scandals.

7) How would you define the performance of CSM in relation to the “Efficiency Market Hypothesis” (EHM)? (Discuss along the lines that Unkind U.S. are semi-strong and China is weak-form)

I am not in a position to give an authoritative answer to this question.

8) How responsive is CSM to wider economic and political events?

Economic news is big right now. The authorities have placed extensive credit controls on key sectors, and this has depressed the market. The government has been trying to prop up the market through new investment incentives, such as a reduced transaction tax, and allowing new funds to invest in the market. There had also been temporary ban on IPOs late last year, but there is a distinct bearishness towards the market right now.

9) How important is political risk to investor decisions in China?

It must surely be a concern, but there seems to be a general consensus that politics is all okay and stable, because the Communist Party is firmly in power. I think political risk is severely underestimated. Yes, there has been a peaceful transfer of power to the “4thgeneration” (Hu Jintao), and Zhao Saying’s funeral passed by without event, but over the next 10 years we could see more unrest if state-owned enterprises are allowed to collapse, rather than being kept on life support by the government through state-owned banks. If rising expectations aren’t met, we could see more unrest, as happened in NE China in recent years.

10) If the volatility and risks associated with holding Chinese securities are too great, would you recommend tapping into the Chinese market via proxies (i.e. foreign companies that have substantial operations in China)

Possibly! Insofar as foreign entities acting as holding companies are concerned (i.e. foreign companies setting up local branches), I as an investor would be sceptical since asset identification and other commercial information would be difficult to verify under those circumstances. However, I am a somewhat risk-averse person!

11) What are the implications of China’s massive economic growth (averaging at 9% pa) for the CSM?

In theory it should boost the market along with the rest of the economy. But because everyone’s still worried about a ‘hard landing’, and the government is actively trying to cool the economy, the market has fallen dramatically. Over the very long term, given China’s growth potential, the stock market should have much more room for gains.

12) Given that China is the number one recipient of Foreign Direct Investment (FDI) in the world, how do your account for the comparatively poor performance of Chinese stock markets?

FDI is clearly bypassing the stock market and instead being used to build new factories and manufacturing plants. Foreign investment does not have to go into equities.

13) Do you envisage foreigners gaining access to A-shares in the Shanghai and Shenzhen stock exchanges in the foreseeable future? (Note: currently foreigners only have access to B shares) And if yes, what implications will it have? (Discuss in relation to investor confidence)

If China wants to develop a modern stock market for the 21stcentury, it’ll have to open up the stock market fully to foreign investors. Yet the government is still weary of letting foreigners gain too big an influence over key industries and sectors, presumably ones of ‘strategic’ importance.

If the CSM is opened up further, foreign forces may well develop a greater presence in Chinese companies, which may help them improve their transparency and accounting standards, as well as business practices. However, old habits are likely to die hard. The Communist Party does not want to lose too much control over the economy.

The questions that were put to this analyst are all designed to elicit genuinely fresh information. They do this by forcing the respondent to think hard about their answers. Moreover there are prompts in place(like asking them to discuss in the context of the “Shanghai Composite Index”) that direct their thinking and response. This prevents the respondent from giving irrelevant or marginally useful information.

In regards to the contents of the respondent’s answers, there are essentially three features that merit special attention. Firstly the respondent highlights poor accounting and financial reporting and decrepit corporate governance as key risk factors. This is remarkable insofar as it confirms the general consensus that CSM will only begin performing to their true potential once the underlying structures have been reformed beyond recognition. Indeed this is a theme that has been discussed at length in this research paper as well.

Secondly the respondent identifies “political” risk as a major issue, and one that is seriously under-estimated by analysts. In this respect the respondent is right, since most observers do not seem to appreciate the political challenges that greater liberalisation and reform, pose tithe Chinese elites. Finally the respondent states in no uncertain terms that he does not have the requisite expertise to discuss CSM in the context of the Efficient Market Hypothesis. This lack of knowledge points to two possible conclusions: namely that EMH is declining as dominant theory and moreover CSM analysts do not factor in EMH in their assessments on the risks of the Chinese capital markets.

While the completed survey outlined here does not necessarily constitute a unique contribution to our understanding of the CSM, it does however indicate that unique information and insights can be accessed through this methodology. In other words if this survey had been distributed to several dozen experts, it is quite possible that wealth of quality information would have ensued as a result. The key task then would revolve around interrogating the data provided by the respondents and eliciting the truly exceptional pieces of information and insights. Incorporating that information in the body of the dissertation in a manner that is suitable to the style, structure and arguments of the piece, will likely determine the overall quality of the dissertation.


This research paper has outlined the emergence of Chinese stock markets, tracked their evolution over the past 15 years and assessed their risk environment on several different fronts and from a number of different perspectives. The central—and most obvious--conclusion of this paper is that the Chinese capital markets are riddled with unacceptably high levels of risks. These risks are not limited to the operations of the CSM itself, but rather emanate from the broadersocio-economic and political structures that determine the regulatory framework of Chinese capital markets.

In regards to the Efficiency Market Hypothesis, this research paper concurs with the widely held consensus that the Chinese markets are weak-form efficient. Whilst an increasing number of research projects are challenging this consensus—ostensibly on the basis that continuing reforms are enhancing the performance of the markets—it is safe to assume that the weak-form efficiency categorisation is broadly correct.

However the central contention here is that EMH is not necessarily the best tool for understanding the fundamental dynamics of capital markets. Certainly in the case of the Chinese stock markets the EMH theory is even less useful. This is because the scope for irrationality; and in particular the proliferation of irrational actors and institutions in the Chinese markets is much higher than in western stock exchanges. After all EMH works on the assumption that stock exchanges are underpinned by rational institutions and actors.

Moreover on the question of China’s accession to the WTO in late2001 and the risks that poses to CSM, this paper has taken an entirely different view from much of the open-source literature. Indeed WTO accession can have very serious consequences for the Chinese economy—and the stock markets in particular—since it has created massive incentives for rapid integration into the global economy. This poses problems since globalisation and internal Chinese reforms are not moving ahead in tandem.

The arguments contained in this paper are essentially premised on the notion that many of the risks associated with CSM are reducible tithe peculiarities of the Chinese political system. More specifically, China’s idiosyncratic reform and liberalisation programme—which limits reforms to the economic sphere and leaves the monopoly of the communist party and its elaborate system of patronage intact—are at the heart of the problem. There is no denying the fact that China’s economy is dynamic and rapidly expanding. But this is primarily because it has many inherent positive features, not least its size, proliferation of cheap labour and the country’s geo-political weight. Moreover, given the immense size of the Chinese market, the country is currently the largest recipient of direct foreign investments.

However as it stands, the country’s economy continues to grow at unprecedented levels, without the stock markets reflecting this economic strength. This is because the stock markets constitute the weakest link in the Chinese economic-financial system and hence reflect the worst features of the country’s economy. While there is little doubt that this state of affairs will improve in the very long-term, the key question revolves around the length of time it will take for key structures to be reformed beyond recognition. In light of the unlikelihood of political liberalisation in the short to midterm, it will probably take a least another generation before the Chinese stock markets are transformed into truly market-oriented institutions.


Hughes, N.C., China’s Economic Challenge: Smashing the Iron Rice Bowl, M.E. Sharpe, London 2002.

Lloyd, P.J. & Zhang, X ed. China in the Global Economy, Edward Elgar Publishing, Cheltenham 2000.

Richter, F.J., The Dragon Millennium: Chinese Business in the Coming World Economy, Quorum Books, London 2000.

Saes, L, Banking Reform in India and China, Palgrave Macmillan, Basingstoke 2004.

Sheen, R, China’s Economic Reform : An Experiment in Pragmatic Socialism, Pager, London 2000.

Tsai, K.S., Back-Alley Banking: Private Entrepreneurs in China, Cornell University Press, New York 2002.

Research Papers

Bottler, P, China and the WTO: Implications for China, the East Asian Region and the World, Tufts University, February 2003.

Chen, J & Strange, R, The Evolution of Corporate Governance in China, King’s College London, April 2004.

Eglin, R, Challenges and Implications of China Joining the WTO, WTO Secretariat, Geneva, 19 June 2000.

Green, S & Wall, D, This little piggy becomes a market: The challenges of Chinese capital market liberalisation, Organisation for Economic Cooperation and Development (OECD), 8 December 2000.

Ianchovichina, E, Martin, W & Fukase, E, Assessing theImplications of Merchandise Trade Liberalization in China’s Accession to WTO, World Bank, June 2000.

Liu, B, Weak-form Market Efficiency of Shanghai Stock Exchange: An Empirical Study, University of Tsukuba, January 2003.

Ma, S & Barnes M.L., Are China’s Stock Markets Really Weak-Form Efficient?, Adelaide University (Centre for International Economic Studies), May 2001.

Milkier, B.G., The Efficient Market Hypothesis and Its Critics, Princeton University (CEPS Working Paper No. 91), April 2003.

Emerging Markets Monitor Journal

Banking Reforms: The Time Is Now, 14/02/05.

Will China Avoid A Hard Landing? , 11/02/05.

Shanghai Bourse : Time For Rebound, 16/11/04.

New Measures To Support Shanghai Bourse, 20/09/04.

Shanghai Composite Index : 1,300 Is Key, 23/08/04.


Have You Ever Bought New Shares from China’s Stock Market? : Research into Under-pricing and Volatility of Initial Public Offerings.

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