Float, Liquidity, , and Prices: Evidence from the Structure Reform in China

Chuan-Yang Hwanga, Shaojun Zhangb, and Yanjian Zhuc

Abstract

Prior to April 2005, only one third of the shares issued by exchange-listed companies in China are publicly tradable. The other two thirds, mainly owned by Chinese government agencies or government-linked enterprises, are prohibited from public trading. On April 29, 2005, the Chinese Securities Regulatory Committee announced a reform plan that aims to abolish the split-share structure by converting all non-tradable shares to be publicly tradable. We investigate the consequences of this unique event and shed light on how increase in share float affects liquidity, speculation and stock prices. Firstly, we find that tradable A-shares command a 60% price premium on average over non-tradable A-shares and this price premium contains both liquidity and speculation components. Secondly, the share structure reform increases share turnover and dampens speculative trading. Relative to control firms, share turnover of restructured firms increases substantially after the reform, with the largest increase (107 %) in firms that had low liquidity and low speculative trading before the reform. In contrast, there is no increase in share turnover of firms that had high liquidity and high speculative trading. Thirdly, stock prices drop substantially on the day when the supply of tradable shares increases due to the reform. Moreover, the higher increase in the supply of tradable A-shares, the larger drop in the stock price. This indicates that the -term demand curve is downward-sloping. Fourthly, despite the fall in stock prices, shareholder wealth increases by 15% on average. We find that the largest price drop and the smallest wealth gain occurs in firms with the highest speculative trading before the reform, which suggests that share structure reform dampens speculative trading in Chinese market. Lastly, split share reform also benefits the B-share market despite that the reform involves only A shares: B-share turnover increases after the reform and the well-known B share price discount narrows substantially. a Nanyang Business School, Nanyang Technological University, S3-01B-46 Nanyang Avenue, Singapore, 639798. Email: [email protected] b Nanyang Business School, Nanyang Technological University, S3-B1A-07 Nanyang Avenue, Singapore, 639798. Email: [email protected] c Nanyang Business School, Nanyang Technological University, S3-B3C-45 Nanyang Avenue, Singapore, 639798. Email: [email protected]

Float, Liquidity, Speculation, and Stock Prices: Evidence from the Share Structure Reform in China

Abstract

Prior to April 2005, only one third of the shares issued by exchange-listed companies in China are publicly tradable. The other two thirds, mainly owned by Chinese government agencies or government-linked enterprises, are prohibited from public trading. On April 29, 2005, the Chinese Securities Regulatory Committee announced a reform plan that aims to abolish the split-share structure by converting all non-tradable shares to be publicly tradable. We investigate the consequences of this unique event and shed light on how increase in share float affects liquidity, speculation and stock prices. Firstly, we find that tradable A-shares command a 60% price premium on average over non-tradable A-shares and this price premium contains both liquidity and speculation components. Secondly, the share structure reform increases share turnover and dampens speculative trading. Relative to control firms, share turnover of restructured firms increases substantially after the reform, with the largest increase (107 %) in firms that had low liquidity and low speculative trading before the reform. In contrast, there is no increase in share turnover of firms that had high liquidity and high speculative trading. Thirdly, stock prices drop substantially on the day when the supply of tradable shares increases due to the reform. Moreover, the higher increase in the supply of tradable A-shares, the larger drop in the stock price. This indicates that the short-term demand curve is downward-sloping. Fourthly, despite the fall in stock prices, shareholder wealth increases by 15% on average. We find that the largest price drop and the smallest wealth gain occurs in firms with the highest speculative trading before the reform, which suggests that share structure reform dampens speculative trading in Chinese market. Lastly, split share reform also benefits the B-share market despite that the reform involves only A shares: B-share turnover increases after the reform and the well-known B share price discount narrows substantially. 1. Introduction

An ongoing debate concerns what caused the stock prices in the internet sector to rise dramatically from early 1998 to February 2000 and then fall precipitously in

April 2000. In the view of Ofek and Richardson (2003), the rapid rise of the internet stock prices during that period occurred because (1) had diverse views and there were relatively more individual investors in the internet sector who in general are less sophisticated than institutional investors, (2) short sales constraint prevented the beliefs of pessimistic investors from being incorporated into prices, and (3) shares were in short supply and hard to borrow because of lockup restrictions. They also argue that the collapse of the internet stock price occurred because expiration of lockup agreement greatly increased the number of shares available for directly selling by corporate insiders and for borrowing and short selling by public investors. Cochrane (2003) holds a similar view and concurs with Ofek and Richardson (2003) on the cause of the development and the collapse of the internet bubble. Motivated by empirical evidences on the internet bubble, Hong, Scheinkman and Xiong (2006) develop a theoretical model and formally demonstrate that the combination of short sales constraint, heterogeneity and limited public float leads to price bubble and an increase in public float could dampen the bubble. However, Schulz (2006) shows new empirical evidence that the collapse of the internet bubble cannot be explained by the increase in public float due to the expiration of lockup agreements. At the center of the debate lies the question whether an increase in the supply of tradable shares causes speculative prices to fall.

In this paper, we contribute to this debate with evidence from a unique event in

China. Chinese stock markets provide an ideal setting to study this issue because they are endowed with all the ingredients that Ofek and Richardson (2003) and Hong, Scheinkman

1 and Xiong (2006) view as responsible for the forming of a speculative bubble in the

NASDAQ internet sector: (1) the market is relatively young and is dominated by inexperienced individual investors who are more likely to hold diverse views on the prospect of stocks; (2) short sale is not allowed; and (3) there is a limited supply of shares available for trade.

Prior to April 2005, only one third of the shares issued by exchange-listed companies in China are publicly tradable. The other two thirds, mainly owned by Chinese government agencies or government-linked enterprises, are not publicly tradable. On

April 29, 2005, Chinese Securities Regulatory Committee (CSRC) announced a reform plan that aims to abolish the split-share structure by converting all non-tradable shares to be publicly tradable. This event provides us a unique opportunity to study how an abrupt increase in share supply (i.e. public float) affects speculation, liquidity, share prices, and shareholder welfare. More importantly, it provides us an out-of-sample and outside-of- the-U.S.-market test of the arguments about speculative stock prices in Ofek and

Richardson (2003) and Hong, Scheinkman and Xiong (2006). It is interesting to see whether their arguments apply to other settings, different from the internet bubble.

According to their arguments, we hypothesize that stock prices in Chinese market are inflated by speculation and the sudden increase in the public float due to the reform dampens speculation.

Under normal circumstances, it is almost impossible to directly test whether stock prices are inflated beyond fundamental values by speculation, or whether stock prices are in the midst of forming a speculative bubble, because the fundamental value is simply unobservable. We are now certain there was an internet bubble only because it has collapsed spectacularly. In this paper, we are able to investigate whether stock prices in

Chinese markets include a speculative component without seeing the collapse of stock

2 prices. Our investigation is based on the belief that the value of non-tradable shares is void of any speculative component because non-tradable shares cannot be traded and hence cannot be speculated upon. Therefore, the price difference between tradable and non-tradable shares can tell the extent to which speculation influences the price of tradable shares. Although this difference cannot be computed directly because the value of non- tradable shares is unobservable, the Chinese split-share reform provides us a unique opportunity to measure the price difference between tradable and non-tradable shares.

If indeed inflate stock prices in Chinese markets, the price difference we calculated would be positively related to the empirical proxy for the degree of speculation in the cross-section. Consistent with this prediction, we find that the price difference is higher for stocks with higher dollar trading volumes, which proxies the degree of speculation activity, even after controlling for liquidity. We also find that the price difference is about 13% smaller for the stocks with both A and B shares than for the stocks with only A shares. This suggests that speculation drives A share prices even higher for stocks that do not have B shares whose prices serve as an anchor than for stocks that do have B shares.1

Furthermore, our results show that the increase in share supply due to the split share reform causes speculative prices to fall. Share price drops by 14% on average after the reform, and the drop is larger for firms under more intense speculation before the reform. In addition, although share turnover increases for all firms due to the increase of public float, the increase of share turnover is smaller for firms under more intense speculation before the reform. This again suggests that larger public float dampens speculative trading.

1 A shares and B shares are two classes of shares with identical rights, but all of the B shares are tradable while only a portion of A shares are tradable. Furthermore, A shares can only be held by Chinese investors while B shares can be held by both Chinese and Foreign investors. Until 2001, B shares can only be held by foreign investors. Despite the identical rights, B shares have been traded at a large discount relative to A shares, known as the AB share discount puzzle.

3 Other than contributing to the literature on speculative bubbles, our paper also contributes to the following literatures. First, we provide new evidence on whether demand curve is perfectly elastic (i.e., horizontal demand curve). Most of the asset pricing models such as CAPM or APT predicate on the assumption that assets have a perfect or close substitute, thus the demand curve for these assets are nearly horizontal (i.e. perfectly elastic). But there have been evidences showing the demand curve are downward sloping, mainly from examining the return of stocks when they are added to S&P 500 index (for example, Harris and Gruel (1986), Shleifer (1986), Lynch and Mendenhall (1997),

Wurgler and Zhuravskaya (2002)) or when the IPO lock-up provisions expire (for example,

Field and Hanka (2001), Ofek and Richadson (2000)). However, these studies cannot completely rule out the alternative explanation that their results are due to new information related to these events. Being included into the S&P index may reflect good news despite

Standard and Poor’s claim to the contrary, while the negative return around the expiration of IPO lock-up provisions may be due to a larger than expected insider selling around expiration dates even though such dates are known well in advance. In contrast, our study is based on a regulatory change event and the public float increases in this event are mandated by regulators on all firms, hence it has the advantage of being free of information contents.

Second, our paper shows that liquidity is priced in the market. Both Silber (1991) and Longstaff (1995) find that stocks under trading restrictions are sold at discount relative to unrestricted shares. Amihud and Mendelson (1991), Naik & Radcliffe (1998), Brennen,

Chordia and Subrahmanyam (19XX ) find stocks with higher liquidity earn lower expected return. Like Silber (1991) and Longstaff (1995), we find that tradable shares command price premiums over their non-tradable counterparts. We provide direct evidence that these premiums are positively related to the liquidity of tradable shares,

4 indicating liquidity is indeed priced. In addition, we obtain other interesting results on this issue from our event-study investigations: (1) both liquidity and share value increase after the reform and (2) the increase in firm value is related positively to the increase in liquidity. While Amihud and Mendelson (1991), Naik & Radcliffe (1998), and Brennen,

Chordia and Subrahmanyam (19XX) study the cross-sectional relations between return and liquidity level, our study examines the relationship between the return and the change of liquidity. Our study of the change in liquidity provides a more powerful test of the relation between liquidity and stock price because change in the liquidity of the same firm controls for other unknown cross-sectional differences in risk that are potentially correlated with the level of liquidity.

Finally, our paper contributes to a growing literature of studies on the Chinese . China has one of the fastest growing economies in the world.

According to Allen et al. (2005), China is the largest economy on the purchasing power basis second only to the U.S., and if current trends continue, will become the largest economy in the world in ten years. The Shanghai and the Shenzhen

Stock Exchange of China have been growing rapidly since their inception in early 1990s.

At the end of 2002, the combined of these two exchanges ranked eleventh in the world. We show that the reform aiming at abolishing the split-share structure of Chinese listed firms, which has been viewed as the major roadblock for further development of Chinese markets, has produced a desirable effect. Evidence in this paper shows that the split share reform has dampened speculative trading and has improved liquidity of shares not only for tradable A shares, but also for B shares which are not involved in the reform. The reform substantially reduced the B shares’ discount from

44% before the reform to 29% post reform. We expect that there will be a further reduction of the B share discount when all of the previously non-tradable shares are

5 available for trade. Currently, only about 15% of the previously non-tradable shares are added to the share supply, while the rest is under a lockup period for one to two years.

Our evidence on B shares is consistent with Mei, Scheikman and Xiong (2005) who argue that the B share discount is partly due to the speculative bubble in the A share market.

The rest of the paper is organized as follows: Section 2 details the share-structure reform in China; Section 3 reviews related literature and develops our research hypotheses;

Section 4 presents our empirical results; Section 5 summarizes and concludes the paper.

2. The share structure reform in China

Prior to April 2005, only one third of the shares issued by exchange-listed companies in China are publicly tradable. The other two thirds, primarily owned by

Chinese government agencies or government-linked enterprises, are prohibited from public trading. This split-share structure is the result of partial of state- owned enterprises (SOE) by Chinese government. Chinese government started the SOE reform in 1978 by allowing employees and domestic institutions to own shares of SOEs.

Because of the desire to conform to the communist public ownership principle, Chinese government kept the majority of shares under direct or indirect state control and disallow these shares from public trading. These shares are known as state shares or legal-person shares.2 China established the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock

Exchange (SZSE) in December 1990 and April 1991, respectively, to facilitate public trading of tradable shares. Only 14 firms were listed on both exchanges at the end of 1991.

As of April 2005, 1353 firms list their shares on these two exchanges, the total market value tradable shares equal to RMB 987 billion.

2 Walter and Howie (2003) and Sun and Tong (2003) give more detailed account of China’s share privatization.

6 As Chinese market grew, this split share structure has proven to have many negative effects on the markets' further development. The split share structure has substantially distorted the pricing mechanism in the and added uncertainty to investors' expectations. The majority shareholders who make corporate policies and have the control of the company’s profits and assets are indifferent to the fluctuations in stock price. As a result, prices and investor behavior do not reflect fundamental values of listed firm (Allen et al. 2005). The stock market is more like a casino than an intermediary channel of capital. Moreover, since the state owns two-thirds of a listed company, there’s no visible owner that holds the controlling interests of that company. The state is simply a notional controlling owner and unable to supervise corporate actions effectively. In addition, there are few market-driven and mergers, and there is no effective corporate governance, both internal and external. Related party transactions that siphon assets from the company are common. The rights of the minority shareholders are frequently violated. In short, the split share structure hinders China from adopting international norms with respect to ownership structure, corporate governance and professional management, among other significant things. The reform of the split share structure is vital to China’s .3

On April 29, 2005, the government announced a reform plan that aims to abolish the split-share structure by converting all non-tradable shares to be publicly tradable. An important feature of this reform plan is that non-tradable-share owners are required to pay a consideration to tradable-share owners before their shares become tradable. The objective of this requirement is to stabilize stock price and preserve shareholder wealth.

Non-tradable shares gain additional value when they become tradable. If non-tradable- share owners do not share this gain with tradable-share owners, tradable-share owners

3 Refer to the speech by Shang Fulin, Chairman of the Chinese Securities Regulatory Committee (CSRC), at the press conference organized by the State Council of China on June 27, 2005,

7 have incentives to sell their holdings before restructuring takes effect, which will drive down stock prices. Chinese regulators learned this lesson from an earlier attempt to float non-tradable shares in 2001. In June 2001, Chinese regulators allowed non-tradable-share owners to gradually sell their shares in the public market without paying a consideration to tradable-share owners. By October 2001, the Shanghai Stock Exchange index dropped by

24% and the Shenzhen Stock Exchange index dropped by 29%. The substantial loss of investors’ wealth forced regulators to delay and eventually stop the selling of non-tradable shares in June 2002.

In this new attempt, Chinese regulators require listed-firms to take a set of measures in implementing the reform. Figure 1 illustrates the time frame of a typical restructuring process. The process is characterized by two trading suspension periods.

Before the first suspension period, the company calls for the major non-tradable-share owners to come up a restructuring plan that proposes a consideration package. Once non- tradable-share owners reach an agreement on this plan, the company announces the official start of its restructuring process on day D0 and requests the stock exchange to suspend trading of its shares from the next trading day. During the first suspension period, the company reveals details of the proposed restructuring plan and consults tradable-share owners for their opinions by press releases, road shows, investor symposiums, etc. Non- tradable-share owners revise the restructuring plan to reflect the inputs from tradable-share owners. The company will announce the finalized plan on day D1, which marks the end of the first trading suspension. Trading resumes on the next day after day D1 and continues until D2. This period gives investors an opportunity to buy or sell the shares before an extraordinary shareholder meeting is called for the approval of the restructuring plan. Only shareholders who hold shares at the closing of day D2 are registered for the extraordinary shareholder meeting and face the consequences of the restructuring. The

8 second trading suspension begins on the day after D2. An extraordinary shareholders' meeting is called for to vote on the plan. Only when over two thirds of all tradable shareholders who participate in the meeting agree with the restructuring plan, can the plan be approved. Once approved, the plan takes effect and trading resumes on day D3. To limit the sudden impact on stock price, although shares held by non-tradable-share owners are legally tradable after reform, they are restricted from trading during the first year after the reform is completed. The supply of tradable shares increased immediately after the completion of the reform because of the bonus shares that non-tradable-share owners transfer to tradable-share owners.

Stage 1: Stage 2:

Regular Plan Publication Regular Rights Confirmation Regular Trading and Negotiation Trading and Online Voting Trading

D0 D1 D2 D3

Trading Plan Confirmed Trading Plan Effected Suspended and Trading Suspended and Trading Resumed Resumed

Figure 1

Table 1 illustrates the restructuring process by chronicling the events that happened to TongRenTang, a well-known traditional Chinese medicine and cosmetic company listed in the Shanghai Stock Exchange. On October 15, 2005 (i.e. D0), the company announced the start of its restructuring process. It has 434 million outstanding shares, 64.2% of them are non-tradable and the rest 35.8% tradable, the closing price on that day is RMB20.38.4

On the next trading day, trading is suspended and the company revealed the plan which states that non-tradable-share owners pay 2.2 shares for every 10 shares held by tradable share owners. Tradable share owners did not like this ratio and voiced their opinions

4 It is equivalent to US$2.52 at the exchange rate of RMB8.09 for US$1.

9 strongly. As a result, non-tradable-share owners revise the ratio to be 2.5 shares for every

10 shares. The revised plan is confirmed on October 26, 2005, which marks the end of the first trading suspension. Trading resumed on the next day (i.e. D1) with a closing price of

RMB19.9. Trading continues until the shareholder registration day November 10, 2005

(i.e. D2) and the closing price is RMB19.92. Trading is suspended again on the next day and registered shareholders vote for the approval of the plan. The plan was approved with an approval rate of 98.8% among all tradable-share holders who participated the voting.

The plan became in effect on November 25, 2005. According to the final plan, non- tradable shares account for 55.24% of shares and tradable shares increased by almost 9% to be 44.76%. Trading resumed on November 30 and closed the day at the price of

RMB15.40, which is substantially lower than RMB20.38 on the last day before the reform.

[ Table 1 is about here. ]

To avoid destabilizing the stock market, Chinese government arranged listed-firm to implement this reform in batches. The first batch of four companies started the reform process on May 9, 2005, followed by the second batch of 42 firms starting on June 20. All firms in these two batches except one completed share restructuring within a short time period, and investors supported the reform. The success of the first two batches strengthened regulators’ confidence and prompted them to extend this reform to all listed companies. Table 2 shows the progress of firms that have started share restructuring process in the first 21 batches.

[ Table 2 is about here. ]

3. Research hypotheses and related literature

3.1. Speculation and the price of tradable shares

10 Chinese markets are known to be highly speculative. Share turnover in Chinese market is extremely high; the aggregate turnover in 2002 is 224% of the total market capitalization (Allen et al. 2005). By comparison, in the same year, the aggregate turnover as a percentage of the total market capitalization is only 160% on Nasdaq and 95% on

NYSE. But it is unclear whether such a high level of trading indeed inflates prices beyond the fundamental value. Mei, Scheikman and Xiong (2005) study 75 Chinese stocks that have both A- and B- shares and find that, relative to B-shares, the price of A-shares is inflated by speculative trading. However, the price difference between A-shares and B- shares may be due to different level of information asymmetry and liquidity in these two segmented markets. Chan et al. (2006) find that difference in the level of information asymmetry between these two markets explains a substantial portion of the B-share price discount. In the following, we derive a formula that links the price difference between tradable A-shares and non-tradable A-shares to the consideration that non-tradable-share owners pay to tradable-share owners in the share restructuring reform. This provides a means to study whether speculative trading in tradable shares leads to a large price difference between tradable and non-tradable shares.

Let P10 and P20 represent the prices of non-tradable and tradable shares before share

structure reform; N1 and N2 represent the number of non-tradable shares and number of tradable A-shares before share structure reform; b is the number of bonus shares as the consideration that non-tradable-share owners pay to tradable-share owners for every tradable share; P is the price of all shares after share restructuring completes.

Let Z be the total gain to the company value due to restructuring, Z1 be the gain

to non-tradable shareholders, and Z 2 be the gain to tradable shareholders. After restructuring, the number of shares held by original non-tradable shareholders will

11 decrease to N1 − b ⋅ N 2 and the number of shares held by original non-tradable

shareholders will increase to N1 + b ⋅ N 2 . Taking this into account, we can calculate the three gains as follows

Z = (N1 + N 2 ) ⋅ P − (N1 ⋅ P10 + N 2 ⋅ P20 ) , (1)

Z1 = (N1 − b ⋅ N 2 ) ⋅ P − N1 ⋅ P10 , (2)

Z 2 = (N 2 + b ⋅ N 2 ) ⋅ P − N 2 ⋅ P20 . (3)

Assuming that the total gain Z is shared by non-tradable and tradable shareholders in proportion to the number of shares they own after restructuring, we have

N1 − b ⋅ N 2 Z1 = ⋅ Z (4) N1 + N 2

Nb2+ ⋅ N2 Z2 =⋅Z (5) NN12+

Substituting Equations (1) and (2) into Equation (4) and rearranging, we obtain

2 − a ⋅ (1− a) ⋅ P10 = b ⋅ a ⋅ (1− a) ⋅ P10 − a ⋅ (1− a) ⋅ P20 + b ⋅ (1− a) ⋅ P20 (6)

N where a = 1 is the proportion of non-tradable shares. N1 + N 2

Let L represent the percentage price difference between tradable and non-tradable shares, that is,

P − P L = 20 10 (7) P10

By combining Equations (7) and (8) and canceling the unobservable value of non-

tradable shares P10 , we can write L as follows

b L = (8) a − b + a ⋅b

12 The above formula shows that, for every firm, the Price Premium of tradable

shares relative to non-tradable shares is related to the bonus share ratio b published in the

share structure reform plan and the proportion of non-tradable shareholders a . According

a a to this formula, as long as b < , the price premium is positive. The upper bound 1− a 1− a is larger than 1 if and only if the percentage of non-tradable shares a is greater than 50%.

Since the percentage a is more than 50% for most Chinese listed firms and at the same time the bonus shares ratio b must be less than 1, the formula must a positive price

premium for Chinese firms.

According to extant literature, tradable shares are more valuable than non-tradable

shares because of liquidity. Longstaff (1995) conducts a theoretical analysis within an

option pricing framework and finds that trading restriction reduces share values. His

theory shows that the loss in value is positively related to of the share price and

duration of the trading restriction. Silber (1991) studied restricted stocks that are issued by

publicly traded firms, not registered with the SEC, and sold through private placements to

investors under SEC Rule 144. Restricted stocks cannot be resold in the open market in

the first year of placement. When a is issued, the issue price is set much

lower than the observable prevailing market price. Silber found that the median discount

for restricted stock is 33.75%. In China, although non-tradable shares cannot be publicly

traded, they are allowed, under certain circumstances, to be transferred from one owner to

another through private placements and auction. Chen and Xiong (2001) collect the

auction and private placement prices of non-tradable shares of 258 Chinese firms and

compare them with the market prices of tradable shares. They report that the price

discount on non-tradable shares is 78% for auctions and 86% for private placement.

The value premium of tradable shares over non-tradable shares is likely dependent

on a few factors. Silber (1991) finds that the price discount on non-tradable shares varies

13 inversely with earnings, total revenues, and market capitalization of the issuing firm.

Chen and Xiong (2001) show that the discount is related to tradable shares’ volatility, firm size, leverage ratio, return on equity, book-to-price ratio, and earnings-to-price ratio.

Amihud and Mendelson (1986) suggest that the price of a tradable share would reflect the present value of the expected transaction costs in future. Using bid-ask spread as the measure of transaction costs and show that small spreads can translate into big illiquidity discounts on the price of tradable shares. Amihud and Mendelson (1991) compare the yields on treasury bonds with less than six months left to maturity with treasury bills that have the same maturity. Consistent with their illiquidity discount theory, the yield on the less liquid treasury bond was 43 basis points higher on an annualized basis than the yield on the more liquid treasury bill. Datar, Naik & Radcliffe (1998) use the turnover ratio as a proxy for liquidity. After controlling for size and the market-to-book-equity ratio, they find that illiquid stocks of the lowest 10% turnover ratio have annual returns about 3.25% higher than liquid stocks of the highest 10% turnover ratio.

Recent studies suggest that speculative trading affects the price of tradable shares.

Owners of tradable shares have the freedom to resell shares at favorable prices. Harrison and Kreps (1978) and Scheinkman and Xiong (2003) suggest that investors pay prices that exceed their own assessment of fundamental value as they anticipate finding a buyer willing to pay even more in the future. This resale option effect can create a speculative component of stock price. Miller (1977) and Chen et al. (2001) show that when investors hold heterogeneous beliefs and there exists short-sale constraints, stock price only reflects the beliefs of the optimistic group as the pessimistic group lack of means to participate.

This optimism effect causes price to be biased upward. Hong, Scheinkman and Xiong

(2006) demonstrate that in the presence of heterogeneous belief and short-sale constraints, limited float magnifies both the optimism effect and the resale option effect because price

14 can easily be moved by the optimistic group when float is small. Since non-tradable

shares have no resale value, speculative trading will affect the price difference between

tradable and non-tradable shares to the same extent as it affects the price of tradable shares.

Chinese market is characterized by limited float, prohibition of short selling, and a great number of inexperienced investors. Therefore, we hypothesize the following.

Hypothesis 1 Cross-sectionally, the price premium of tradable shares in Chinese markets

is related to proxies for the level of speculative trading after controlling for difference in

liquidity, marketability restriction, and transaction costs.

3.2. Impact of the reform on share turnover

One of the main objectives of the share-structure reform is to diminish speculative trading in Chinese market. According to Hong et al. (2006), the value of the resale option is negatively related to the public float. Increase in public float reduces the option value and lowers investors’ incentives to buy shares, which should lead to less speculative trading. Therefore, we hypothesize the following.

Hypothesis 2 Turnover increases after the reform. Stocks that were lack of liquidity before the reform have a larger increase than those that had sufficient liquidity. Stocks that were subject to speculative trading have a smaller increase than those without speculative trading.

3.3. Impact of the reform on stock price and shareholder wealth

Literature suggests that the short-term demand curve of stock is downward sloping.

Harris and Gurel (1986), Shleifer (1986), Lynch and Mendenhall (1997), Wurgler and

15 Zhuravskava (2002), and others document significant abnormal returns of around 3%

when stocks are added to the S&P 500 index. In contrast, stocks have significant negative

abnormal returns around removal from the S&P 500 index. Similar results are reported for

stocks that are added to or deleted from foreign indexes. Since the share restructuring

reform will cause the supply of shares to increase abruptly, a downward sloping demand

curve dictates a drop in price.

However, it does not necessarily mean that the share restructuring reform will

erode shareholder’s wealth. The value of non-tradable shares increases because of the

liquidity they acquire. Thus owners of non-tradable shares gain from this reform. The

reform requires that non-tradable-share owners transfer part of this gain with tradable-

share owners. So long as tradable-share owners receive adequate consideration, their

wealth may increase despite the drop in the market price of tradable shares. We expect the

negotiation process required by the regulator will lead to a win-win outcome for both

groups. Therefore, we expect the following.

Hypothesis 3 The share restructuring reform will cause stock price to drop, but shareholder wealth will increase.

4. Empirical Results

4.1. Data Sources

Table 2 shows that 509 firms have started the share structure reform before March

25 2006. Thirty-one firms are still in the process of the share structure reform as of March

25, 2006. Out of the 478 firms that completed restructuring, 89 firms adopted a consideration package that is more complex than paying bonus shares. We also exclude

16 IPO firms in the year before March 25 2006 and firms whose price data are not available

from Bloomberg terminal. Our final sample includes 309 firms.

We collect the information about share restructuring from the information

disclosure website officially designated by the CSRC. We also collect profitability

measures ROE and ROA for the fiscal year ending on December 31, 2004. We collect

stock prices and trading volume data from the Bloomberg system.

4.2. Summary statistics about the price premium of tradable shares

Table 3 reports the summary statistics of the price premium of tradable shares and related variables. On average, firms in our sample have 136 million A- before share restructuring. The proportion of tradable A-shares to total A-shares is on

average 35%. Non-tradable-share owners in these firms paid on average 0.313 shares to

tradable-share owners for each share in their hand. The price premium of tradable shares

is based on Equation (8) and the average price premium is 60.8%. This means that

tradable shares are about 60.8% more valuable than non-tradable shares.

In addition, Table 3 reports the characteristics of firms in our sample. The market

price of tradable shares ranges from 1.72 RMB to 27.6 RMB at the closing of April 28

2005, the day before CSRC announced the plan to reform split-share structure. The

average price is 5.5 RMB. Market capitalization is calculated as the closing price on April

28 2005 times the number of tradable A-shares before reform. It ranges from 87 million

RMB, to 8.1 billion RMB, with a mean of 731 million RMB. The average daily dollar

volume for the one-year period before April 29, 2005 varies considerably across our

sample firms, with the minimum of 0.687 million RMB, the maximum of 89.011 million

RMB and the mean of 9 million RMB. The majority of our firms are profitable; the first

quartiles of the Return on Equity (ROE) and Return on Assets (ROA) in our sample are

17 4.47% and 1.76%, respectively. The percentage of zero return trading days in the one-

year period before April 29 2005 has the minimum of 0.42%, the maximum of 11.5%, and

the mean of 3.69%. The return volatility is the standard deviation of daily returns in the

one-year period before April 29 2005, and the mean volatility is 2.4%.

[ Table 3 is about here. ]

4.3. Liquidity premium and speculation component in the price of tradable shares

In this section, we report evidence on liquidity premium and speculation component in the price of tradable shares. More specifically, we study the relation between the price premium of tradable shares and the following factors: the reciprocal of the closing price (in RMB) on April 28 2005, the logarithm of the average daily trading volume (in million RMB) for the one-year period before April 29 2005, the logarithm of the market capitalization (in million RMB) calculated as the closing price on April 28,

2005 multiplied by the number of tradable A-shares before share restructuring, return on equity (ROE) and return on assets (ROA) for the 2004 fiscal year, the percentage of zero return days in the one-year period before April 29 2005, and the daily return volatility measured by the standard deviation of daily returns in the one-year period before April 29,

2005.

[ Table 4 is about here. ]

Panel A of Table 4 reports correlation coefficients between these variables. It is not surprising to see that trading volume and market capitalization are highly correlated with a correlation coefficient of 0.76, and that ROE and ROA are also highly correlated with a correlation coefficient of 0.86. The other correlation coefficients seem reasonable and unlikely to cause the multicollinearity problem in regression.

18 Panel B of Table 4 reports the estimated coefficients from four regressions of the price premium of tradable shares on these factors. Because ROE is highly correlated with

ROA and trading volume is highly correlated with market capitalization, we include them in the separate regressions. In all regressions, the profitability measures, ROE and ROA, are significantly negative. This is consistent with the evidence in Silber (1991) and Chen and Xiong (2001). Non-tradable shares of profitable firms tend to have a better chance of finding a potential buyer through private placement or auction and thus are more valuable, which leads to smaller price premium of tradable shares.

The coefficient of return volatility is insignificant in all regressions. Longstaff

(1995) predicts that return volatility has an influence on the discount. The option pricing framework of Longstaff (1995) assumes that stock price is exogenous, i.e., not affected by the trading restriction imposed on a small number of restricted shares relative to total shares. However, in our case, non-tradable shares account for such a large proportion that liquidation of these shares will have an impact on the supply of tradable shares and the market price. This suggests that the theoretical framework of Longstaff (1995) does not apply in our study. Therefore, the insignificance of daily return volatility in our regressions does not contradict with Longstaff (1995)’s prediction.

The coefficient of the percentage of daily zero return days is significantly negative at 5% level in all four regressions. Lesmond et al. (1999) show that the percentage of zero-return days is a reliable proxy for the level of transaction costs and is highly correlated with other proxies such as quoted bid-ask spread and Roll’s measure of the effective spread. Stocks that have high percentage of zero-return days tend to have high transaction costs. According to Amihud and Mendelson (1986), stocks of high transaction costs tend to have a lower price on tradable shares than those of low transaction costs. On the other hand, transaction costs have no impact on the value of non-tradable shares.

19 Therefore, the price premium of tradable shares over non-tradable shares is negatively

related to the percentage of zero-return days.

The coefficients of both trading volume and market capitalization are significantly

positive at 5% level in all regressions. Since trading volume and market cap are highly

correlated, it is not surprising that they affect the price premium in the same direction.

Trading volume is often viewed as a proxy for liquidity. Stocks of low trading volume

tend to have low liquidity, which reduces the price of tradable shares according to Amihud

and Mendelson (1986).5 This provides an explanation of the positive coefficient of trading volume in our price premium regressions. However, trading volume is also related to the level of speculative trading. Hong et al. (2005) show that speculative trading generates trading volume. Firms of high trading volume are more likely to have speculative trading.

If speculative trading pushes up the price of tradable shares, trading volume will have a positive effect on the price premium. Both liquidity and speculative trading are plausible explanations for the positive coefficient of trading volume.

The coefficient of the reciprocal of share price is significantly positive at 1% level in all four regressions. A few studies, including Stoll and Whaley (1983) and Bhardwaj and Brooks (1992), show that low-price stocks have higher transaction costs measured by both bid-ask spread and commission fees than high-price ones. Since high transaction costs lower the price of tradable shares, low-price stocks should have lower price premium than high-price stocks. This is in contradiction to the positive coefficient on the reciprocal of share price. On the other hand, low-price stocks are very likely traded by individual investors. In Hong et al. (2006)’s model, the resale option value increases in the overconfidence parameter, a measure of the degree of behavioral bias. Many individual investors in China have limited experience of investing in stock market. To the extent that

5 Empirically, Brennan et al. (1998) and Chordia et al. (2001) document a negative relation between stock returns and trading volume.

20 they have a larger overconfidence parameter, low-price stocks that they actively trade are

likely to have a larger speculative component and thus a higher price premium of tradable

shares.

The last variable in the regression provides further evidence that the price of

tradable shares is inflated by speculative trading. This dummy variable is equal to 1 when

the firm has both A- and B-shares. Twenty-seven firms in our sample have both A- and

B-shares. Since the B-share price serves as an anchor that helps to prevent price from

deviating too far away from the fundamental value, firms with B-shares should have a

smaller price premium. In fact, Table 4 shows that after controlling for the effect of

transaction costs, profitability and liquidity, the dummy variable is significantly negative

in all four regressions.

4.4. Impact on share turnover and trading volume

We study the impact of share restructuring on share turnover in this section. There are 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we find a control firm that has not started share restructuring, is in the same industry as the restructured firm and has the closest market capitalization. Since only 296 control firms have the required price and trade data in the Bloomberg system, our final sample includes the 296 pairs of restructured and control firms.

For both restructured and control firms, we measure the change in daily turnover as

(Average daily turnover after reform) / (Average daily turnover before reform) -1. Daily

turnover is equal to the daily number of A-shares traded divided by the total number of

tradable A-shares. The average daily turnover before reform is based on the 30 trading

days immediately before April 29, 2005. The average daily turnover after reform is based

21 on the first 30 trading days after the restructured firm completed the reform. The excess

change in daily turnover of a restructured firm is equal to the change in daily turnover of

the restructured firm minus that of the control firm. Compared with the pre-reform period,

the share turnover post reform increased by 1.78 times on average for all restructured firms, whereas share turnover increased by only 1.40 times on average for all control firms.

The median excess change of daily turnover is statistically significant at 1% level.

We classify the restructured firms by the level of liquidity and the level of speculative trading before reform. Firms of high liquidity before reform have a percentage of zero return days below the median, whereas firms of low liquidity have a percentage of zero return days above the median. Firms of high speculative trading before reform have the average daily dollar volume above the median, whereas firms of low speculative trading have the average daily dollar volume above the median. This classification splits the whole sample into four subsamples. Table 5 reports the mean and median excess change in daily turnover of restructured firms in these four subsamples, and the two- sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

[ Table 5 is about here. ]

Comparing firms that had high liquidity before restructuring with those that had low liquidity, it is evident that firms of high liquidity experienced smaller increase in share turnover. The mean (median) excess change of share turnover is -0.039 (0.239) for high liquidity firms and 0.796 (0.768) for low liquidity firms. The difference between high and low liquidity firms is statistically significant at 10% level in both mean and median.

Next, we compare firms that had high speculative trading before restructuring with those that had low speculative trading. Despite the increase in the supply of tradable shares, restructured firms of high speculative trading on average experienced smaller

22 increase in share turnover than their control firms did. The mean excess change in share

turnover of restructured firms of high speculative trading is only -0.375. In contrast,

restructured firms of low speculative trading on average experienced larger increase in

share turnover than their control firms did; the mean excess change in share turnover is

1.131. The difference between firms of high and low speculative trading is statistically

significant at 1% level.

Furthermore, we compare the four subsamples sorted by the level of liquidity and

the level of speculative trading. We find that the restructured firms that had high liquidity

and high speculative trading before reform, on average, had no increase in share turnover

relative to their control firms. Other restructured firms that had low liquidity or were less

speculated all experienced significant increase in turnover relative to their control firms.

In summary, the above evidence shows that relative to control firms, restructured

firms that had low liquidity or low speculative trading experienced significantly higher increase in turnover, whereas restructured firms that had high liquidity and high speculative trading did not. The evidence suggests that the share restructuring reform reduce the share turnover due to speculative trading.

Besides share turnover, daily dollar volume is often used to proxy for the level of speculative trading. We examine the impact of the reform on trading volume in the following. For both restructured and control firms, we measure the change in daily dollar volume as (Average daily dollar volume after reform) / (Average daily dollar volume before reform) -1. The average daily dollar volume before reform is based on the 30 trading days immediately before April 29, 2005. The average daily dollar volume after reform is based on the first 30 trading days after the restructured firm completed the reform. The excess change in daily dollar volume of a restructured firm is equal to the change in daily dollar volume of the restructured firm minus that of the control firm.

23 Table 6 reports the mean and median of excess change in daily dollar volume of

restructured firms in every subsample, and the two-sample t and Wilcoxon statistics to test

whether the difference in mean and median between subsamples are statistically

significant.

[ Table 6 is about here. ]

Table 6 shows a similar pattern as Table 5. Comparing firms that had high speculative trading before reform with those that had low speculative trading, despite the increase in the supply of tradable shares, restructured firms of high speculative trading on average experienced smaller increase in trading volume than their control firms did. The mean excess change in trading volume of restructured firms of high speculative trading is only 0.110. In contrast, restructured firms of low speculative trading on average experienced larger increase in trading volume than their control firms did; the mean excess change in trading volume is 1.649. The difference between firms of high and low speculative trading is statistically significant at 1% level.

Among the four groups sorted by the level of liquidity and the level of speculative trading, only the restructured firms that had high liquidity and high speculative trading

before reform, on average, had smaller increase in trading volume than their control firms.

The other three groups all had significant increase in trading volume than their control

firms.

In summary, the evidence for both share turnover and trading volume shows that

the reform reduced the level of speculative trading, and the effect is more significant for

firms that were subject to speculative trading before reform.

4.5. Impact on stock price and downward sloping demand curve

24 We study the impact of share restructuring on share price. This table reports evidence on the impact of share restructuring reform on price of tradable shares. Our sample includes 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we measure the price change as (Price of tradable shares after reform) / (Price of

tradable shares before reform) -1. Price before reform is the closing price on April 28th,

2005. Price after reform is the closing price on the first trading day after the completion of share structure reform.

We classify the restructured firms by the level of liquidity and the level of speculative trading before reform. Firms of high liquidity before reform have a percentage of zero return days below the median, whereas firms of low liquidity have a percentage of zero return days above the median. Firms of high speculative trading before reform have the average daily dollar volume above the median, whereas firms of low speculative trading have the average daily dollar volume above the median. This classification splits the whole sample into four subsamples. Table 7 reports the mean and median price change of restructured firms in every subsample, and the two-sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

[ Table 7 is about here. ]

Because of the increase in the supply of tradable shares, it is not a surprise that the price of restructured firms drop significantly relative to control firms. We compare firms that had high speculative trading before restructuring with those that had low speculative trading. Firms of high speculative trading experienced much greater drop in share price after reform. The average decrease in share price is 15.1% for restructured highly- speculated firms, but only 9.8% for restructured less-speculated firms. Among the four

25 subsamples sorted by both liquidity and speculative trading, restructured firms that had

high liquidity and low speculative trading had the least average drop in stock price

whereas restructured firms that had low liquidity and high speculative trading had the

largest average drop in stock price. The above evidence indicates that the reform reduced the bubble component in the stock price of firms that were subject to speculative trading before reform.

The downward sloping demand curve implies that a larger increase in supply of

shares causes a larger drop in price. Since the amount of increase in share supply differs

across firms in our sample, we can directly test this implication of the downward sloping

demand curve. Table 8 reports the empirical results. In Panel A, we regress the

percentage change in share price on the percentage increase in tradable A-shares (in

Models 1 to 4), and other factors that control for the difference in profitability, transaction

costs, and liquidity across restructured firms. To facilitate the interpretation of the

coefficients, all the variables are adjusted by subtracting the means from their original

observations. As expected, Model 1 to 4 shows that the higher increase in the supply of

tradable A-shares, the larger drop in the stock price.

[ Table 8 is about here. ]

4.6. Impact on shareholder wealth

We study the impact of share restructuring reform on shareholder wealth. Our sample includes 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we measure the change in shareholder wealth of a restructured firm by (Price of tradable shares times the total number of tradable shares after reform) / (Price of tradable

shares times the total number of tradable shares before reform) – 1. The total number of

26 tradable shares after reform is the total number of tradable shares before reform plus the

bonus shares non-tradable-share owners paid to tradable-share owners. Price of tradable

shares before reform is the closing price on April 28th, 2005. Price after reform is the closing price on the first trading day after the completion of share structure reform. Table

9 reports the mean and median change in shareholder wealth of restructured firms in all four subsamples classified by the level of liquidity and the level of speculative trading before reform, and the two-sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

[ Table 9 is about here. ]

Despite the drop in stock price after reform as evidenced in Table 8, the post- reform shareholder wealth on average increased by 14.8% for all restructured firms. The average difference in the change of shareholder wealth between a restructured firm and its control firm is 12.7%, statistically significant at 1% level. Comparison between firms of high speculative trading before reform with those of low speculative trading shows that firms of high speculative trading experienced much smaller increase in shareholder wealth after reform. The average increase in shareholder wealth is 10.7% for restructured highly- speculated firms, but 18.9% for restructured less-speculated firms. Among the four subsamples sorted by both liquidity and speculative trading, restructured firms that had high liquidity and low speculative trading had the highest average increase in shareholder wealth whereas restructured firms that had low liquidity and high speculative trading had the least average increase in shareholder wealth. The evidence confirms the findings in

Table 7 that the reform dampens speculative trading and firms that were subject to speculative trading before reform benefits less from the reform than those that had less speculation.

27 Next, we examine the relation between shareholder wealth gain and liquidity

improvement after share restructuring reform. We regress the change in shareholder

wealth on two variables that proxy the change in liquidity -- the change in daily turnover

and the change in dollar volume, and other control factors. Table 10 reports the estimated

regression coefficients. The coefficients on the proxy for the change in liquidity are both

significantly positive. The relation is the same no matter whether we compute wealth gain

based on the closing price of the first day after the reform or the closing price 30 days later.

The evidence suggests that investors have already priced in the benefits of liquidity

improvement even before the impact of the reform on trading can be observed.

[ Table 10 is about here. ]

4.7. Evidence from the B-share market

As of March 25 2006, a total of 90 Chinese listed firms have issued both A- and B- shares. B-shares were initially only available to foreign investors. Chinese government relaxed the restriction in November 2001 and since then domestic investors can own and trade B-shares as well. But A- and B-shares are still traded in segmented markets. Since all B-shares are tradable and only A-shares are divided into tradable and non-tradable

portions, the share structure reform involves only A-shares and aims to convert all non-

tradable A-shares to be tradable A-shares. Therefore, only owners of tradable A-shares

are entitled to the consideration paid by non-tradable-share holders. B-share owners are not directly involved in the reform. However, since the above evidence in the A-share market shows that share restructuring improves the liquidity of A-shares and increases the wealth of A-share owners, we are interested to know whether this effect spills over to the

B-share market.

28 We exclude 31 of the 90 firms with dual-class shares from our analysis because 20

of them were undergoing the reform as of March 25 2005, five completed reform before

March 25 2005 but had a complex consideration package, and six do not have price data in

the Bloomberg system. The remaining 69 firms fall into two groups: 27 in the group of

restructured firms and 32 in the group of benchmark firms. The restructures firms

completed share restructuring before March 25 2006 and paid only bonus shares as the

consideration. The benchmark firms had not started the restructuring process before

March 25 2006. We obtain the price and volume data from Bloomberg system.

In Panel A of Table 11, we examine the change in B-share price and the change in daily B-share turnover of both restructured firms and benchmark firms after the reform.

We define the change in B-share price for both restructured and benchmark firms as the difference between the post-reform price on March 24 2006 and the pre-reform price on

April 28 2005 scaled by the pre-reform price. We define the change in daily B-share turnover as the difference between the post-reform turnover and the pre-reform turnover scaled by the pre-reform turnover. The daily turnover is equal to the ratio of the number

of B-shares traded to the total number of B-shares outstanding. For the restructured firms,

the pre-reform turnover is the average of daily turnover over the 30 trading days

immediately before April 28 2005, and the post-reform turnover is the average of daily

turnover over the 30 trading days immediately after March 21 2006.6 For the benchmark firms, the pre-reform turnover is the average of daily turnover over the 30 trading days immediately before April 28 2005, and the post-reform turnover is the average of daily turnover over the 30 trading days immediately before April 10 2006.7

[ Table 11 is about here. ]

6 March 21 2006 is the day when the last one of the 27 restructured firms completed its reform. 7 We choose the period ending on April 10 2006 because one of the 32 benchmark firms started its share restructuring reform on April 10 2006.

29 Panel A shows that the post-reform daily turnover increased, on average, by 170% for restructured firms, but only 74% for benchmark firms. The difference between restructured and benchmark firms is significant at 1% level. In addition, the B-share price increased, on average, by 22% for restructured firms, but only 11% for benchmark firms.

It is clear that the reform had an impact on the B-share price of restructured firms.

Although the difference is not statistically significant at a conventional level, the two- sample t-statistics is 1.49, a quite big number in view of the small sample size we have.

In Panel B of Table 11, we compare the before- and after-reform B-share discounts of restructured firms with those of benchmark firms. The B-share discount before reform is the price difference between A-share and B-share as a percentage of the B-share price on April 28 2005. The B-share discount after reform is the price difference between A- share and B-share as a percentage of the B-share price on March 24 2005. Restructured firms and benchmark firms had similar level of B-share discount before reform; the mean

(median) discount was 43.8% (44.7%) for restructured firms and 43.1% (44.7%) for benchmark firms. After reform, the B-share discounts of the benchmark firms remain almost the same with a mean (median) of 43.4% (42.7%), but the B-share discounts of the restructured firms became much smaller with a mean (median) of only 30.3% (29.3%).

The two-sample t (Wilcoxon) statistic shows that the mean (median) B-share discount of restructured firms is the same as that of benchmark firms before reform, but significantly different from that of benchmark firms after reform. This suggests that the reform significantly reduces the B-share discount.

5. Summary and conclusion

30 The split-share structure of Chinese listed firms has long been viewed as the major roadblock for further development of Chinese markets. On April 29, 2005, the Chinese

Securities Regulatory Committee announced a plan to gradually convert non-tradable shares of all Chinese listed firms to be publicly tradable. We use this unique event to study the price premium between tradable shares and non-tradable shares. We find the price premium is significantly influenced by speculative trading, even after controlling for liquidity, profitability and firm size. In addition, we examine the impact of this reform on share turnover, stock price, and shareholder wealth. Evidence in this paper shows that this reform increases share turnover, dampens speculative trading, decreases stock price, and increases shareholder wealth. We also find that the reform reduces the B-share discount significantly. Overall, the reform successfully abolished the split-share structure and at the same time brought benefits to Chinese shareholders. In future, it will open doors to market-driven mergers and acquisitions and adoption of international corporate governance by Chinese firms, and make Chinese markets more accessible and attractive to the investment community worldwide.

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34 Table 1: Illustration of the typical restructuring process for the split share reform in China

Full Name BEIJING TONGRENTANG CO., LTD Security Short Name TongRenTang Security Code 600085 List Exchange Shanghai Stock Exchange Major Products Traditional Chinese medicine and cosmetic

Share Structure Reform Process Share Price Date Milestone (RMB) • Share structure reform announced; Start of Non-tradable and tradable shareholders held restructuring 2005-10-15 • 20.38 64.19% (state-owned) and 35.81% of total (D0) shares respectively. • Share trading suspended; • Draft reform plan published; 2005-10-17 • Non-tradable shareholders pay tradable First trading shareholders 0.22 shares for every share held suspension by tradable shareholders. period • Revised reform plan confirmed;

2005-10-26 • Non-tradable shareholders pay tradable shareholders 0.25 shares for every share held by tradable shareholders. D1 2005-10-27 • Share trading resumed 19.90 D2 2005-11-10 • Rights of receiving the bonus shares recorded 19.92 2005-11-11 • Share trading suspended 2005-11-18 • Online voting starting Second trading 2005-11-22 • Online voting ending suspension • Plan implemented; period 2005-11-25 • Non-tradable and tradable shareholders held 55.24% (state-owned) and 44.76% of total shares • Share trading resumed; • All shares held by tradable shareholders, End of including the bonus shares received, can be restructuring 2005-11-30 15.40 traded freely; (D3) • All shares held by non-tradable shareholders can be traded only after 1, 2, or 3 years.

35

Table 2: Progress of the split share reform until the end of March 2006

A total of 509 firms in 21 batches initiated the share restructuring process. For every batch, this table reports the date of announcing a batch, the number of firms in a batch, the number of firms that completed restructuring before the end of March 2006, the number of firms that completed restructuring before the end of March 2006 and whose consideration includes only bonus shares, the smallest and largest number of days between announcement and completion.

# of Firms Smallest # of Largest # of # of Announcement # of Firms Completed days between days between Batch Firms in Date Completed and Paid only Announcement Announcement the batch Bonus Shares and Completion and Completion 1 2005-05-09 4 4 2 50 81 2 2005-06-19 42 42 34 45 80 3 2005-09-12 40 40 34 39 77 4 2005-09-18 38 38 34 38 72 5 2005-09-26 21 21 18 39 56 6 2005-10-10 21 21 18 38 66 7 2005-10-16 21 21 18 44 73 8 2005-10-24 18 18 14 42 81 9 2005-10-31 18 18 10 45 84 10 2005-11-06 20 20 17 42 73 11 2005-11-13 20 20 19 38 70 12 2005-11-20 17 17 14 38 88 13 2005-11-27 22 20 15 42 87 14 2005-12-04 19 19 15 42 73 15 2005-12-11 21 20 17 39 81 16 2005-12-18 27 27 22 36 80 17 2005-12-22 38 37 29 46 89 18 2005-12-31 19 15 12 44 74 19 2006-01-08 13 12 9 43 67 20 2006-01-15 24 17 11 43 53 21 2006-01-22 46 31 22 39 59 Total 509 478 384

36 Table 3: Descriptive Statistics

Our sample consists of 309 firms that satisfied three requirements: 1) the firm completed share restructuring before March 25, 2006, 2) the firm paid only bonus shares as a consideration, and 3) we can obtain data for all the following variables. Share Price (in RMB) is the closing price on April 28, 2005, the day before CSRC announced the plan to reform split-share structure. Trading Volume (in million RMB) is the average daily volume for the one-year period before April 29, 2005. Market Capitalization (in million RMB) is equal to the closing price on April 28, 2005 multiplied by the number of tradable A-shares before share restructuring. Tradable Proportion is the proportion of tradable A-shares to total A- shares before share restructuring. Bonus Ratio is the number of shares paid by non-tradable shareholders for each tradable share. Price Premium of Tradable Shares is the price difference between tradable shares and non-tradable shares scaled by the price of non-tradable shares. Return on Equity (ROE) and Return on Assets (ROA) are for the fiscal year ending on December 31, 2004. Percentage of Zero Returns equals the percentage of zero return trading days in the one-year period before April 29, 2005. Return Volatility is the standard deviation of daily returns in the one-year period before April 29, 2005. We collect data from the official website designated by the CSRC, the annual report, and the Bloomberg data system. This table reports descriptive statistics of these variables.

# of tradable Share Volume Market Cap Percentage Tradable Bonus Price Return A-shares Price (in million (in million ROE ROA of Zero Proportion ratio Premium Volatility (in million) (in RMB) RMB) RMB) Return Days Mean 135.967 34.92% 0.313 0.608 5.567 9.002 731.972 8.48% 4.05% 3.69% 2.39% Median 99.009 35.59% 0.300 0.576 4.679 5.183 456.500 7.43% 3.41% 3.43% 2.34% Std. Dev. 120.561 10.30% 0.063 0.203 3.121 10.639 812.319 8.23% 4.61% 1.79% 0.45% Min. 13.318 7.15% 0.100 0.162 1.720 0.687 87.757 -41.53% -18.56% 0.42% 0.99% Q1 63.879 28.50% 0.280 0.483 3.591 2.925 288.215 4.47% 1.76% 2.17% 2.08% Q3 165.362 40.70% 0.350 0.684 6.566 10.561 822.622 12.11% 6.01% 4.68% 2.68% Max. 982.800 75.69% 0.500 1.801 27.640 89.011 8055.791 52.97% 42.50% 11.49% 3.70%

37 Table 4: Liquidity Premium and Speculation Component in the Price of Tradable Shares

This table reports evidence on liquidity premium and speculation component in the price of tradable shares. We calculate the Price Premium of tradable shares as the price difference between tradable shares and non-tradable shares scaled by the price of non-tradable shares. We regress the price premium on the following factors: the reciprocal of Share Price, the logarithm of Trading Volume, the logarithm of Market Cap, ROE, ROA, the Percentage of Zero Return Days, and Return Volatility. Share Price (in RMB) is the closing price on April 28, 2005, the day before CSRC announced the plan to reform the split-share structure. Trading Volume (in million RMB) is the average daily dollar volume for the one- year period before April 29, 2005. Market Capitalization (in million RMB) is equal to the closing price on April 28, 2005 multiplied by the number of tradable A-shares before share restructuring. Return on Equity (ROE) and Return on Assets (ROA) are for the fiscal year ending on December 31, 2004. Percentage of Zero Return Days equals the percentage of zero return trading days in the one-year period before April 29, 2005. Return Volatility is the standard deviation of daily returns in the one-year period before April 29, 2005. Our sample consists of 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have complete data for the above variables. We collect data from the official website designated by the CSRC, the annual report, and the Bloomberg data system. Panel A reports correlation coefficients between these variables and Panel B reports the regression results.

Panel A: Correlation coefficients Ln (Market Percentage of Zero Return 1/Price Ln (Volume) Cap) ROE ROA Return Days Volatility Price Premium 0.22a 0.07 0.07 -0.12b -0.12b -0.04 0.02 1/Price 1.00 -0.30a -0.33a -0.42a -0.42a 0.38a 0.12b Ln (Volume) -0.30a 1.00 0.76a 0.24a 0.26a -0.35a 0.20a Ln (Market Cap) -0.33a 0.76a 1.00 0.28a 0.29a -0.07 -0.34a ROE -0.42a 0.24a 0.28a 1.00 0.86a -0.06 -0.24a ROA -0.42a 0.26a 0.29a 0.86a 1.00 -0.08 -0.23a Percentage of Zero Return 0.38a -0.35a -0.07 -0.06 -0.08 1.00 -0.41a Volatility 0.12b 0.20a -0.34a -0.24a -0.23a -0.41a 1.00 a,b,c Correlation is significant at the 0.01, 0.05 and 0.10 levels (2-tailed).

38

Panel B. Regressions

The dependent variable is the price premium of tradable shares. Because ROE is highly correlated with ROA and Ln(Volume) is highly correlated with Ln(Market Cap), we include them in the separate regressions.

Model 1 2 3 4 0.22 -0.19 0.20 -0.21 Intercept 0.92 -0.47 0.87 -0.52 -0.28b -0.24c ROE -2.17 -1.90 -0.41c -0.35c ROA -1.93 -1.69 -5.74 -2.23 -5.57 -2.06 Return Volatility -1.55 -0.62 -1.50 -0.57 0.03b 0.03b ln(Volume) 2.45 2.43 0.04b 0.04b ln(Market Cap) 2.21 2.23

-1.45b -1.58b -1.50b -1.62b Percentage of Zero Return -1.95 -2.21 -1.99 -2.24

0.62a 0.64a 0.65a 0.67a 1/Price 3.28 3.31 3.36 3.38

-0.13a -0.13a -0.12a -0.12a Dummy -5.17 -4.90 -5.05 -4.81 Adj. R2 0.106 0.109 0.104 0.107 # of obs. 309 309 309 309 a,b,c Coefficient is significant at the 0.01, 0.05 and 0.10 levels.

39 Table 5: Impact on Share Turnover

This table reports evidence on the impact of share restructuring reform on share turnover. There are 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we find a control firm that has not started share restructuring, is in the same industry as the restructured firm and has the closest market capitalization. Since only 296 control firms have the required price and trade data in the Bloomberg system, our final sample includes the 296 pairs of restructured and control firms. For both restructured and control firms, we measure the change in daily turnover as (Average daily turnover after reform) / (Average daily turnover before reform) -1. Daily turnover is equal to the daily number of A-shares traded divided by the total number of tradable A-shares. The average daily turnover before reform is based on the 30 trading days immediately before April 29, 2005. The average daily turnover after reform is based on the first 30 trading days after the restructured firm completed the reform. The excess change in daily turnover of a restructured firm is equal to the change in daily turnover of the restructured firm minus that of the control firm. We classify the restructured firms by the level of liquidity and the level of speculative trading before reform. Firms of high liquidity before reform have a percentage of zero return days below the median, whereas firms of low liquidity have a percentage of zero return days above the median. Firms of high speculative trading before reform have the average daily dollar volume above the median, whereas firms of low speculative trading have the average daily dollar volume above the median. This classification splits the whole sample into four subsamples. We report the mean and median of excess change in daily turnover of restructured firms in every subsample, and use two-sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

Test stat. of High Low the difference speculation speculation Sub-total between high firms firms and low # of obs. 87 61 148 High liquidity Mean -1.028 1.370 -0.039 -2.76a firms Median -0.068 1.238 0.239 -3.32a # of obs. 61 87 148 Low liquidity Mean 0.557 0.964 0.796 -0.91 firms Median 0.388 0.923 0.768 -1.99b # of obs. 148 148 296 Sub-total Mean -0.375 1.131 -3.05a Median 0.136 0.968 -4.01a Test stat. of Mean -2.14b 0.80 -1.67c the difference between high Median -1.81 0.18 -1.72c and low a,b,c Coefficient is significant at the 0.01, 0.05 and 0.10 levels.

40 Table 6: Impact on Speculative Trading

This table reports evidence on the impact of share restructuring reform on speculative trading. There are 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we find a control firm that has not started share restructuring, is in the same industry as the restructured firm and has the closest market capitalization. Since only 296 control firms have the required price and trade data in the Bloomberg system, our final sample includes the 296 pairs of restructured and control firms. We use daily dollar volume to proxy for the level of speculative trading. For both restructured and control firms, we measure the change in daily dollar volume as (Average daily dollar volume after reform) / (Average daily dollar volume before reform) -1. The average daily dollar volume before reform is based on the 30 trading days immediately before April 29, 2005. The average daily dollar volume after reform is based on the first 30 trading days after the restructured firm completed the reform. The excess change in daily dollar volume of a restructured firm is equal to the change in daily dollar volume of the restructured firm minus that of the control firm. We classify the restructured firms by the level of liquidity and the level of speculative trading before reform. Firms of high liquidity before reform have a percentage of zero return days below the median, whereas firms of low liquidity have a percentage of zero return days above the median. Firms of high speculative trading before reform have the average daily dollar volume above the median, whereas firms of low speculative trading have the average daily dollar volume above the median. This classification splits the whole sample into four subsamples. We report the mean and median of excess change in daily dollar volume of restructured firms in every subsample, and use two-sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

Test stat. of High Low the difference speculation speculation Sub-total between high firms firms and low # of obs. 87 61 148 High liquidity Mean -0.330 1.921 0.597 -3.98a firms Median -0.054 1.581 0.550 -3.70a # of obs. 61 87 148 Low liquidity Mean 0.738 1.458 1.162 -1.33 firms Median 0.670 1.443 0.916 -2.21a # of obs. 148 148 296 Sub-total Mean 0.110 1.649 -3.75a Median 0.204 1.475 -4.29a Test stat. of Mean -1.79c 0.80 -1.35 the difference between high Median -1.45 0.33 -1.24 and low a,b,c Coefficient is significant at the 0.01, 0.05 and 0.10 levels.

41 Table 7: Impact on Price of Tradable Shares

This table reports evidence on the impact of share restructuring reform on price of tradable shares. Our sample includes 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we measure the price change as (Price of tradable shares after reform) / (Price of tradable shares before reform) -1. Price before reform is the closing price on April 28th, 2005. Price after reform is the closing price on the first trading day after the completion of share structure reform. We classify the restructured firms by the level of liquidity and the level of speculative trading before reform. Firms of high liquidity before reform have a percentage of zero return days below the median, whereas firms of low liquidity have a percentage of zero return days above the median. Firms of high speculative trading before reform have the average daily dollar volume above the median, whereas firms of low speculative trading have the average daily dollar volume above the median. This classification splits the whole sample into four subsamples. We report the mean and median price change of restructured firms in every subsample, and use two- sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

Test stat. of High Low the difference speculation speculation Sub-total between high firms firms and low # of obs. 90 65 155 High liquidity Mean -14.01% -8.70% -11.78% -1.83c firms Median -14.54% -11.81% -13.20% -1.90c # of obs. 64 90 154 Low liquidity Mean -16.68% -10.54% -13.09% -2.10b firms Median -19.64% -13.05% -15.76% -2.56a # of obs. 154 155 309 Sub-total Mean -15.12% -9.77% -2.59a Median -17.16% -12.58% -2.89a Test stat. of Mean 0.81 0.70 0.63 the difference between high Median 1.14 0.79 0.91 and low a,b,c Coefficient is significant at the 0.01, 0.05 and 0.10 levels.

42 Table 8: Further evidence on the downward sloping demand curve

Our sample consists of 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have complete data for the above variables. The dependent variable is the change in the price of tradable shares of restructured firms, measured by (Price of tradable shares after reform) / (Price of tradable shares before reform) - 1. Price before reform is the closing price on April 28th, 2005. Price after reform is the closing price on the first trading day after the completion of share structure reform. The independent variables include the percentage increase in tradable A-shares, which is equal to the bonus ratio, and the reciprocal of Share Price, the logarithm of Trading Volume, the logarithm of Market Cap, ROE, ROA, the Percentage of Zero Return, and Return Volatility. Share Price (in RMB) is the closing price on April 28, 2005, the day before CSRC announced the plan to reform split-share structure. Trading Volume (in million RMB) is the average daily volume for the one-year period before April 29, 2005. Market Capitalization (in million RMB) is equal to the closing price on April 28, 2005 multiplied by the number of tradable A- shares before share restructuring. Return on Equity (ROE) and Return on Assets (ROA) are for the fiscal year ending on December 31, 2004. Percentage of Zero Return Days equals the percentage of zero return trading days in the one-year period before April 29, 2005. Return Volatility is the standard deviation of daily returns in the one-year period before April 29, 2005. To facilitate the interpretation of the coefficients, all the variables are adjusted by subtracting the means from their original observations. Model 1 2 3 4 -0.13a -0.13a -0.13a -0.13a Intercept -12.06 -12.08 -12.12 -12.14 -0.46a -0.48a -0.46a -0.48a b -2.57 -2.72 -2.55 -2.69 -0.14 -0.18 ROE -1.14 -1.43 -0.24 -0.30 ROA -1.08 -1.37 1.32 -2.37 1.36 -2.30 Return Volatility 0.46 -0.76 0.47 -0.74 -0.03a -0.03a Ln(Volume) -2.68 -2.65 -0.04a -0.04a Ln(Market Cap) -3.01 -2.99 -1.09 -0.97 -1.11 -0.99 Percentage of Zero Return -1.33 -1.21 -1.37 -1.25 0.09 0.06 0.09 0.07 1/P 0.53 0.39 0.60 0.46 0.05 0.04 0.05 0.05 Dummy 1.18 1.08 1.30 1.22 Adj. R2 0.04 0.04 0.04 0.04 # of obs. 309 309 309 309

43 Table 9: Impact on Shareholder Wealth

This table reports evidence on the impact of share restructuring reform on shareholder wealth. Our sample includes 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. For each restructured firm, we measure the change in shareholder wealth of a restructured firm by (Price of tradable shares times the total number of tradable shares after reform) / (Price of tradable shares times the total number of tradable shares before reform) – 1. The total number of tradable shares after reform is the total number of tradable shares before reform plus the bonus shares non-tradable-share owners paid to tradable-share owners. Price of tradable shares before reform is the closing price on April 28th, 2005. Price after reform is the closing price on the first trading day after the completion of share structure reform. We classify the restructured firms by the level of liquidity and the level of speculative trading before reform. Firms of high liquidity before reform have a percentage of zero return days below the median, whereas firms of low liquidity have a percentage of zero return days above the median. Firms of high speculative trading before reform have the average daily dollar volume above the median, whereas firms of low speculative trading have the average daily dollar volume above the median. This classification splits the whole sample into four subsamples. We report the mean and median change in shareholder wealth of restructured firms in every subsample, and use two-sample t and Wilcoxon statistics to test whether the difference in mean and median between subsamples are statistically significant.

Test stat. of High Low the difference speculation speculation Sub-total between high firms firms and low # of obs. 90 65 155 High liquidity Mean 13.29% 21.07% 16.56% -2.02b firms Median 12.07% 16.93% 14.95% -2.16b # of obs. 64 90 154 Low liquidity Mean 7.01% 17.36% 13.06% -2.85a firms Median 3.11% 14.37% 10.86% -3.09a # of obs. 154 155 309 Sub-total Mean 10.68% 18.91% -3.07a Median 7.83% 15.69% -3.39a Test stat. of Mean 1.50 1.11 1.29 the difference between high Median 1.57 1.05 1.33 and low a,b,c Coefficient is significant at the 0.01, 0.05 and 0.10 levels.

44 Table 10: Wealth Gain and Liquidity Improvement

This table reports evidence on the relation between shareholder wealth gain and liquidity improvement after share restructuring reform. Our sample includes 309 firms that completed share restructuring before March 25, 2006, paid only bonus shares as a consideration, and have the required data. We measure the change in shareholder wealth of a restructured firm by (Price of tradable shares times the total number of tradable shares after reform) / (Price of tradable shares times the total number of tradable shares before reform) – 1. The total number of tradable shares after reform is the total number of tradable shares before reform plus the bonus shares non-tradable-share owners paid to tradable-share owners. Price of tradable shares before reform is the closing price on April 28th, 2005. Price after reform is the closing price on the first trading day after the completion of share structure reform. We regress the change in shareholder wealth on two variables that proxy the change in liquidity: the change in daily turnover and the change in dollar volume.

Wealth gain Wealth gain

(first trading day after reform) (30 trading days later) Model 1 2 3 4 0.10a 0.02a 0.13a 0.03a Intercept 6.05 1.22 7.33 1.84 2.98a 4.75a Change in Turnover 3.31 4.84 Change in Dollar 0.14a 0.19a

Volume 8.63 10.02 -0.03b 0.00 -0.04 b 0.01 ln(Volume) -2.35 0.21 -2.45 0.73 0.07 0.07 0.07 0.07 Dummy 1.26 1.33 1.11 1.17 0.09 0.01 0.05 -0.05 1/P 0.60 0.07 0.30 -0.30 Adj. R2 .057 0.184 0.084 0.232 # of obs. 309 309 309 309 a,b,c Coefficient is significant at the 0.01, 0.05 and 0.10 levels.

45 Table 11: Impact on the B-share market

As of March 25 2006, a total of 90 Chinese listed firms have issued both A- and B- shares. We exclude 31 of them from our analysis because 20 were still undergoing the reform on March 25 2005, five firms completed reform before March 25 2005 but had a complex consideration package, and six firms do not have price data in the Bloomberg system. Out of the remaining 69 firms, 27 have completed share restructuring before March 25 2006 and the other 32 have not started the restructuring process. Panel A reports summary statistics on the change in B-share price and the change in daily B-share turnover of restructured firms and benchmark firms, separately. The change in B-share price for both restructured and benchmark firms is the difference between the post-reform price of March 24 2006 and the pre-reform price of April 28 2005 scaled by the pre-reform price. The change in daily B-share turnover is the difference between the post-reform turnover and the pre-reform turnover scaled by the pre-reform turnover. Daily turnover is the ratio of the number of B-shares traded to the total number of B-shares outstanding. For restructured firms, the pre-reform turnover is the average of daily turnover over the 30 trading days immediately before April 28 2005, and the post- reform turnover is the average of daily turnover over the 30 trading days immediately after March 21 2006. For benchmark firms, the pre-reform turnover is the average of daily turnover over the 30 trading days immediately before April 28 2005, and the post-reform turnover is the average of daily turnover over the 30 trading days immediately before April 10 2006. Panel B reports summary statistics on the pre- and post-reform B-share discounts of restructured firms and benchmark firms, separately. The B-share discount before reform is the price difference on April 28 2005 between A-shares and B-shares scaled by the B-share price. The B-share discount after reform is the price difference on March 24 2005 between A-share and B-share scaled by the B-share price. We use the two-sample t and Wilcoxon statistics to test whether the mean and median differ between restructured and control firms.

46

Panel A. Change in turnover and share price in the B-share market

Change in turnover Change in price

Restructured Benchmark Test Stat. Restructured Benchmark Test Stat. # of obs. 27 32 27 32 Mean 169.69% 73.93% 2.06b 21.90% 10.86% 1.49 Median 132.12% 53.99% 2.08b 18.86% 6.25% 1.59 Std. Dev. 229.67% 80.57% 28.67% 28.05% Min. -62.52% -41.70% -25.48% -31.13% Q1 29.78% 17.89% -0.86% -9.22% Q3 229.34% 117.68% 45.86% 30.44% Max. 1142.03% 308.54% 77.33% 79.71%

Panel B. Change in the B-share discount

Before reform After reform Restructured Benchmark Test Stat Restructured Benchmark Test Stat # of obs. 27 32 27 32 Mean 43.79% 43.07% 0.17 30.31% 43.45% -3.13a Median 44.73% 44.71% 0.11 29.32% 42.66% -2.78a Std. Dev. 14.97% 16.82% 15.99% 16.14% Min. 12.58% 4.06% 1.21% 1.38% Q1 35.63% 35.30% 17.78% 36.59% Q3 57.85% 55.53% 44.34% 57.59% Max. 63.95% 68.60% 56.70% 69.50% a,b,c Significant at the 0.01, 0.05 and 0.10 levels.

47