Structural Changes in Chinese Stock Market

Structural Changes in Chinese Stock Market Haitian LU, The Hong Kong Polytechnic University Jiajia FU, The Hong Kong Polytechnic University CAFR CONFERENCE

What do we do? • This report is based on our survey of the articles published in 15accounting and finance journals using data from firms publicly traded in Chinese stock market from 1998 to 2013. • We first search articles whose title contains the word “China” or “Chinese” in these 16 journals, and then manually identify those in relation to China stock market. We exclude articles on Chinese banking, debt market, futures market and monetary market, etc. • Our objectives are to identify: • Major structural changes in Chinese stock market that give rise to research opportunities; AND • The ‘distinctiveness’ of Chinese stock market compared with developed stock markets (e.g. U.S) CAFR CONFERENCE

Scope of Survey • Accounting Journals: • The Accounting Review (TAR) • Journal of Accounting & Economics (JAE) • Journal of Accounting Research (JAR) • Contemporary Accounting Research (CAR) • Review of Accounting Studies (RAS) • Journal of Accounting and Public Policy (JAPP) • Journal of Accounting, Auditing & Finance (JAAF) • Finance Journals: • Journal of Finance (JF) • Journal of Financial Economics (JFE) • Review of Financial Studies (RFS) • Journal of Financial and Quantitative Analysis (JFQA) • Journal of Business (JB) • Journal of Banking & Finance (JBF) • Journal of Corporate Finance (JCF) • Journal of International Money and Finance (JIMF) CAFR CONFERENCE

China Stock Market Research is On The Rise CAFR CONFERENCE

Chinese Stock Market Development:An Overview CAFR CONFERENCE

Share Issue Privatization (SIP) and the Development of Chinese Stock Market • The development of Chinese stock market must be understood in the context of the “partial privatization” process of SOEs in the 1990s. • Unlike in most other countries where privatizations are through secondary offerings, the Chinese privatizations were primary offerings that did not involve subsequent secondary offerings (Fan, Wang and Zhang 2007 JFE). • This creates differences and conflict of interests between non-tradable (state and legal person) shares (NTS) and tradable (private investor) shares (TS). Huang, Shen and Sun (2011 JCF) • As of February 2005 (immediately before the NTS reform), non-tradable shares accounted for 63.51% of all outstanding stock. (Jiang, Lee and Yue 2010 JFE) • The 2005 NTS reform involves the non-tradable shareholders proposing a compensation package to the tradable shareholders in exchange for the listing rights of their shares. • Two papers study the determinants of the size of compensation package in NTS reform: Firth, Lin and Zou (2010 JFQA) “state and institutional ownership”, and Li et al. (2010 RFS) “NTS holder’s risk sharing motives”. CAFR CONFERENCE

Rapid development stage • 2005 – Now 109 • National capital markets took shape • 1992 - 1998 • Initial development stage • 1999 – 2004 China Capital Markets Experienced 3 Stages in 20 Years • In April 2005, the CSRC launched the non-tradable share reform, which was basically completed by end of 2007 • In 2004-2009, the CSRC set forth the sponsorship mechanism and offering mechanism reform to further liberalize company offering practices • In 2010, stock index futures and stock borrowing and margin trading were launched to deepen China capital markets reform • In 1999, the Securities Law was promulgated, providing the legal framework governing China capital markets • Since 2000, the CSRC decided to “encourage the development of institutional investors”, largely improving the investor base in China capital markets • The approval mechanism was in place instead of quota mechanism for share offerings • In December 1990, SSE and SZSE started operation • In October 1992, the CSRC was established to exercise centralized regulation over China capital markets • In November 1997, the government set out the principle of separate operation of banking, securities and insurance players in China financial sector China capital markets stepped onto a new stage since 2006, driven by successive IPOs of large SOEs (RMB TN) National capital markets took shape Initial development stage Rapid development stage Since 2006, a number of large SOEs, including the “Four Big” SOE banks, Petro China and China Shenhua listed on the A-share market Note: Stock market cap refers to the total ending market cap, including all SSE and SZSE listed companies Source: TX CAFR CONFERENCE

Growth of Number of Companies in Stock Market（1990－2012） Source: CSMAR database (2013version) & HKEx CAFR CONFERENCE

Market Segmentation of Shares Sun, Tong and Wu (2013 JBF) CAFR CONFERENCE

Puzzle of A-B share price discount • Foreign investors, who trade B-shares, have an informational disadvantage relative to domestic investors, who trade A-shares. (Chan, Menkveld and Yang 2008 JF) • Governance explanation: foreign investors care more about a firm’s governance quality than domestic investors. It is found B-share price discount is higher for firms that have weaker governance. (Tong and Yu 2012 JIMF) • Hong Kong as a substitutes for the B-share market. It is found when more H shares and red chips are listed in Hong Kong, the B-share discount becomes larger. (Sun and Tong 2000 JBF) Source : Tong and Yu 2012 (JIMF) CAFR CONFERENCE

Market Segmentation: More Implications • Different Investor Protection Law & Enforcement Barrier • H-shares are associated with higher earnings management than local Hong Kong, and this relationship is weaker after China implemented the Securities Law in 1999. (Fung, Su and Gul, 2013 JAPP) • Pay-for-performance sensitivity • No difference between H shares and A shares, but higher for “Red Chip” shares (Ke, Rui and Yu, 2012 RAS) • Private benefit of successful overseas listing • Hung, Wong and Zhang (2012 JAE) find managers of connected firms can gain private benefits (political media coverage or a promotion to a senior position) following successful overseas listing than domestic listing. CAFR CONFERENCE

China has Become One of the Most Important Capital Markets Globally Global top 10 listed companies Market cap of global major stock markets US$ TN Source: Bloomberg, as of February 20th 2011 Average Daily Trading Volume (ADTV) of major stock markets US$100 MM Source: Bloomberg, as of February 20th 2011 Note: ADTV is the average of recent 20 trading days Source: Bloomberg, as of February 20th 2011 12 CAFR CONFERENCE

Retail investors still account for a large portion, while institutional investors play an increasingly important role. Retail investors constitutes the largest component Institutional investors plays an increasing important role with significant potential for growth Institutional Investors’ Contribution in Turnover A-share Market Cap Breakdown by Investor Source: SSE, as of 2008 Rapid growth of China’s fund management companies Overseas funding enters into A-share market via QFII RMB 100 MM USD 100 MM AUM 00-10 CAGR 40.4% AUM 00-10 CAGR 41.1% Source: Wind, as of Feb. 20, 2011 CAFR CONFERENCE Source: Wind, as of Feb. 20, 2011

Multi-layered Marketwith high p/e ratio Chinext enjoys a large premium in IPO P/E ratio Good aftermarket performance Source: Wind, as of Feb. 20, 2011, based on IPO data in 2010 Source: Wind Create a funding platform for new industries Provide higher profitability growth Chinext market cap breakdown by industry CAGR of 2009~2011E Source: Wind, as of Feb. 20, 2011 Source: Wind, as of Feb. 20, 2011Note: net income in 2011 based on wind consensus CAFR CONFERENCE

Chinese Stock Market Characters • Large information asymmetry, high IPO under-pricing level (Chan, Wang and Wei, 2004 JCF). • Synchronous stock price movements low stock price informativeness on firm-level information (Morck, Yeung and Yu, 2000 JFE). • Firm investment does not significantly respond to the stock market valuation (Wang, Wu and Yang 2009 JBF) CAFR CONFERENCE

Who are the Controllers of Chinese Listed Companies? • State and Privately Controlled Manufacturing Firms on Shanghai and Shenzhen Stock Exchange 1999-2008 (Firth et al. 2012 JCF) CAFR CONFERENCE

Benefit of Privatization: Empirical Evidence I • Ownership & Firm Value • Both state and legal person shares are significantly negatively related to firm value proxied by Tobin's Q (Wei, Xie and Zhang 2005 JFQA) • Ownership & Firm Performance • Share issue privatization (SIP) has positive effect on earnings ability, real sales, and workers’ productivity. Legal persons behave differently from the state government due to monitoring and business ties (Sun and Tong 2003 JFE) • SIP firms continued to experience negative post-SIP profitability changes however their performance decline was significantly less than that of their matched non-SIP SOEs. (Jiang, Yue and Zhao 2009 JBF) • Control transfer from-state-to-private is associated with better operating performance and positive market reaction, but control transfer from-state-to-state has no such effect (Chen et al. 2008 JFQA) • Private ownership of listed firms in China is not necessarily superior to certain types of state ownership. Chen, Firth and Xu (2009 JBF) • Ownership & Transparency • Synchronicity (a proxy of firm-specific information) is higher when the largest shareholder is government related, and foreign ownership and auditor quality is inversely associated with synchronicity (Gul, Kim and Qiu 2010 JFE) CAFR CONFERENCE

Benefit of Privatization: Empirical Evidence II • Ownership & Earnings Management • SOE have lower incentive to manipulate earnings than NSOEs. (Chen et al, 2011CAR) • Ownership & Pay-Performance Sensitivity (PPS) • Private ownership positively affects PPS (Cao, Pan and Tian 2011 JCF). • Even within state-ownership, the PPS is higher for SOEs as controlling shareholder than state agency as controlling shareholder (Firth, Fung and Rui 2006 JCF). • Ownership & Accounting Conservatism (AC) • SOEs adopt less AC than NSOEs because lenders are less concerned with downside risk for SOEs than for NSOEs. (Chen et al. 2010 JAR) • Ownership & Choice of Auditor • Compared with NSOEs , Local SOEs are more likely to hire small, local auditors. (Wang, Wong and Xia, 2008 JAE) • Ownership & Audit fee • SOEs incur significantly lower audit fees than NSOEs, for lower bankruptcy risk brings lower litigation risk for auditors. (Liu and Subramaniam 2013 JAPP) CAFR CONFERENCE

Political Connections (‘PC’) • In China, access to equity market is a politically determined process. • Before 1999, a quota system was used: Central government determines the overall size of the IPO market on a yearly basis, each province received its IPO quota from and identified prospective candidates based on applications by firms under its jurisdiction. • 2000-2004, a channel system, regulators assigned channels directly to sponsors, according to their size and performance. Sponsors with channels recommended prospective firms to the CSRC for an IPO. • 2005-present, a sponsorship system, the sponsor recommends its client firms for an IPO listing, which must be approved by the CSRC. • State firms usually received priority for an IPO, whereas only a few (politically connected) private entrepreneurial firms would be selected for listing. Incentive to establish PC • In China, state firms have ‘natural’ PC, whilst private entrepreneurs can establish PC by (1) participate in politics themselves; and (2) hiring politicians on their board of directors. (Fan, Wang and Zhang 2007 JFE) CAFR CONFERENCE

The Role of Political Connections: Empirical Evidence • PC & IPO probability • PC firms have higher probability of IPO, higher offering price, lower under-pricing (Francis, Hasan, and Sun 2009 JIMF), and better post-IPO performance (Liu, Tang and Tian 2013 JCF). • PC & Earnings Management before IPO • PC firms have easier access to the equity market less incentive to manage earnings to increase their IPO chance (Aharony, Lee and Wong 2000 JAR). • PC & Firm’s operating performance • PC firms underperform those without politically connected CEOs, because government bureaucrats makes the board unprofessional (Fan, Wang and Zhang 2007 JFE). • Private firms with politically connected managers enjoy tax benefits, whereas local SOEs with politically connected managers are prone to more severe over-investment problems. (Wu et al 2012 JAPP) • Market reaction on losing PC • When partially privatized firms’ announced proposed sales of remaining government shares stock market react negatively, and there is symmetric positive reaction from the cancellation of such plan (Calomiris, Fisman and Wang 2010 JFE) They argue the benefits of political ties outweigh the efficiency costs of government shareholdings. • PC & Acquirer’s returns • Tu, Lin and Liu (2013 JAPP) find politically connected private acquirers receive preferential treatment and acquire higher quality firms during full privatization. However,they tend to tunnel the target firm after acquisition. CAFR CONFERENCE

More implications on Political connections • Politicians are rewarded for capital market activity. Career incentives of local politicians can accelerate the pace of IPO activity in certain politicized environments (Piotroski and Zhang 2013 JFE) • After their partners are appointed to the Stock Issuance Examination and Verification Committee, non–top-tier audit firms significantly increase their IPO audit fees and market share, and significantly reduce the IPO rejection risk for their clients, whereas the same is not the case for top-tier audit firms. (Yang 2012 CAR) • Based on archival records of the government’s evaluation scores and ratings given to 63 SOEs between 2005 and 2007, Du, Tang and Young (2012 TAR) find political connection of SOE CFOs, the geographic proximity of SOE headquarters to the SASAC central office, and political rank of the firm affect the SASAC’s evaluations. CAFR CONFERENCE

Type II Agency Problem in Chinese Listed Firms • Agency problems may arise from the separation of ownership and management (Type I) or from conflicts of interest between controlling and non-controlling shareholders (Type II). • In Chinese publicly traded firms due to the ownership structure the primary corporate governance problem is Type II agency problem whereby controlling shareholders use their control rights to expropriate wealth from minority shareholders via various types of related party transactions (RPT). • Statistics show that out of 719 listed firms in 1997, 84.6% were involved in different degrees of connected transactions. In 2000, this number reached 93.2%. Among those connected transactions, more than 70% were conducted between the controlling shareholders and their listed firms. (Peng, Wei and Yang 2011 JCF) CAFR CONFERENCE

How serious is the RPT problem? Source: Lo, Wong, and Firth, (2010 JCF), based on a sample of 266 publicly traded companies listed that disclosed their gross profits on RPTs in 2004. CAFR CONFERENCE

Related Party Transactions: Empirical Evidence • Tunneling and Propping • Tunneling through abnormal related sales (Lo, Wong, and Firth 2010 JCF) • Tunneling through inter-corporate loans (Jiang, Lee and Yue 2010 JFE) • Tunneling through loan guarantee (Berkman, Cole, and Fu 2009 JBF) • Controlling SH tunnel when their company are financially healthy, and prop when they are in financial distress (i.e. “ST status”). (Peng, Wei and Yang 2011 JCF) • Controlling SH prop up their listed firms through abnormal related sales and then tunnel back through related lending. (Jian and Wang 2010 RAS) • Controlling SH’ tunneling reduces the pay-performance sensitivity of executive compensation. (Wang and Xiao 2011 JAPP) CAFR CONFERENCE

Corporate Governance in Chinese Listed Companies: Executive Compensation and Turnover • Executive compensation / Pay-for-Performance Sensitivity (PPS) • Since 2006 listed firms were required to report each individual board member's and top management's total compensation as the sum of salary, bonus, stipends, and other benefits. (Conyon and He 2011 JCF) • Private ownership positively affects PPS (Cao, Pan and Tian 2011 JCF). • Even within state-ownership, the PPS is higher for SOEs as controlling shareholder than state agency as controlling shareholder (Firth, Fung and Rui 2006 JCF). • Red chip firms have higher PPS than A and H share firms (Ke, Rui and Yu, 2012 RAS) • CEO turnover • Annual CEO turnover rate of 25.5% during 1995-2001, firms more likely to replace CEO when firms are incurring financial losses. (Chang and Wang 2009 JCF) • Managerial Ownership • For partially privatized SOEs, Wei et al. (2005 JFQA) report an average stock holding of only 0.015% by senior managers and directors. • employee stock ownership plans (ESOPs) do not appear to have effect on firm value and performance. (Meng et al. 2011JBF) • Using a sample of non-listed Chinese firms, Hu and Zhou (2008 JBF) find firms of significant managerial ownership outperform firms whose managers do not own equity shares. CAFR CONFERENCE

Dividend Payout • The propensity to pay dividend and the payout ratio are not higher than that of U.S. firms (Weston and Siu 2003) and European firms (Von Eije and Megginson 2008). • The % of non-tradable shares and the %of these shares held by the controlling shareholder are positively associated with the likelihood of paying dividends and the payout ratio. • Cash dividend payments have been required by the CSRC since 2001 as a precondition for listed firms to have rights issues. (Huang, Shen and Sun 2011 JCF) CAFR CONFERENCE

Corporate Governance • Independent directors • Since 2001, CSRC required (1) listed firm shall have 1/3 independent directors; (2) the opinions of independent directors on important board decisions be disclosed. Tang, Du and Hou (2013 JAPP) find firms with more independent directors saying ‘no’ can help to protect the interests of outside investors. • Disclosure • Investors desire transparency in Chinese listed companies and reward companies for more voluntary disclosure.(Cheung, Jiang and Tan 2010 JAPP) • Diversification and Firm Value • In China diversification has premium (Tobin’s Q) rather than discount, but the extent of premium depends on ownership (Lin and Su 2008 JCF). CAFR CONFERENCE

Corporate Governance: Institutional Investors • Equity ownership by mutual funds (average <3%) has positive effect on firm performance (Yuan, Xiao and Zou 2008 JBF). • Institutional investors trade on their insider information during share-structure reform (Tong, Zhang and Zhu 2013 JBF). • Bank ownership associated with poorer operating performance via inefficient investments (Lin, Zhang and Zhu 2009 JIMF). CAFR CONFERENCE

Financial Reporting • Restatements • About 3.7% of listed firms make restatement each year, causes and consequence of restatements (Firth, Rui and Wu 2011 JCF). • Impact of China’s IFRS adoption in 2007 • constrains earnings management and increased value relevance (Zhang, Lu and Ye 2010JAPP, Liu et al 2011JAAF) • FVA has several unintended effects in China, in particular, earnings management through trading security and debt restructuring (He, Wong, and Young 2011CAR) • Earnings Management to meet regulatory requirements • Firms manage their earnings to meet a regulatory ROE benchmark for rights issue. (Chen and Yuan 2004 TAR; Haw et al 2005 CAR; Yu, Du and Sun 2006 JBF) CAFR CONFERENCE

The Auditing Market in China • Less market concentration & Buyer’s market • In 2001, the concentration ratio for the Top 4 and Top 8 auditors was 30.32% and 44.7% (Xia and Lin 2003), and the average market share of the Big 5 (now the Big 4) auditors in the statutory audit market between 1995 and 2003 was 26 percent (Chen et al. 2007). • At the end of 2006, there were 73 audit firms qualified to audit approximately 1,400 listed companies,  one qualified firm had less than 20 listed clients on average. • Auditor independence and organizational form • CICPA’s disaffiliation program(1998-1999) required disaffiliated CPA firms be registered in the form of either unlimited liability partnership or a limited liability company. Firth, Mo and Wong (2011 CAR) find partnership CPA firms are more likely to issue MAOs (i.e., more conservative) than limited liability firms. • Market reaction to Modified Audit Opinion (MAO) • A significantly negative association between MAOs and cumulative abnormal returns (Chen, Su and Zhao 2000 CAR) CAFR CONFERENCE

How often do Chinese Auditors Issue Modified Audit Opinions (MAO)? Chan and Wu (2010 CAR) CAFR CONFERENCE

Determinants of Auditor Independence Regulatory Shocks • Auditing standard • MoF’sadoptionofenhancedauditingstandardsin1995leadsto the increase in MAO, but is followed by a decline in audit market share among large auditors(DeFond, Wong, and Li 2000 JAE). • Audit firm size • Exogenousincreaseinauditfirmsizewithout increase in competency  auditorindependence: a natural experiment from auditormergers1999-2006 (Chen and Wu 2010 CAR). • Audit tenure • An 2004 policy that auditors for CGSOEs to be assigned by SASAC, with a tenure fixed at 2-5 years limits management influence over auditor choice  moreMAO (Chi et al. 2013 JAPP). • Litigation risk • Private Securities Litigation Rules bySupremePeople’sCourtin2002  auditor’spropensitytoissueMAO.(Chen, Sun and Wu 2010 TAR). CAFR CONFERENCE

Litigation Risk is Increasing • Directors and managers in China are required by CSRC to seek shareholder’s approval for purchasing D&O insurance. Zou et al. (2008 JBF) identified 53 such case during 2000-2004, and find firms with more acute controlling-minority shareholder incentive conflicts are more likely to consider purchasing D&O insurance. CAFR CONFERENCE

Other Monitors • CSRC • Enforcement actions of CSRC have a negative impact on stock prices with most firms suffering wealth losses of around 1–2% in the 5 days surrounding the event (Chen et al. 2005 JAPP). • Analysts • Analyst coverage is positively associated with stock return synchronicity measured by a firm’s R2 in China, but star analyst coverage actually decreases stock return synchronicity. (Xu et al. 2013 JBF) • Institutional investors pressure financial analysts through trading commission fees to issue optimistic opinions in support of their stock positions. (Gu, Li and Yang 2013 TAR) CAFR CONFERENCE

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Structural Changes in Chinese Stock Market