China Stock Market in a Global Perspective

DOW JONES INDEXES SEPTEMBER 2002 CHINA STOCK MARKET IN A GLOBAL PERSPECTIVE

Research Report by Executive Summary Sheldon Gao, PhD. China’s stock market has experienced amazing growth since establishing its two Senior Director, Dow Jones exchanges in 1990, although the growth has been uneven and irregular, and the Indexes market remains in the early stages of its development. This report seeks to identify 609-520-4114 the key characteristics of China’s market and how they combine to form the most [email protected] dynamic and intriguing developing market in the world.

The current structure of China’s market is one of its key obstacles to further development. There are very few stocks that would fit the definition of “blue-chip” trading on China’s mainland exchanges. Whereas most developed markets are dominated by a limited number of large-cap stocks, China’s market is cramped by a multitude of small-cap stocks. This feature allows for increased speculation and higher turnover for both investors and indexes, among other problems.

A related matter is the reliance of China’s market on external expansion, that is, expansion through the issuance of new shares rather than the appreciation in value of existing stocks. Since these shares generally do not experience sustained growth, often because of market manipulation, they contribute to the dominance of smaller size stocks in China’s market. Ultimately, the current structure is a major obstacle to the creation of viable index-related products in China.

Another issue is the fact that, despite the tremendous growth of the stock market, China’s companies are not operating at a high level of profitability. They are plagued by poor earnings and low dividend yields. China’s companies need to increase their profitability if they are to compete in global markets.

Finally, government seems to have too much influence on the market. It keeps a tight control on the issuance of IPOs, and, as a result of widespread government holdings, many listed companies in China have very low free-float ratios. Meanwhile, due at least in part to the unusual market structure, market manipulation and speculation are common. The solution is simply a matter of strengthening controls in certain areas while relaxing them in others in order to foster an environment in which China’s stock market can continue to thrive. DOW JONES INDEXES September 2002

4 Introduction 6 Abnormal Performance 9 Tremendous Volatility ONTENTS

C 12 Insulated Market 14 Substantial Government Ownership 17 Irregular Expansion 19 Influence of IPOs 21 Typical Emerging Market 24 Pyramid Structure 30 Unstable Core 33 Outperformance of Micro Stocks 36 Incredible Speculation 38 Manufacturing Orientation 40 Disappointing Earnings of Companies 44 Low Dividend Yield 47 Conclusions

6 Performance of Major Indexes Worldwide (1994—2001) 7 First Eight Years of the Dow Jones China Index ABLES

T 8 Ten Biggest Up and Down Days in the China Market 8 Crucial Role of the Ten Best Days in the China Market 9 Performance of China Indexes in Domestic and Overseas Markets 10 Volatility of Major Indexes Worldwide (1994—2001)

HARTS AND 11 Bull and Bear Markets in China (1994—2001) C 11 Bull and Bear Markets in the U.S. and China (1896—2001) 13 Annual Return of Major Indexes Worldwide 13 Correlation Between Major Indexes Worldwide 14 Tracking Error Between Major Indexes Worldwide 15 Float Ratios of Major Stock Markets Worldwide 15 Free-Float Ratios of the China Market (%)

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) 16 Float Ratio vs. Stock Return in China’s Market 16 Government Ownership in the U.S. and Japan 18 Stock Market Expansions in the U.S. and China CONTINUED 19 The Role of IPOs in the U.S. and China Stock Markets 20 IPO Change vs. Index Performance in China’s Market

ABLES ( 23 Shareholder Statistics in the U.S. and Japan Stock Markets T 24 Correlation Between Major China Indexes 25 Market Concentration Measured by % of Stocks 26 Market Concentration Measured by # of Stocks 26 Market Coverage of Dow Jones Country Titans Indexes HARTS AND 27 Market Coverage of China Stocks (January 31, 2002) C 27 Comparison of Market Concentration in China and Rest of the World 28 Tracking Error Between Major China Indexes 29 Stock Number: Dow Jones Global Indexes and China Indexes 30 Turnover Rate of Blue-Chip Indexes in Market Value 31 Turnover of Blue-Chip Indexes in Number of Stocks 32 Benchmark vs. Blue-Chip Indexes in China 33 Performance Comparison of China Indexes (1994 – 2001) 34 Composite Index vs. Stock-Selected Index in a Global Market 35 Performance Comparison of Benchmark vs. Tradable Indexes 37 Turnover Comparison of Several Stock Exchanges 38 Comparison of Sector Representation 39 Sector Representation of China’s Stock Indexes 40 P/E of Blue-Chip Indexes in Several Major Markets 42 P/B of Blue-Chip Indexes in Several Major Markets 43 P/E and P/B of TOPIX in Japan 43 Ratio of Stock Market Capitalization Over GDP in China 44 Summary of Index Payout Percentage Over the Past Two Years 45 Payout Ratio and Dividend Yield of Some Blue-Chip Indexes 47 Comparison of Several New Emerging Markets

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Introduction China’s stock market has grown China’s stock market has experienced tremendous growth and development with amazing rapidity since the in the ten years since the inceptions of the Shanghai Stock Exchange establishment of its two exchanges (December 19, 1990) and the Shenzhen Stock Exchange (December 1, 1990). in 1990. However, that growth has The number of listed companies reached 1,160 at the end of 2001 — up from been extremely irregular and has only 10 companies in the early 1990s — with a total market capitalization of not followed traditional models of 525.6 billion USD. In addition, more than 65 million investment accounts are stock-market development. In many ways, it is still in the early stages on record as of the end of 2001. of development. However, two sets of phenomena have been identified in media reports. One is the rapid growth of the stock market: almost 1,200 listed companies, swelling numbers of stock investors and the generally upward trend of the local stock indexes all indicate that the basic shape of a large country’s stock market has formed. The other set of phenomena also deserves the same attention: an incomplete corporate-governance structure, inadequate regulatory capacity, intrinsic structural defects of the market, ferocious market manipulators and all kinds of traps. In other words, China’s market is still in the early stages of development. Building a solid foundation and appropriate structure is pivotal to the consistent long-term growth of China’s financial market. People have been trying to understand this paradox, but have failed to figure out precisely the growth and decline of these two components. This has made it difficult to unravel the mystery of China’s stock market. For instance, how high is the price-to-earning ratio (P/E) in China’s market and what kind of stocks have been the driving power of the market? Furthermore, is China’s market ready for financial derivative products? On May 26, 1996, the one-hundredth anniversary of the Dow Jones Industrial Average (DJIA), Dow Jones & Company introduced its China index series. The first China index series developed by a global index provider, it consists of four indexes. The Dow Jones Shanghai and Shenzhen Indexes cover about 80% of the market capitalization of the Shanghai and Shenzhen Stock exchanges, respectively. The Dow Jones China Index, the composite of the Dow Jones Shanghai and Shenzhen indexes, tracks the general trends in China’s stock market. The Dow Jones China 88 Index, a tradable index designed specifically for investment products and derivatives, is made up of the 88 largest and most liquid stocks. With a base value of 100 as of the base date of December 31, 1993, for each of its indexes, the series includes only class A shares, which are restricted to domestic Chinese investors.

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Since the Dow Jones China index series is constructed according to the same rules and concepts as the Dow Jones Global Indexes (DJGI), it provides a unique platform from which to make a direct comparison between China’s market and major developed markets worldwide. Using the DJGI and the Dow Jones China Index series as tools, this article scrutinizes China’s stock market from a global perspective by comparing its structural characteristics and movement patterns with those of other markets around the world.

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1. Abnormal Performance From 1994 through 2001, the China’s stock market delivered impressive returns during the eight-year peri- Dow Jones China Index outpaced od from 1994 through 2001, as measured by the Dow Jones China Index1. many of the world’s best-known The index included 549 stocks as of January 31, 2002 (282 in Shanghai and indexes. But much of that superior 267 in Shenzhen). As shown in Table 1, it outpaced many of the world’s best- performance is attributable to a known indexes, including Japan’s Nikkei 225, Hong Kong’s Hang Seng specific share class, specific days Index, the Dow Jones STOXX 600 covering Europe, and the Dow Jones and a specific year. World Emerging Markets Index that covers 11 major emerging markets around the world. Of the market indexes considered for this study, the Dow Jones China Index’s cumulative return of nearly 80% for the eight-year period is second only to the high-tech driven U.S. stock market, measured by the Dow Jones Industrial Average (DJIA). Coincidentally, the Dow Jones China Index’s annualized return of 7.61% almost matched the annualized growth rate of China’s GDP. But none of this means that China’s stock-market performance can be used as any sort of economic barometer.

Table 1. Performance of Major Indexes Worldwide (1994—2001) DJ World Nikkei Hang Emerging DJIA STOXX 225 Seng Markets DJ China Cumulative Return 166.95% 68.74% -39.47% -4.13% -41.16% 79.82% Annualized Return 13.06% 6.76% -6.08% -0.53% -6.41% 7.61% Volatility 15.80% 14.53% 20.80% 31.09% 27.92% 51.10% Return/Risk 0.83 0.46 – – – 0.15

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

The performance of the Dow Jones China Index in the first two tumultuous years of its calculated history was grim at best — the index fell more than 50% even while China’s economy experienced explosive GDP growth. Excluding 1994’s performance causes the annualized return over the past seven years to rise steeply from 7.6% to 16.8%. Eliminating 1995 as well, the annualized return for the six years would jump to 23.3%. The story behind this performance is unusual and intriguing. The China stock market displays unique performance characteristics at three different levels, suggesting that the historical outperformance of China’s market is concentrated on a particular year, on particular days and within a particular segment of the market. We have labeled these three trends the “1996 Oddity,” the “Single-day Oddity” and the “Segment Oddity.”

1 The base date for the Dow Jones China Index Series was set at December 31, 1993. This date roughly coincides with the availability of reliable data and adequate market supervision, qualities that were lacking in the stock market’s early stages.

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Chart 1, below, tracks the performance of the Dow Jones China Index for the past eight years. Each 50-point interval of the Dow Jones China Index seems to constitute a threshold. After dropping 30% in the first three months of 1993 and more than 60% in the first eighteen months of its existence, the index took almost two and one-half years to recover its losses and regain its base value of 100. Thanks to a 125% surge in 1996, the index broke through both the 100- and 150-point barriers. But while the index first passed the 200-point mark in mid 1997, it finally encountered resistance at 250 points when three upward surges in 2000 failed to cross that particular milestone. The index’s high close remains 249.80 on August 21, 2000. The market downturn that began in July 2001 has driven the index back to its levels at the end of 1996. Therefore, while China’s stock market experienced five strong upward surges in eight years, as marked in Chart 1, the one in 1996 was in actuality the sole contributor. This phenomenon can be termed the “1996 Oddity.”

Chart 1. First Eight Years of the Dow Jones China Index

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5 250

3 4 200

150 2 1

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0 1 /99 /00 31/93 / /30/94 /31/98 /30/01 6 6/30/95 6/30/96 6/30/97 6/30 6 12 12/31/94 12/31/95 12/31/96 12/31/97 6/30/98 12 6/30 12/31/99 12/31/00 12/31/0

Individual trading sessions also play a similarly decisive role in the index’s performance, as shown by the “Single-Day Oddity.” Table 2 lists the top ten one-day percentage gains and losses in China’s stock market over the past eight years. The two worst years, 1994 and 1995, contain nine of the ten largest “up” days and five of the ten largest “down” days. This concentration might be due in part to the implementation of a 10% circuit breaker since December 26, 1996. However, since the circuit breaker is applied to individual stocks rather than a particular index as at the New York Stock Exchange, its effectiveness in muting fluctuations in the entire market is still fairly limited.

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Table 2. Ten Biggest Up and Down Days in the China Market Date % Gain Date % Loss 1 08/01/94 34.20 05/23/95 -17.20 2 05/18/95 28.57 10/05/94 -12.27 3 08/03/94 19.18 08/09/94 -10.73 4 08/05/94 16.59 12/16/96 -9.95 5 08/10/94 16.44 12/17/96 -9.86 6 09/05/94 15.93 10/14/94 -9.36 7 05/19/95 11.37 12/18/97 -9.28 8 10/07/94 10.91 05/22/97 -8.97 9 04/26/96 10.24 09/29/94 -8.42 10 02/22/95 10.04 05/16/97 -8.28 Average 17.35 -10.43

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

Experts and academia strongly advocate long-term investment and buy-and- hold strategies and often provide justification for their theories by showing what might befall an investor who missed the ten best trading sessions through inept market timing. China represents an extreme case due to the frequency and magnitude of these exceptional trading sessions, as well as the contrast between the best and worst. For example, as illustrated in Chart 2, if an investor missed all the ten best days in Table 2, he would have suffered a 65% loss over the past eight-year period, even if he was in the market on all other days including during the best year—1996. Therefore, these ten best days determined much of the positive performance of the investor’s portfolio.

Chart 2. The Crucial Role of Ten Best Days in the China Market

250 DJ China Index

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150

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Missing 10 Best Days 50

0 4 4 7 /9 0/95 0 1/98 6/30/9 /3 6/30/96 6/30/98 /3 6/30/99 6/30/00 12/31/93 12/31/9 6 12/31/95 12/31/96 6/3 12/31/97 12 12/31/99 12/31/00 6/30/01 12/31/01

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At the market level, deviations among the performances of China’s indexes covering different segments and serving different investor groups also reflect the unusual nature of China’s stock market. We call this “Segment Oddity.” In addition to the aforementioned four A-share stock indexes, Dow Jones also developed the Dow Jones China Offshore Index, which covers all shares of Chinese companies with non-RMB denominations that are available to global investors such as class B and H shares and red-chips traded in Hong Kong. With a base value of 100 as of December 31, 1991, this index covers 80% of the total universe and of each sector and had 59 components as of April 30, 2002. As demonstrated in Chart 3, in contrast to the approximately 80% gain on the Dow Jones China Index, the Dow Jones China Offshore Index fell 35% over the same eight-year period, or 5.24% per year on the average. Worse still, the 30-stock China Free Trade Stock Index derived from the Morgan Stanley Capital International (MSCI) China-Free Index tumbled more than 87% in the same time period.

Chart 3. Performance of China Indexes in Domestic and Overseas Markets

250 DJ China Index

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150 DJ China Offshore Index

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50 MSCI China-Free Index

4 7 00 01 6/1/95 6/1/96 6/1/97 6/1/98 6/1/99 /1/01 12/1/93 6/1/9 12/1/94 12/1/95 12/1/96 12/1/9 12/1/98 12/1/99 6/1/00 12/1/ 6 12/1/

China’s stock market displayed 2. Tremendous Volatility extreme volatility during the eight years from 1994 through 2001: an It is a generally accepted premise in the investment world that higher return average of 51.10% for the Dow is accompanied by higher volatility. The efficient-frontier curve, which Jones China Index versus 15.80% reflects this intrinsic relationship, is also the foundation for modern invest- for the Dow Jones Industrial ment portfolio theory. These rules hold true in China, despite the unique Average. Bear markets also nature of its stock market. occurred much more frequently in the Dow Jones China Index but As shown below in Table 3, along with fairly impressive returns over the past were of shorter duration than those eight years, China’s stock market also demonstrates exceptionally high registered by the DJIA.

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volatility, as measured by the annualized standard deviation of the monthly returns of the Dow Jones China Index. The index’s average volatility of 51.1% during the eight-year period is more than double—in some cases triple —the figures for the developed-market indexes considered in this study. It is also nearly double the number for the Dow Jones World Emerging Markets Index. China’s market also demonstrates the top figures in terms of highest and lowest volatility among the world markets examined in the comparison. This high level of volatility is particularly unusual in a market like China, where derivatives trading and short selling have never been permitted.

Table 3. Volatility of Major Indexes Worldwide (1994—2001) DJ World Nikkei Hang Emerging DJIA STOXX 225 Seng Markets DJ China Average Volatility 15.80% 14.53% 20.80% 31.09% 27.92% 51.10% Highest Volatility 20.90% 20.79% 25.13% 46.02% 45.14% 117.03% (Year) 1998 2001 1995 1998 1998 1994 Lowest Volatility 8.19% 5.24% 16.61% 15.99% 12.33% 17.34% (Year) 1995 1996 1999 1996 1996 2001

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

To put the Dow Jones China Index’s volatility in perspective, the DJIA’s most volatile period in its 106-year history occurred during the Great Depression with 50.7% volatility in 1933 and 45.7% in 1932. It has only occa- sionally risen above the 20% level since World War II and was even trending lower in 1990s. The Nasdaq 100, long considered the most volatile major index in the U.S., has never seen its volatility rise above 28% in its more than 17 years of existence. It seems intuitive that an increase in the number of an index’s component stocks would help reduce its volatility by enhancing the index’s diversification. However, at last count, the Dow Jones China Index had 549 stocks, which is somewhat comparable with the 600 stocks in the Dow Jones STOXX 600 and the 823 in the Dow Jones Emerging Markets Index. Although the 30-stock DJIA, the 33-stock Hang Seng Index and the Nikkei 225 Index all have far fewer components, each of them had lower volatility than the broad Dow Jones China index, as shown in Table 3. This suggests that the high level of volatility of the Dow Jones China Index reflects actual market movements rather than a flaw in its construction. Another measurement of market volatility is to examine the frequency, magnitude and duration of market crashes. Although there are various methods in the global financial arena for determining a bear market, the generally

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accepted standard is a 20% drop from a peak value. Table 4 lists all 12 bear markets in China’s market since 1994. The falls range from 21% to 46%, with an average drop of 34%. The longest bear market lasted for 426 days and the shortest one for just 16 days, with an average duration of 4.5 months.

Table 4. Bull and Bear Markets in China (1994—2001) Bull Markets Bear Markets Start End % Up Days Start End % Down Days 1 01/22/02 03/21/02 33.8% 59 11/22/00 01/22/02 -41.2% 426 2 12/27/99 11/22/00 56.4% 324 06/29/99 12/27/99 -26.0% 180 3 05/18/99 06/29/99 71.9% 42 11/16/98 05/18/99 -21.1% 185 4 08/18/98 11/16/98 20.0% 90 06/01/98 08/18/98 -26.2% 78 5 09/23/97 06/01/98 35.3% 251 05/12/97 09/23/97 -35.1% 133 6 12/24/96 05/12/97 92.2% 140 12/09/96 12/24/96 -34.1% 16 7 01/22/96 12/09/96 242.0% 320 08/14/95 01/22/96 -29.6% 160 8 07/03/95 08/14/95 23.5% 42 05/22/95 07/03/95 -31.4% 42 9 05/10/95 05/22/95 54.6% 12 10/24/94 05/10/95 -29.5% 199 10 10/17/94 10/24/94 20.0% 7 09/06/94 10/17/94 -39.6% 42 11 07/29/94 09/06/94 167.0% 38 05/10/94 07/29/94 -44.1% 80 12 04/20/94 05/10/94 20.5% 20 01/10/94 04/20/94 -45.6% 101 Average 69.8% 112 -33.6% 137

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

In Table 5, the tremendous volatility of China’s stock market in comparison with the DJIA can be viewed from four different perspectives: frequency, magnitude, density and duration. The DJIA has experienced 32 bear markets over the past 106 years but only ten since World War II—an average of once every 5.5 years. But the Dow Jones China Index has gone through 12 bear markets in eight years, averaging once every eight months.

Table 5. Bull and Bear Markets in the U.S. and China (1896—2001) Index Bull Average Average Bear Average Average History Market % Gain Days Market % Loss Days DJIA 106 years 30 108.6 915 32 -34.1 343 DJ China 8 years 12 69.7 112 12 -33.6 137 Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

The average magnitude of each bear market is comparable: a fall of 34.1% for the DJIA and 33.6% for the Dow Jones China Index. However, the average upswing for the two indexes after a bear market reaches its trough differs

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significantly: a 108.6% rise for the DJIA but only a 69.7% rise for the Dow Jones China Index. During the Depression, the DJIA experienced two bear markets every year in three consecutive years from 1931 through 1933—its densest concentration of bear-market occurrences ever. By contrast, as demonstrated in Table 4, China’s market witnessed a bear market three times in 1994, and two times each in 1995, 1996 and 1999. Finally, a bull market is much longer than a bear market in the U.S.—915 vs. 343 days, but a bull market is even shorter than a bear market in China—112 vs. 137 days. Put another way, while the average length of a bear market in the U.S. is almost three times that of one in China—343 vs. 137 days—the bull market in the U.S. is more than eight times longer that in China—915 vs. 112 days. Volatility is generally a negative characteristic as far as financial investments are concerned. It plays havoc with compound earnings, for one thing, but also encourages a speculative mentality in investors who are led to make short- term bets rather than long-term investments. As a developing market, China’s economy is growing at a very fast pace, allowing its stock market to deliver strong returns, despite its extreme volatility. The Dow Jones China Index rose 49% in 2000—the last time the DJIA experienced such gains for a calendar year was 1933. And while the DJIA’s record percentage increase for a calendar year is 81.7% in 1915, the Dow Jones China Index far outstrips that figure with a 125% rise in 1996. 3. Insulated Market The isolation of China’s stock In China, class A shares—the shares restricted to domestic investors—are market can be attributed to the listed on either the Shanghai or Shenzhen exchanges and are denominated in government’s currency shield and Renminbi (RMB), which are not freely convertible to any international cur- the existence of separate share rencies. Chinese investors cannot buy shares listed in Hong Kong and over- classes for foreign and domestic seas, and foreign investors are not allowed to trade class A shares. The class B investors. In comparison with other markets, China displays low corre- shares that were created specifically for foreign investors have been available lation and high tracking error. to local Chinese investors since Spring 2001, but their market hardly compares with that of the A shares. The number of class B shares, 112, is less than 10% the number of A-shares (1,160), and the B-share market’s total market value is only 2.4% of the A-share market’s value. The long-term performance of the B-share market also lags far behind that of the A-share market. Market segregation and the currency shield helped China to protect its economy and markets during the Asian economic crisis of 1997 and the global financial turmoil of 1998, but they remain a barrier between China’s capital markets and international investors. The astonishing degree of this insulation is revealed in an index-performance comparison.

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For example, fluctuations in the regional and global markets never impact China’s A-share market. As shown in Table 6, China’s market soared by 38% during the Asian financial crisis in 1997; and in 1995, when the global market was being driven higher by low interest rates worldwide, China’s market tumbled another 15.6% following a plummet of 39% in the previous year. More recently, in 2000, the market surged forward with a 49% gain even as global markets faltered under the collapse of the Internet bubble.

Table 6. Annual Return of Major Indexes Worldwide (%) DJ World Nikkei Hang Emerging DJIA STOXX 225 Seng Market DJ China 2001 -7.1 -21.6 -23.5 -24.5 2.9 -25.5 2000 -6.2 -10.4 -27.2 -11.0 -34.0 49.3 1999 25.2 15.0 36.8 68.8 63.4 15.9 1998 16.1 25.3 -9.3 -6.3 -28.2 -12.2 1997 22.6 19.4 -21.2 -20.3 -23.0 37.9 1996 26.0 19.5 -2.6 33.5 4.4 124.9 1995 33.5 16.3 0.7 23.0 -7.9 -15.6 1994 2.1 0.4 13.2 -31.1 -0.3 -39.4

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001. The insulation of China’s market is also demonstrated by the correlation between China and the world’s major developed markets. As shown in Table 7, the correlation coefficient, ranging from +1 to –1, measures the relationship between the movements of two indexes. For instance, the Japanese market has a relatively low correlation across the board, suggesting it does not influence and is not influenced by other markets, even though it is the world’s second-largest stock market. China, however, represents a far more extreme example. Of the four major developed markets used in the comparison in Table 7, none displayed a correlation coefficient with China higher than 0.05.

Table 7. Correlation Between Major Indexes Worldwide DJIA STOXX Nikkei 225 Hang Seng STOXX 0.6791 Nikkei 225 0.4628 0.3946 Hang Seng 0.6760 0.5800 0.3238 DJ China 0.0332 -0.0351 0.0488 0.0323

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

Tracking error, another statistical figure, also highlights the insulation of China’s stock market. It measures the relationship between two indexes

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based on the magnitude of their movements. Typically, any figure above 2% suggests a significant deviation between the two. A clear pattern in Table 8 can be easily identified. In general, the Law of Universal Gravitation works in global markets just as it does in physics—the bigger a market in size, the greater its influence on the movements of other markets and the lower the tracking error between them. While China’s market follows this law, it demonstrates extremely high tracking errors with the other indexes, providing further evidence of its extreme insulation.

Table 8. Tracking Error Between Major Indexes Worldwide DJIA STOXX Nikkei 225 Hang Seng STOXX 3.52% Nikkei 225 5.59% 5.78% Hang Seng 6.76% 7.34% 8.99% DJ China 15.29% 15.48% 15.65% 17.02%

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

4. Substantial Government Ownership Due to widespread government Every stock market in the world has non-tradable shares, such as cross-hold- ownership, China has a very low ings, government-owned shares and private holdings. To accurately represent float ratio, averaging just under a stock’s liquidity and investability, an index must account for free float— the 30% from 1993 through 2001. proportion of freely tradable shares available to investors. With the growth of index-based investment at the global level in which traditional benchmark indexes serve as portfolio models, all four leading global index providers switched or began the switch from full market value calculation to float- adjusted methodologies in the late 1990s. The Dow Jones World Index, part of the Dow Jones Global Indexes (DJGI) benchmark family, covers 34 stock markets in the world, including 23 developed markets and 11 emerging markets. Europe and the emerging markets are both represented as unified regional markets. Designed to consistently account for 95% of the free-float shares in each market, the index family’s methodology further separates each total market index into three size segments—large, mid and small. As of December 31, 2001, the Dow Jones World Index included 4,865 stocks with a total market cap of over $23 trillion and a float-adjusted market value of nearly $20 trillion. The average free-float ratio was 86.2%—86.4% for developed markets and 77.5% for emerging markets. As illustrated in Table 9, among seven developed markets, the U.S. has the highest free-float ratio at

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93.9%, while Hong Kong has the lowest at 48.5%. The U.K., if examined separately from Europe, has the highest ratio of any local market in the DJGI family at 95.1%.

Table 9. Float Ratios of Major Stock Markets Worldwide Emerging U.S. Europe Japan Canada Australia HK Singapore Markets No. of Stocks 1,676 1,167 704 203 148 133 90 823 Global Weight 57.4 25.7 8.4 2.1 1.6 0.8 0.3 3.8 Float Ratio 93.9 79.7 79.6 82.0 87.8 48.5 51.0 77.5 Source: Dow Jones Indexes. As of January 31, 2002.

In contrast, the float ratio in China’s market is extremely low due to widespread government ownership. As an existing state-owned enterprise con- verts to a listed corporation, only one-third of its shares are typically issued to the public. The rest remain in the hands of either the government or the business itself and are not allowed to trade. Table Table 10. Free-Float Ratios 10 shows an average float ratio of close to 30% for of the China Market (%) the 9-year period covering 1993 through 2001. Year Float Ratio Because of the market’s extremely restricted 2001 33.2 float, the Dow Jones China index series has been calculated with a float-adjusted methodology 2000 33.5 since its inception, unlike the composite indexes 1999 31.0 compiled by local exchanges. 1998 29.5 1997 29.7 Generally speaking, stock markets in Asia such as 1996 29.1 Hong Kong and Singapore tend to have relatively low free-float ratios—probably because of cultur- 1995 27.0 al and historical reasons—but have never 1994 26.3 dropped to the levels that are standard in China. 1993 24.4 On the other hand, although more than two- Average 29.3 thirds of outstanding shares are not tradable in Source: China Statistical Yearbook; China at this time, the steady increase in the Quarterly Report, People’s Bank of float ratio from 24% in 1993 to 33% in 2001 China. reflects a healthy trend. Does the impressive performance of China’s market come from its abnormal- ly low free-float ratio? Or it would perform even better with a high float ratio? So far there is no clear evidence to support any suppositions in this regard. When the index calculation method is changed to free-float adjusted from full market cap, the weight of the stocks in the index shifts from low to high float-ratio stocks. Without the evidence on a global basis, it is hard to determine if this would help or hurt index performance. As shown in Table 11, the

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stocks with the highest and lowest float ratios outperformed all other three groups in the middle in 2001, indicating that China’s market performance was not related to its low float ratio.

Table 11. Float Ratio vs. Stock Return in China’s Market

Free-Float Ratio (%) 0-20 20-40 40-60 60-80 80-100 Average Average Return (%) -26.0 -27.5 -28.1 -29.3 -26.5 -27.77 Source: Dow Jones Indexes. As of January 31, 2002.

Government ownership of public companies around the world is shrinking, and in the U.S. and Japan, the world’s two largest markets, it is severely limited. As summarized in Table 12, government holdings in Japan in 1996 represented 0.3% of the stock market, falling to 0.12% in 2000. In the U.S., the number peaks at 0.83% in 2000, but many of these holdings are owned by state or municipal governments instead of federal governments. Moreover, the majority of government holdings in the world is concentrated in such sectors as telecommunications and utilities. Companies such as NTT in Japan and Deutsche Telekom in Germany sometimes have as much as 40% of their market capitalization controlled by the government.

Table 12. Government Ownership in the U.S. and Japan (%) U.S. Japan Year 2000 1999 1998 1997 1996 2000 1999 1998 1997 1996 Ownership 0.83 0.66 0.59 0.65 0.59 0.12 0.21 0.22 0.21 0.30

Source: Statistics Report, Federal Reserve; Yearbook of Tokyo Stock Exchange.

But in China, the depth and breadth of government ownership of publicly traded companies is truly unique. Based on data from Dow Jones Indexes, the average government ownership in China’s stocks was 45%, as of January 31, 2002, with a maximum of 89%. Of 1,131 class A shares, only 117 on the Shanghai exchange and 130 on the Shenzhen exchange could be considered free of government ownership. This indicates that the government has ownership interests in 884 remaining stocks, or more than 78% of the total issues. This “overhang” of unlisted shares means that shareholders have very little control of the companies in which they invest. Such a high percentage of government ownership does not exist anywhere else in the world. It is a serious obstacle to the healthy development of China’s economy and stock market, but it is hard to find an easy solution to this historical issue. A plan implemented to reduce government ownership in July 2001 triggered a 45% market crash and was ultimately abandoned on June 24, 2002.

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Like all other economic phenomena, the valuation of a stock market is dependent on the equilibrium of supply and demand. A sudden boom in supply—in this case, the availability of stocks for trading—inevitably leads to a market drop if demand fails to increase accordingly. There is the possibility that a shift from full market-cap weighting to float-adjusted weighting by an index provider could cause a disturbance in the marketplace by flooding the market with shares as investors shift their portfolios to reflect the indexes. Faced with an explosion of available shares, any market would be at risk of a collapse. For example, if all family-owned shares were put on the market in Hong Kong, float shares would almost double, an effect the Hong Kong market would find hard to bear. A case in point is the Tracker Fund of Hong Kong, the first exchange-traded fund (ETF) in the Asia Pacific. It was origi- nally created as a vehicle for the Hong Kong government to unload the shares it bought during the financial turmoil in 1998 to maintain market stability. Since its launch in November 1999, the Hong Kong market has always dropped significantly before its quarterly issuance. 5. Irregular Expansion While most stock markets grow There are only two modes for the growth of stock market size. One is the primarily through the appreciation issuance of new shares such as IPOs, secondary offerings and follow-up offer- of stock values, China’s market ings, and the other is the appreciation of existing stocks. The former is con- growth mainly has been the result sidered external expansion, while the latter is viewed as internal growth. of new share issuances, or external While both are driving factors for the growth of any stock market, the rapid expansion. growth of China’s market primarily has relied on external expansion. In most cases worldwide, the opposite has been the true. Every index has a divisor, which can be adjusted to filter out the impact from component changes and corporate actions such as stock splits and spin-offs in order to maintain the continuity and consistency of the index. With a divisor in position, the performance of a benchmark index that covers a consistent portion of a market—say 80%—can be used as an indicator of the market’s internal growth; the growth difference between the index and the total value of the stock market measures the market’s external expansion. Since IPOs are not immediately included in stock indexes, their value would be included in the value of the entire stock market but not in the value of the index. However, external expansion does not necessarily mean that market itself has expanded in size. Often the introduction of new IPOs just means more stocks competing for the same amount of money, while a lot of mergers and acquisi- tions might cause the market’s size to contract even as more IPOs are issued. Table 13 compares the internal growth and external expansion of the U.S. and China markets during an eight-year period. The “Size Change” and “Index Gain/Loss” represent the changes in the total market capitalization

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and index prices for each year. To achieve complete market representation for the U.S. market, the 30-stock DJIA that covers roughly 25% of the total market at any given time has been replaced by the 6,800-stock Wilshire 5000 index. The growth rate of the total market value in the U.S. during the eight-year period averaged at 14.6% per year, of which 12.3% came from the appreciation of existing stocks, with only 2.3% resulting from new stock issuance (IPOs) and foreign stock listing (ADRs). In other words, 84% of the market growth in the U.S. was the result of internal growth while only 16% was con- tributed by the issuance of new stocks. China’s market presents an entirely different scenario. While the total market value grew at an annual rate of 47.4%, three times faster than the U.S., only 16.9% was the result of internal growth, compared with 30.5% from external expansion. Therefore, almost two-thirds of the market’s growth (64.4%) came from the issuance of new stocks, making external expansion the principal driving force behind the market’s expansion. Not surprisingly, the market-growth pattern in China has been labeled irregular.

Table 13. Stock Market Expansions in the U.S. and China (%) U.S. China Year Size Change Index G/L Difference Size Change Index G/L Difference 2001 -11.1 -12.1 1.0 -9.5 -25.5 16.0 2000 -9.9 -11.8 1.9 81.7 49.3 32.4 1999 23.8 22.0 1.8 35.7 15.9 19.8 1998 23.0 21.7 1.3 11.3 -12.2 23.5 1997 33.3 29.2 4.1 78.1 37.9 40.2 1996 23.7 18.8 4.9 183.3 124.9 58.4 1995 35.3 33.4 1.9 -5.9 -15.6 9.7 1994 -1.3 -2.5 1.2 4.5 -39.4 43.9 Average 14.6 12.3 2.3 47.4 16.9 30.5 Percentage 84.3% 15.7% 35.6% 64.4%

Source: Dow Jones Indexes; China Statistical Yearbook; Quarterly Reports, People’s Bank of China.

Obviously, when a stock market mainly relies on external expansion, the relationship between changes in market size and the return on existing stocks becomes weaker, and the return on existing stocks may fall far behind any increases in market size. The growth of entire market no longer objectively reflects the real investment performance of the majority of shareholders, because they are unable to benefit from an external-expansion-driven scheme unless they are consistently able to participate in one-day-profit IPOs. When investors talk about the fast growth of China’s market, they may

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be focusing on the change of its total market value but ignoring the means by which it has grown. In reality, extreme external expansion distorts percep- tions of a marketplace because it has little relation to the actual investment returns of long-term shareholders. 6. Influence of IPOs IPOs represent a larger proportion For a market primarily driven by external expansion, steady growth depends of the market capitalization of upon the non-stop stream of new listings, including IPOs and follow-up offer- China’s stock market than in other ings. China’s stock market is a prime example of this. Table 14 compares the world markets. The direction of the role of IPOs in the U.S. and China. Over the 11-year period from 1991 to stock market in any given year 2001, there was an average of 508 new IPOs in the U.S. each year with a total seems to be closely linked to average market value of 42 billion dollars. By way of contrast, China averaged whether the number of IPOs in that year has increased or decreased 105 issues each year with a total market value of 70.3 billion RMB (about 8.5 from the previous year. An increase billion dollars). It is not surprising that the U.S. market easily surpassed in IPOs is accompanied by a rise in China’s market with regard to the number of IPOs and the total market value the index and vice versa. amount. The key factor in this comparison is the discrepancy between how much of each market these new issues represent.

Table 14. The Role of IPOs in the U.S. and China Stock Markets U.S. China Number Total IPO Total Percent of Number Total IPO Total Percent of Year of IPO (Bil.) Market (Tril.) IPO (%) of IPO (Bil.) Market (Tril.) IPO (%) 2001 85 36.3 13.8 0.26 72 116.8 4,352.2 2.68 2000 437 80.5 15.5 0.52 141 210.2 4,809.1 4.37 1999 541 72.8 17.2 0.42 96 94.5 2,647.1 3.57 1998 381 39.6 13.9 0.28 106 84.2 1,950.6 4.31 1997 592 47.2 11.3 0.42 215 129.4 1,752.9 7.38 1996 864 56.1 8.5 0.66 207 42.5 984.2 4.32 1995 575 34.8 6.9 0.51 32 15.0 347.4 4.33 1994 570 22.7 5.1 0.45 108 32.7 369.1 8.85 1993 664 33.8 5.1 0.66 130 37.6 353.1 10.63 1992 512 23.4 4.5 0.52 39 9.4 104.8 8.98 1991 365 16.3 4.1 0.40 6 0.5 10.9 4.58 Average 508 42.1 9.6 0.46 105 70.3 1,607.4 5.82

Source: Dow Jones Indexes; China Statistical Yearbook; Thomson Financial; Dealogic.

In the U.S., new issuance accounts for less than 0.5% of the total market capitalization, but in China new listings represent close to 6% of the full market value and 20% of the available float. In the more developed U.S. market, IPOs are typically much smaller in comparison with well-established blue-

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chip companies. However, in the still-developing China market, companies launching IPOs can be significantly larger than many that have been trading for some time. This is partly due to the fact that currently China’s market lacks a stable core of blue-chip companies. The number of IPOs not only determines the growth rate of the stock market, but also seems to be closely related to the direction of the market’s movement in China. Table 15 depicts an odd and puzzling phenomenon: whenever the total IPO amount increased from the previous year, the market would rise; whenever it decreased, the market would fall. It would be simple to dismiss this as coincidence, but the fact that the phenomenon repeated itself for eight consecutive years without exception indicates otherwise.

Table 15. IPO Change vs. Index Performance in China’s Market Year IPO (RMB-Bil.) IPO Change China Index Index G/L 2001 116.81 -44.5% 179.82 -25.5% 2000 210.30 122.5% 241.34 49.3% 1999 94.52 12.5% 161.65 15.9% 1998 84.01 -35.1% 139.45 -12.2% 1997 129.38 204.4% 158.81 37.9% 1996 42.51 182.8% 115.17 124.9% 1995 15.03 -54.0% 51.20 -15.6% 1994 32.68 -13.0% 60.64 -39.4% 1993 37.55 100.00

Source: Dow Jones Indexes; China Statistical Yearbook; Quarterly Reports, People’s Bank of China.

It seems that the issuance of new stocks plays a key role in China’s stock market. The market’s movement reflects neither China’s economic growth nor changes in international markets. Instead, the direction of China’s stock market seems to be determined by the increase or decrease in the number of new listings. The question remains as to whether the number of IPOs is a reflection of market conditions or a driving factor. On one hand, the issuance of new shares could dilute the concentration of money invested in other shares as investors move their investments around, thereby causing a drop of existing stock prices. In this sense, the increase of IPOs could be a main reason for a stock-market fall, while the suspension of new listings could help stabilize the market or even drive it up. But on the other hand, a run-up in an IPO could also cause the prices of

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other related stocks to be pulled along as well, because price rallies in IPOs are usually not limited to the first trading session but can last for several weeks or even months. In the case of a very large IPO that gains immediate admission to the index, the adjustment of the divisor on the first trading day can certainly filter out its impact on the index, but continuous price increases during the following days will inevitably push the index up. In addition, the IPO effect may also have some positive impact on existing stock prices—a rise in the tide lifts every boat in the sea. From this perspective, an increase in the number of IPOs may help boost an index. Whatever the answer, nowhere else is this correlation between the number of IPOs and market movements so sharply defined. The effect of IPOs on China’s stock market mainly depends on if IPOs effectively attract assets to the stock market or if they are competing with existing stocks for limited capital. In the case of the former, the stock market would be stimulated by the new listings, but if the IPOs are competing for limited capital, the market would suffer as a result. In truth, the reality probably lies somewhere between these two extreme examples, but the question remains as to whether the market is stimulated by new listings or whether the new listings are the result of an invigorated stock market. 7. Typical Emerging Market China is a typical emerging market Both of China’s exchanges are recent creations established in December in many ways, including its large 1990. There were no laws to govern corporations until 1994, and there were number of small-cap stocks, its no laws to regulate securities until 1999. Open-ended mutual funds were cre- large number of share classes, the ated as recently as 2000, and a draft of investment company law is not sched- dominance of retail investors, its uled to be submitted to Congress until 2003. Not surprisingly, China demon- two-exchange structure and the strates many of the features that are characteristic of emerging markets. They strict regulation of IPOs by the government. are not only seen in the primary IPO market for public offerings but also in the secondary stock-trading market. These features can be summarized into five major points. First, there is an overwhelming number of share classes to confuse investors. Besides class A shares, which are restricted to domestic investors, and the B shares trading in China for foreign investors, there are several additional classes available to global investors and denominated in hard currencies. The H, N, L and S shares are listed in Hong Kong, New York, London and Singapore, respectively. If foreign-currency financing is the sole purpose, ADRs or GDRs can be readily created, even if the RMB is non-convertible. They are simpler and more flexible and effective in terms of raising capital in hard currencies. Also, they put domestic and international investors on the same platform, thus eliminating differences between them. The Deutsche Bank and the United Bank of Switzerland (UBS) even created another brand-

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new share class in 2001 by issuing “global shares” denominated in multiple currencies. Many of China’s blue-chip companies are listed only on overseas exchanges and are not available to local investors. Although foreign listing is a commonly chosen option for companies in countries such as South Africa and Israel, China’s implementation of this practice far outstrips that of any other country. China Mobile, China Unicom, CNOOC, and Legend are all leading Chinese companies as well as components of the Hang Seng Index. But while mainland Chinese are the customers, suppliers, producers and even employees of these companies, they are unable to invest in them. As can be seen later, this strange issue creates many structural drawbacks for China’s stock market. Secondly, the Chinese government strictly regulates initial public offerings. While regulations and government supervision are necessary for the success- ful and fair operation of any stock market, China represents an extreme case. The government sets the quota for new listings each year, selects the qualified companies based on provincial and sector allocation, and — until 2001 — even determined where the new stocks would list. China is the only country in which the government completely controls the size of the stock market, the pace of issue and the allocation of resources. Also, under current laws in China, no company is allowed to list without three years of continuous profitability. As a result, only a few of the listed companies in China are young and dynamic enterprises. This has led to the criticism that the stock market favors state-owned companies over entrepreneurial ventures. Another consequence of the overseas listing of China’s large companies is the predominance of small-cap stocks, in both absolute size and in relation to the rest of the world. The low free-float ratio in China makes the situation even worse. For instance, the Dow Jones Emerging Market Index includes 12 markets—South Korea, Taiwan, Malaysia, Indonesia, the Philippines, Thailand, South Africa, Mexico, Brazil, Chile, Colombia and Venezuela—and covers 95% of the combined market value. According to the parameters of this index, the cutoff lines between large and mid-cap, and mid and small-cap stocks are 1.2 billion and 210 million dollars respectively, as of December 31, 2001. Based upon this standard, only one company listed in China can be classified as a large stock—Shenzhen Development Bank (Sinopec and China Merchants Bank have big full but limited float market capitalization), and 130 qualify as mid-cap stocks. The remaining 1,000-plus companies, or 88% of the total number, are small-cap or micro-cap companies. The dominance of small stocks in China also can be measured by the average trading price of all stocks. As of February 28, 2002, 326 stocks, or 9%, of the 3,3736 stocks trading on the Nasdaq stock market had a closing price under

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$1, meeting the definition of a “junk stock.” At the same time, China’s market had a total of 521.8 billion shares outstanding with a full market value of $525.6 billion dollars. This translates into an average price of $1.007 dollar per share, compared with $34 and $23 at the NYSE and Nasdaq, respectively. Another unusual feature of China’s stock market is the dominance of retail investors. By contrast, in developed markets institutional investors tend to dominate or at least represent a significant portion of the market. Table 16 summarizes the shareholder structure in the U.S. and Japan, where individual investors account for no more than 40% of the market capitalization. In the U.K., insurance companies also hold about one-third of the total market. However, the holdings of institutions in China are estimated at less than 20% of the market. Additionally, foreign investors, restricted to the B-share market, represent less than 2.5% of the A-share market’s total capitalization. Foreign holdings for the U.S. and Japan represent 11% and 19% of each market, respectively.

Table 16. Shareholder Statistics in the U.S. and Japan Stock Markets U.S. Japan 2000 1999 1998 1997 1996 2000 1999 1998 1997 1996 Institutional 49.6 47.7 44.6 45.8 45.1 36.5 41.0 42.1 41.3 41.4 Individual 38.4 41.6 47.0 46.1 47.4 18.0 18.9 19.0 23.6 23.6 Foreign 11.2 10.0 7.8 7.4 6.9 18.6 14.1 13.4 9.8 9.4 Other 0.8 0.7 0.6 0.7 0.6 26.9 26.0 25.5 25.3 25.6

Source: Statistics Report, Federal Reserve; Yearbook of Tokyo Stock Exchange.

Finally, China’s stock market consists of two exchanges of similar size coex- isting side-by-side. While many now-developed markets experienced a multiple-exchange period in their early stages, most have migrated to a single- exchange structure as smaller exchanges were driven out of business or merged with the dominant exchange due to the introduction of electronic platform trading. Australia had seven exchanges for more than 100 years until 1987, and Hong Kong had four exchanges from 1969 to 1986. Both markets now have only one exchange each. Europe is an example of consolidation in progress: alliances and partnerships between exchanges are constantly form- ing due to the creation of the Eurozone and euro currency. Based on these examples, China’s market structure is definitely rare. The only similar case today exists in India, where the National Stock Exchange and Bombay Stock Exchange compete fiercely for investors and listings. What is most unusual about China’s two-exchange system, however, is that the stocks traded on the two exchanges perform quite differently. Though

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the Shanghai Composite Index and Shenzhen Composite Index look to have a similar trend, their correlation coefficient is as low as 0.82, close to the correlation between the Dow Jones Shanghai and Dow Jones Shenzhen indexes, as shown in Table 17. Moreover, the difference in return has exceeded 5 percentage points for the past eight years.

Table 17. Correlation Between Major China Indexes DJ DJ Dj Shanghai DJ China China 88 Shanghai Shenzhen Composite DJ China 88 0.9930 DJ Shanghai 0.9695 0.9590 DJ Shenzhen 0.9312 0.9294 0.8159 Shanghai Composite 0.9594 0.9444 0.9964 0.7973 Shenzhen Composite 0.9353 0.9227 0.8296 0.9873 0.8177 Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

Although the correlation between the DJIA and the Nasdaq Composite from February 1971 through November 1999 was just 0.75, the two indexes were thought to represent the stocks of two different kinds of companies—Old Economy and New Economy. But the two exchanges in China do not have large differences in their sector representation, quotation systems and trading schemes that the U.S. exchanges once had, making it that much harder to explain the deviation between them. A listing freeze on the Shenzhen exchange since January 12, 2001, has been suggested as a possible reason. But in reality, the correlation between the two exchange-calculated composite indexes has risen to 0.9846 from 0.8146 and to 0.9755 from 0.8128 between the Dow Jones Shanghai and Dow Jones Shenzhen indexes since the freeze. 8. Pyramid Structure China’s stock market lacks truly Looking beyond the volatility and external growth of China’s stock market, blue-chip stocks and so is an observation of the structure of the market is more revealing. Because the dominated by a large number of China market lacks real blue-chip stocks with high profitability, investors are smaller capitalization stocks, giving left to tinker in small-cap stocks for quick profits, which makes for a highly it a pyramid structure. By contrast, speculative trading environment. developed markets tend to be dominated by a small number of large In each matured market, there is a group of blue-chip companies that acts as blue-chip stocks, giving them a the core or backbone of the market structure. These outstanding companies funnel-shaped structure. usually share four key characteristics: large market value, low volatility, high liquidity and a solid shareholder base. A developed stock market is generally shaped like a top-heavy gyroscope or funnel—a few of these blue-chip companies may easily represent a huge chunk of the market or dominate the

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benchmark index’s movement. Meanwhile, the numerous small-cap companies at the bottom are relatively insignificant. A typical example is Nokia. A single company represents roughly 73% of Finland’s total market value. In Hong Kong, HSBC and China Mobile, combined, account for almost half of the Hang Seng Index. But such is not the case in China. Without true blue- chip companies in the A-share market, the market structure resembles a pyramid, and with the increasing number of listed companies, the aggregate market value accumulates slowly as more shares compete for a limited amount of money. Table 18 illustrates the top-down market concentration of several major markets in the world based on the DJGI family. In the U.S., the top 5% of the total number of stocks in the benchmark total market index represented 58.4% of its market capitalization; this is close to the ratio for the global market—58.6%. While the distribution is far less top-heavy in markets such as Japan, Australia and the emerging markets region, the top 5% of the total number of stocks in each market still represents more than 40% of the broad index. Before Nortel took its fall when the Internet bubble burst in 2000, the top 5% of stocks represented 53% of Canada’s total market index. However, in sharp contrast, the largest 5% of stocks in China represent only 18% of the Dow Jones China Index; and the largest 33% of stocks account for 58.5%, equivalent to the coverage of the top 5% of blue-chip stocks in the U.S. and the world.

Table 18. Market Concentration Measured by % of Stocks (%) % of Stocks 5% 10% 15% 20% 25% # of Composite U.S. 58.4 70.9 77.7 82.5 85.9 1,676 Japan 43.9 58.6 68.3 74.6 79.1 704 U.K. 57.3 69.4 76.6 82.0 85.8 328 Canada 36.2 52.7 63.0 71.3 76.8 203 Australia 42.2 60.8 69.5 76.7 81.2 148 Global 58.6 71.1 78.3 83.1 86.6 4,865 Emerging Market 44.7 58.6 67.2 73.7 78.6 823 China 18.1 28.9 36.4 43.1 51.8 549 Source: Dow Jones Indexes. As of January 31, 2002.

The contrast in market structure is even sharper when China is compared with heavily concentrated markets. Table 19 lists those markets and provides a comparison of the market coverage of the top stocks in their benchmark indexes using data as of January 31, 2002. In Singapore—the least concentrated market after China in Table 19—the largest company, United Overseas Bank, accounts for 16.5% of the free-float market value of the 90-stock

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Singapore’s benchmark index. And the top 15 stocks represent 79% of the index. But in China, the largest stock in terms of free-float market value— Shenzhen Development Bank—represents less than 2% of the 549-stock Dow Jones China Index.

Table 19. Market Concentration Measured by # of Stocks (%) # of Stocks 1 3 5 10 15 # of Composite Finland 73.1 84.7 88.2 92.9 95.3 30 Netherlands 24.6 43.3 57.6 79.2 87.7 61 Sweden 22.8 35.5 44.7 60.2 72.6 64 Switzerland 20.3 49.4 67.4 82.6 87.9 77 Singapore 16.5 42.8 56.8 70.8 79.1 90 Hong Kong 18.2 39.3 50.7 65.2 73.3 133 China 1.8 3.5 5.2 8.6 11.4 549 Source: Dow Jones Indexes. As of January 31, 2002.

The pyramid structure presents several unusual problems. First, no single segment can be used as a proxy for the broader market with any accuracy. The Dow Jones Country Titans Index series covers most of the developed markets in the DJGI family. The Titans indexes are a series of tradable indexes derived from the broad indexes of the countries they represent. As shown in Table 20, the limited number of stocks—30, 50 or 100—of the blue-chip indexes provides significant market coverage for each country, usually at least 60%. Therefore, a blue-chip index can generally and consistently represent the whole market in these countries. However, China’s tradable index, the Dow Jones China 88 Index, with the 88 largest and most liquid stocks in China, represents only 24% of the broad market index’s capitalization. While these stocks are the blue chips of China’s market, they have little in common with the generally accepted global standard.

Table 20. Market Coverage of Dow Jones Country Titans Indexes (%) Global Europe Asia Japan UK Canada Australia HK Singapore China 88 # of Stocks 50 50 50 100 50 40 30 30 30 88 Coverage 23.9 48.2 37.8 57.3 65.7 66.1 68.2 62.5 66.2 24.3 Source: Dow Jones Indexes. As of January 31, 2002.

Second, the pyramid structure forces index providers to add more components to the index to achieve appropriate market coverage. Table 21 breaks down the number of stocks required to provide different levels of coverage for China’s market. As can be seen, due to the pyramid structure it takes

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roughly 100, 200, 300, 400 and 500 stocks to achieve market coverage levels of 30%, 40%, 50%, 60% and 70%, respectively. In other words, 513 stocks, or 45% of the total, are required to represent 70% of market capitalization. In contrast, the U.S. market has just 186 stocks in its large-cap segment at the same time according to the Dow Jones U.S. Total Market Index. Should China’s stock market gradually grow to 3,000 or 5,000 stocks under its current structure, how many stocks will be needed to represent the top 70% of the market?

Table 21. Market Coverage of China Stocks (January 31, 2002)

Market Coverage 10 20 30 40 50 60 70 80 90 100 # of Stocks 21 61 119 192 282 387 513 664 851 1,131 % of Stocks 1.9 5.4 10.5 17.0 24.9 34.2 45.4 58.7 75.2 100 Source: Dow Jones Indexes. As of January 31, 2002.

Table 18 above illustrates that the largest 15% of stocks in a developed market often represent about 70% of the broad markets, the worldwide standard definition Dow Jones uses to classify the large-cap segment. However the percentage of stocks needed to represent approximately 70% of the broad market index is three times higher for China. This unique market structure is also vividly depicted below in Chart 4.

Chart 4. Comparison of Market Concentration in China and Rest of the World

100

70 Global

60 Emerging Market 50

Market Coverage 40

20 China 10

0 0% 5% 10% 15% 20% 25% % of Stock Number

Third, the defects of the pyramid structure make it difficult to introduce index products in China because of the inevitable disparities between the benchmark index and any tradable index derived form it. A pyramid structure

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increases the likelihood that these indexes will diverge from each other significantly because the blue-chip stocks that generally dictate the direction of these indexes are simply not present. Divergence between these two types of indexes can be measured by the tracking error between them. Generally, tracking error below 1% indicates a close relationship between two data series while anything above 2% suggests a significant gap. Table 22 shows that the tracking error between any two of the indexes considered is far above 1% and actually hovers around 10% in some cases. Such gaps in performance are major obstacles to the development of index-based investment vehicles in China, particularly index futures and other derivatives — tools that are vital for hedging, arbitrage and risk management.

Table 22. Tracking Error Between Major China Indexes DJ DJ DJ Shanghai DJ China China 88 Shanghai Shenzhen Composite DJ China 88 1.76% DJ Shanghai 4.72% 5.38% DJ Shenzhen 5.22% 5.19% 9.88% Shanghai Composite 5.32% 6.10% 1.55% 10.38% Shenzhen Composite 5.11% 5.51% 9.6% 2.23% 9.90%

Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.

Additionally, the pyramid structure of China’s market makes it impossible to create size-based subindexes using a globally consistent methodology. Style indexes are an even more distant concept. Forcing the issue by applying a size methodology designed for a different type of market structure would only create artificial groupings and performance data completely lacking in statistical significance. The DJGI family methodology divides each of its covered markets into large-, mid- and small-cap segments. The stocks in each market are ranked by float- adjusted market cap in descending order. Stocks falling within the top 70% of the index’s market capitalization are classified as large cap; the next 20% are considered the mid-cap segment. The remaining 10% are considered the small-cap segment, but only the most liquid and largest companies representing half of the segment’s market capitalization are included in the index. An obvious pattern can be seen for the eight markets shown in Table 23. While the large-cap segment accounts for 70% of the total market, in each case the number of stocks is less than that of the combined mid-cap and small-cap segments. Likewise, the mid-cap segment, representing only 20% of the market value, usually has fewer stocks (with Japan and Emerging

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Market as the only exceptions) than the small-cap segment which represents 5% of the total market capitalization.

Table 23. Stock Number: Dow Jones Global Indexes and China Indexes Emerging Size U.S. Europe Japan Canada Australia HK Singapore Markets China Large 186 153 146 45 29 16 11 200 513 Mid 524 400 321 73 58 52 39 332 339 Small 966 614 237 85 61 65 40 291 114 Total 1,676 1,167 704 203 148 133 90 823 966 Source: Dow Jones Indexes. As of January 31, 2002.

These are generally accepted patterns that are followed by most markets with the glaring exception of China. As demonstrated in Table 23, to represent just the top 70% of the Dow Jones China Index requires more than 500 stocks, or 45% of the total. Moreover, contrary to generally accepted norms, China’s large-cap segment has the largest number of stocks—even more than the mid-cap and small-cap stocks combined. This disparity can be explained by the short history of China’s market economy and the fact that all of its largest companies are listed on foreign exchanges but not on domestic ones. Furthermore, if the index’s market coverage was expanded to 95% from the current 80%, a total of 966 stocks would be needed to cover what Dow Jones Indexes defines as total market representation—95%. The smallest stock would have a capitalization of $59 million (500 million RMB), far below the global average and standard. Another drawback to the pyramid structure is the fact that it is not an effective shield against market manipulation. A normal top-heavy structure dis- courages market speculation because the large issues dominating the market are too big to be manipulated and the small stocks have so little impact that manipulation is not a big concern at the market level. But in a market with a pyramid structure it is relatively easy to manipulate an index or even the whole market by focusing on just a few stocks. This would jeopardize the fairness and effectiveness of any index-based products, including futures and ETFs. The only obvious way to reduce the risk of manipulation is to add more component stocks to the index, but this course of action would lead to other problems such as maintaining the liquidity and investability of the index. China has several dozen truly liquid stocks, and adding many more constituent stocks would have an adverse effect on the index’s liquidity. As a consequence, the pyramid structure makes it difficult to strike an appropriate

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balance between market coverage and stock liquidity. Finally, the pyramid structure also makes index-based investing particularly difficult in China. With limited capital and assets under management, most mutual funds and other institutional investors in China do not have enough money or resources to hold the vast number of stocks required for index replication over a long period of time. Accordingly, the creation of ETFs remains a distant possibility as long as only a few financial institutions can afford a large basket of stocks. 9. Unstable Core China’s stock market lacks a The “core-satellite” structure is another model that is typical of the world’s dominant core of blue-chip stocks. stock markets. In this construct, the core of the index is composed of blue- This problem is closely linked to chip stocks with long histories of performance that seldom experience any high turnover in market indexes dramatic changes. The satellites are those companies sliding in and out of the and rampant market speculation. index because of insufficient size or liquidity and poor or unstable fundamen- These factors are serious obstacles tals. to the creation of viable index- based products. This core-satellite scheme is a key factor contributing to the stability of an index as measured by turnover rate. Table 24 shows the turnover rates of Dow Jones Country Titans indexes over an 8-year period, calculated in terms of market capitalization. The figure seldom reaches into the double digits, and the average for each country ranges between 3.5% and 7% for developed markets. This suggests that any displacement of component stocks involves only smaller stocks that are not part of an index’s core. The same pattern exists in the regional and global markets as well. The annual turnover rates of the Dow Jones Global Titans 50, the Dow Jones STOXX 50 and the Dow Jones Asian Titans 50 are never higher than 12%; and their average annual turnovers are all below 8.5%.

Table 24. Turnover Rate of Blue-Chip Indexes in Market Value (%) Year Global Europe Asia Japan U.K. Canada Australia HK DJ China 88 2001 7.8 1.3 3.6 14.7 4.2 13.2 3.8 10.5 20.3 2000 11.3 9.8 11.4 12.1 8.6 7.9 3.6 5.9 17.8 1999 10.1 15.2 5.5 0.9 1.7 3.5 5.8 1.1 25.2 1998 10.8 6.3 1.9 4.3 6.5 2.0 15.3 8.5 38.8 1997 11.6 7.8 3.7 3.9 3.4 3.9 3.8 5.9 50.9 1996 6.3 11.8 4.6 4.9 0.0 7.6 6.7 9.2 64.5 1995 3.1 5.3 0.6 2.7 2.2 3.2 1.8 5.6 34.0 1994 5.4 6.2 3.2 0.0 1.6 1.2 1.4 9.2 19.8 Average 8.3 8.0 4.3 5.5 3.5 5.3 5.3 7.0 33.9 Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.

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However, this pattern does not manifest in China because there is no blue- chip core—unless it is a highly unstable one—that can provide a focus point for medium and small stocks. As shown in Table 24, the average annual turnover rate in China during this eight-year period was nearly 34% with a low of 17.8% in 2000. That low is still higher than the highest turnover level for any of the other markets used in the comparison. This high turnover cannot be explained by the replacement of small-cap satellite stocks but rather must involve the replacement of what would normally be considered core stocks if China had a standard market structure. But what is more surprising is the index turnover rate that is calculated based on the number of constituents being replaced. Using the same eight markets as before, Table 25 shows an average turnover rate of 56.5% for the Dow Jones China 88 Index, at least four times higher than the highest figure of 13.1% in developed markets. Especially in 1996 and 1997, the turnover rate reached a three-digit level for two consecutive years, indicating that the entire component list was replaced in the course of one year, or all the constituent stocks were thoroughly shuffled at least once within a year.

Table 25. Turnover of Blue-Chip Indexes in Number of Stocks (%) Year Global Europe Asia Japan U.K. Canada Australia HK DJ China 88 2001 8.0 4.0 6.0 32.0 12.0 35.0 6.7 20.0 35.2 2000 10.0 14.0 12.0 10.0 18.0 10.0 8.6 13.3 27.3 1999 14.0 18.0 12.0 1.0 4.0 10.0 8.6 6.7 36.4 1998 16.0 8.0 4.0 6.0 12.0 7.5 14.3 13.3 61.4 1997 20.0 9.0 4.0 8.0 6.0 12.5 8.6 23.3 105.7 1996 10.0 11.0 8.0 6.0 0.0 17.5 14.3 6.7 106.8 1995 6.0 8.0 2.0 4.0 4.0 10.0 8.6 13.3 48.9 1994 10.0 12.0 6.0 0.0 4.0 2.5 2.9 6.7 30.7 Average 11.8 10.5 6.8 8.4 7.5 13.1 9.0 12.9 56.5 # of Stocks 50 50 50 100 50 40 30 30 88 Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.

These frequent shifts in constituent stocks have caused massive index reshufflings—rare in international markets. The two types of turnover figures can be interpreted as indicators of the stability of an index, and—by exten- sion—the products based on it. If a low turnover rate based on market value indicates the replacement of small-caps outside the index core, a low turnover rate in terms of the number of stocks suggests the limited replacement of component stocks. However, both turnover rates have remained at

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high levels in China, demonstrating that the index reviews involve the replacement of a significant portion of the index and must include what would normally be considered core stocks. While it is not at all unusual for stocks to experience substantial rises or drops in price due to management or financial issues, it extremely unusual for so many stocks to go through such dramatic changes in such a short period of time. The most likely explanation is the speculative nature of China’s stock market. An index with an unstable core is unsuitable as the basis for investment products. The lack of an index core has dragged heavily on the performance of the Dow Jones China 88 Index in comparison with its benchmark, the Dow Jones China Index. Table 26 shows that the Dow Jones China 88 Index lagged the broad market significantly for all but two years. Its cumulative return for the same period is less than half of that of the benchmark index.

Table 26. Benchmark vs. Blue-Chip Indexes in China (%) Returns Volatility Year DJ China DJ China 88 DJ China DJ China 88 2001 -25.49 -28.14 18.05 16.87 2000 49.30 33.40 20.64 23.07 1999 15.92 13.06 43.76 51.64 1998 -12.19 -23.09 21.61 19.64 1997 37.89 40.41 35.82 35.79 1996 124.92 129.18 48.87 46.42 1995 -15.56 -18.25 32.26 31.60 1994 -39.36 -40.10 117.03 110.08 Cumulative 79.8 31.4 51.1 50.0 Source: Dow Jones Indexes.

One likely explanation for the performance disparity is the “Tide Theory". Speculation and manipulation activities drive a stock’s price up (flood tide) until it becomes a component in the blue-chip index (high tide). But after profits have been taken, the price of the stock falls (ebb tide) until it is removed from the index in the coming review (low tide) and replaced by another stock caught up in a flood tide. This leads to the outperformance of non-core stocks in a flood tide over the core companies in an ebb tide. The theory is given credence by the high turnover rates both in the number of stocks and in market capitalization and by the significant performance differ- ential between the blue-chip and benchmark indexes.

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China’s market also displays abnormal volatility patterns. In most markets, more constituents mean lower volatility due to increased diversification. But Table 26 shows that the broad index for China was more volatile than the China 88 in six years out of eight, despite the fact that the broad index has 461 more stocks. Furthermore, the Dow Jones China Index and Dow Jones China 88 Index display a high correlation of 0.9930 as shown in Table 17 in spite of the discrepancy in their returns, indicating that while the two indexes displayed similar price movements, the Dow Jones China Index consistently beat the China 88 Index. The underperformance of China’s tradable index makes it less desirable as the basis for index-based products such as derivatives, particularly since in most markets, money chases performance. In addition, high turnover in a tradable index reduces the effectiveness of many of the usual advantages of index-based investing by raising management fees and detracting from the usual tax advantages. 10. Outperformance of Micro Stocks While in most developed markets, The question of which market segment has displayed the best performance blue-chip stocks outperform is answered in Table 27. The Dow Jones China 88 Index, which includes the smaller capitalization stocks over largest and most liquid 88 stocks, had the most disappointing returns of the the long term, China’s micro-cap six indexes used in the comparison. Its cumulative and annualized returns of segment apparently outperforms 31.4% and 3.5% trailed those of the other indexes by significant margins. And what would normally be considered its blue-chip segment. while the “blue-chip” index underperformed the 80%-coverage benchmark Dow Jones Shanghai and Dow Jones Shenzhen indexes, those indexes in turn underperformed the Shanghai and Shenzhen all-share composite indexes compiled by the local exchanges.

Table 27. Performance Comparison of China Indexes (1994 – 2001) DJ DJ DJ Shanghai Shenzhen DJ China China 88 Shanghai Shenzhen Composite Composite Cumulative Return 79.8% 31.4% 92.8% 82.7% 102.0% 103.3% Annualized Return 7.6% 3.5% 8.6% 7.8% 9.2% 9.3% Volatility 51.1% 50.0% 60.8% 46.8% 61.3% 48.0% Return/Risk 0.1489 0.0694 0.1407 0.1671 0.1500 0.1930 Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.

What is even more puzzling is that with the increasing number of stocks, the volatility of indexes rises rather than falls with the improved diversification. In particular, the volatility of the Shanghai Composite and Dow Jones Shanghai benchmark indexes far exceeds that of the tradable Dow Jones China 88 Index. Obviously, this runs counter to accepted norms and even common sense.

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However, it is important to consider for the sake of this comparison three major differences between the Dow Jones indexes and those calculated by the local exchanges. First, while the Dow Jones indexes include only A shares, the composite indexes contain both A and B shares. Furthermore, while the Dow Jones indexes are float-weighted, the exchange indexes use full market cap in their calculation. Finally, the composite indexes include every share traded on their respective exchanges, while the Dow Jones Shanghai and Shenzhen indexes only cover the top 80% of the market. The class B shares included in the composite indexes have trailed class A shares significantly in performance and only represent about 2.5% of the size of the A-share market with very slim trading volume. If they have any effect on index performance, it is a negative one. As for index calculation, there is no evidence that float-adjustment helps or hurts index performance. Therefore, if neither of these two factors sufficiently explains the outperformance of the composite indexes, it must be the result of the differences in the number of components. This reasoning suggests that the best-performing segment of China’s market is not the blue-chips represented in the Dow Jones China 88 or the large- and mid-cap stocks embraced by the two Dow Jones benchmark indexes, but the small- or micro-cap stocks that are excluded from the Dow Jones indexes2. The higher volatility of small-cap and micro-cap stocks also helps to explain why the Shanghai and Shenzhen Composite indexes show greater fluctuations than the Dow Jones indexes despite the larger number of stocks.

Table 28. Composite Index vs. Stock-Selected Index in a Global Market

Benchmark Index Stock-Selected Index December 31, 1983 – December 31, 2001 Wilshire 5000 DJIA Returns 521.2% 696.2% Volatility 15.6% 15.7% January 31, 1983 – December 31, 2001 Nasdaq Composite Nasdaq 100 Returns 685.3% 1166.6% Volatility 23.9% 27.5% August 31, 1988 – December 31, 2001 TSE 300 TSE 35 Returns 134.0% 205.9% Volatility 15.3% 15.4%

Source: Dow Jones Indexes.

2 The small-cap stocks here refer to those with relatively low capitalization in the market, rather than the small stocks mentioned earlier that are distinguished from large- and mid-cap stocks in the statistical sense.

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There are stocks that most investors will not bother to look at in any stock market. They are generally characterized by small capitalization, low credit rankings, disappointing performance and poor liquidity, and therefore are naturally excluded from all stock-selected indexes but still included in a composite index. As a result, it has become a universal pattern and principle that indexes with parameters for inclusion have always outperformed composite or quasi-composite indexes, as displayed in Table 28. Furthermore, a tradable index also usually beats the benchmark index it is based on over the long run as shown in Table 29. Benchmark indexes are typically dragged down by bottom-tier stocks that are usually filtered out by more focused indexes. A notable exception is Canada where Nortel dominated the index for a time with its huge market capitalization before entering into a spectacular decline. This general trend makes the performance patterns of China’s market a bit of a mystery.

Table 29. Performance Comparison of Benchmark vs. Tradable Indexes Global Europe Asia U.S. Japan Canada Australia HK Tradable Returns 68.4 126.4 -1.1 191.4 -29.2 68.1 71.6 153.9 Volatility 15.1 14.9 22.7 14.4 23.7 20.2 18.9 30.8 No. of Stocks 50 50 50 30 100 40 30 30 Benchmark Returns 61.2 79.2 -21.4 130.0 -32.0 75.9 60.1 84.5 Volatility 15.1 14.9 22.7 14.4 23.7 20.2 18.9 30.8 No. of Stocks 4766 1049 1653 1626 704 201 152 128

Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001. Small-cap stocks sometimes outperform blue chips in a developed market for a variety of reasons. The small base and low starting point of small-cap companies makes it fairly easy for them to achieve relatively rapid growth in sales and profits, which eventually translates into a corresponding rise in stock prices. By contrast, the “Law of Large Numbers” and the law of “Diminishing Marginal Efficiency of Productivity” both contribute to the dif- ficulty faced by large companies in achieving similar growth rates. Also, the investment environment can contribute to small-cap outperformance — a “flight to quality” can cause investors to shift their capital to blue-chips and drive up the prices of those stocks, rendering the small-cap stocks more attractive because of their more reasonable valuations. In addition, small-cap stocks are more likely to be manipulated due to their relatively small sizes. Speculation and manipulation activity may achieve tremendous short-term gains as investors blindly follow the momentum. And finally, IPOs, which are

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generally small-cap companies, typically deliver impressive returns after listing, because they are always priced with some room for increases. Such “IPO Effects” may impact an index despite any divisor adjustments, because their initial rise may continue for a number of days. In developed stock markets, a small-cap rally usually is the result of high valuations in the large-cap segment and the fact that it is much easier for small- cap stocks to show high percentage increases for their prices. These small-cap rallies usually do not last that long. For one thing, IPO effects and any attempts at market manipulation are always small enough to be ignored because of the dominance of blue-chip stocks in most markets. But in China, the outperformance of its smallest stocks is driven mainly by speculation and new IPOs. On one hand, statistically speaking, small-caps in China have neither a higher growth rate nor a significantly lower market valuation in P/E ratio. On the other hand, the pyramid structure of the market indirectly amplifies the influence of stock manipulation on an index. The limited size differences among companies make stock prices easier to manipulate, and that manipulation can easily affect the movement of the index. Meanwhile, since IPOs are so much larger in proportion to the rest of China’s market than in other markets, as analyzed before, they play a much more significant role in composite indexes, and IPO effects may become a decisive element influ- encing the market movement to some extent. 11. Incredible Speculation China’s stock market displays The most commonly used indicator to measure the degree of speculation in a extremely high turnover, with an market is the average stock turnover calculated as the total annual trading average holding period of about two value divided by the average market capitalization. A higher turnover points months from 1994 through 2001. to a higher frequency of trading, or a shorter holding period, which in turn The figure is indicative of the implies a greater level of speculation. A turnover of 100% suggests that the market’s rampant speculation. average holding period for a single stock is one year. Statistics show that a developed market usually has a lower turnover level than an emerging market, because long-term investing and buy-and-hold strategies are more ingrained in the investing culture. Investors have more confidence in long- term economic development and the steady growth of corporate profits. Table 30 compares the turnover in China with that of several developed markets on an annual basis from 1994 to 2001. The annual average for China over the eight-year period was more than 500%, suggesting that an individual stock changed hands five times a year on average, or the average holding period is merely a little over two months. That is roughly ten times the average turnover of most developed markets. In a developed market, the normal holding period for a single stock is about two years — even three years for Canada and Singapore. However, China’s annual turnover fell steadily throughout the eight-year period, reflecting a healthy trend.

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Table 30. Turnover Comparison of Several Stock Exchanges (%) NYSE Tokyo Toronto Australia HK Singapore Taiwan China 2001 87.9 61.3 56.7 65.5 50.2 34.3 159.6 264.8 2000 89.0 60.8 59.4 58.2 63.5 38.8 195.3 378.1 1999 72.7 50.7 41.8 47.1 40.5 33.8 237.6 381.3 1998 67.4 35.0 41.0 47.9 63.9 28.3 261.8 409.7 1997 59.6 34.5 33.4 50.6 118.3 28.8 368.5 590.4 1996 54.3 28.6 25.5 – 40.6 – 243.4 744.1 1995 50.8 23.1 18.9 – 34.3 – 199.6 430.3 1994 55.1 25.6 17.3 – 51.7 – 352.5 838.8 Average 67.1 40.0 36.7 53.8 57.9 32.8 252.3 504.7

Source: Yearbook of Stock Exchanges; China Statistical Yearbook; Quarterly Statistics, People’s Bank of China.

Speculation is so widespread throughout China’s stock market that no one group can take the blame. Individual investors, driven by the “herd mentality” to take profits where they can, are simply fighting for financial survival in a cutthroat investing environment. Institutional investors frequently engage in speculation, but the bizarre features of China’s stock market make the construction of a traditional portfolio all but impossible. The fundamental truth is that the investing environment of China’s stock market simply does not encourage long-term investment strategies. Speculation can jeopardize the integrity of an index, particularly in the area of constituent selection. For example, liquidity is a standard criterion used in stock selection for almost any kind of index. In a market rife with manipulation, small stocks experiencing strong momentum and unusual liquidity might be selected into the index, even though it would be for largely manu- factured reasons. This danger may partly explain why such well-known and long-established indexes as the DJIA, the S&P 500, the Hang Seng and the Nikkei 225 have used a committee-based approach to component selection since their inceptions. When they were created, the markets they represented were the developing markets of their day, and speculation and manipulation were very common. It must be noted that speculation is not an entirely negative phenomenon— it provides liquidity in a market and encourages trading activity. The QQQs and SPDRs, the two largest and most traded ETFs in the world, had turnover figures of 3250% and 1380% in 2001, respectively. But those are only two trading products in the broad and diversified U.S. market, whereas China represents a much more extreme example. The high level of liquidity in China’s markets is accounted for in the construction of the Dow Jones China

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index series, which uses three-month average prices rather than single-day “snapshot” data. The cycle of speculation pervades the movements of China’s stock market. A few small-cap stocks are pushed higher through manipulation, but as they turn into large caps and index consituents with a broad range of investors, they are abandoned in profit-taking in favor of a new group of small-cap stocks ripe for manipulation. This repetitive cycle’s long-term effect is to boost the small-cap segment while running down the large-cap segment, thwarting the development of an index “core” and the emergence of a blue- chip segment. Given this, we can conclude that the pyramid structure of China’s stock market is a leading cause of its instability, the dominance of small-cap stocks and high levels of market speculation. 12. Manufacturing Orientation China’s stock market has a high China’s stock market leans heavily towards the industrial sector, with many concentration of industrial stocks, manufacturing-oriented operations. Based on the Dow Jones Global according to the Dow Jones Global Classification Standard, the Industrial sector, one of ten economic sectors, Classification Standard—more than represents 24% of the Dow Jones China Index, much more than the Dow 24%. The allocation for the Dow Jones World Index’s allocation of 11.2%. The Dow Jones Japan Total Market Jones World Index is just 11.2%. Index comes the closest with an industrial sector that accounts for 20% of its benchmark. Other sectors with strong manufacturing ties also have significant representation in China’s stock market. As demonstrated in Table 31, the Industrial, Basic Materials, Consumer Cyclical and Consumer Noncyclical sectors combined cover more than 70% of the broad index’s market capitalization. At the

Table 31. Comparison of Sector Representation (%) U.S. Europe Japan Canada Australia HK Singapore Global China Basic Materials 2.2 4.3 5.6 12.6 15.3 0.6 0.4 3.5 17.8 Consumer, Cyclical 13.5 12.0 26.9 7.0 18.7 5.4 12.4 13.9 18.9 Consumer, Noncyclical 7.6 8.6 5.4 3.1 5.5 1.9 3.4 7.5 8.5 Energy 5.6 10.2 0.6 14.6 2.2 2.6 0.0 6.4 3.4 Financial 19.0 27.3 16.8 32.5 42.1 34.5 58.3 21.9 9.0 Healthcare 14.3 10.8 6.3 2.8 3.4 0.0 0.8 11.6 6.2 Industrial 11.7 7.2 20.3 11.3 7.5 19.2 11.5 11.2 24.2 Technology 18.1 6.9 9.4 9.1 0.2 3.6 5.6 14.0 6.8 Telecommunications 5.0 8.6 3.3 5.4 4.2 22.6 7.7 6.4 0.2 Utilities 3.0 4.1 5.4 1.6 0.9 9.7 0.0 3.6 5.0

Source: Dow Jones Indexes. As of January 31, 2002.

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global level, those same sectors only account for about 36% of the Dow Jones World Index, so it’s not surprising that China has been nicknamed the World’s Factory and the Global Manufacturer. By contrast, sectors representing a significant portion of the global market, such as Financial, Technology and Healthcare, are severely reduced in China. There are some other interesting features of the sector distribution of China’s stock market that are the result of government policies. For example, China Mobile and China Unicom are listed and traded in Hong Kong only; as a result, Hong Kong is heavily over-weighted in telecommunications stocks at 22.6%, while China’s telecommunications sector represents about 0.2% of its market. Likewise, CNOOC and Legend Holdings, the leading companies in the energy and technology sectors are only listed in Hong Kong, skewing the representation of the sectors in both markets. And none of the four leading state-owned commercial banks are listed in China, creating a further distor- tion in the representation of its financial sector. However, it must be noted that the sector representation in China’s market is not unreasonable for a market with only a decade of history under its belt. Developed markets may have severely skewed sector allocations too. In Singapore, Australia, Hong Kong and Canada, the financial sectors account for between one-third and one-half of the broad market indexes, while their consumer noncyclical and healthcare sectors are extremely small.

Table 32. Sector Representation of China’s Stock Indexes

In Number of Stocks In Market Value (%) DJ DJ DJ DJ DJ DJ DJ DJ Shanghai Shenzhen China China 88 Shanghai Shenzhen China China 88 Basic Materials 42 61 103 13 14.1 21.5 17.8 14.6 Consumer, Cyclical 64 46 110 15 22.0 15.8 18.9 17.9 Consumer, Noncyclical 31 25 56 3 9.3 7.7 8.5 2.7 Energy 6 9 15 5 2.3 4.4 3.4 4.4 Financial 15 14 29 12 8.0 10.1 9.0 17.3 Healthcare 20 17 37 2 6.7 5.6 6.2 2.1 Industrial 79 68 147 19 26.3 22.2 24.2 20.3 Technology 13 14 27 12 6.6 7.1 6.8 12.8 Telecommunications 1 1 2 0 0.2 0.2 0.2 0.0 Utilities 11 12 23 7 4.7 5.4 5.0 7.9 Total 282 267 549 88 100 100 100 100 Source: Dow Jones Indexes. As of January 31, 2002.

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Another aspect of the sector allocation of China’s market to be considered is the differences between the broad and tradable indexes. As shown in Table 32, those differences are not terribly large, neither in terms of the number of stocks nor the portion of market capitalization. The Dow Jones China Index and China 88 have relatively similar sector allocations. The same cannot be said for the rest of the world. For example, the top few banks in Canada, Singapore and Australia are always among the largest companies in their markets and tend to dominate their respective indexes. While there is no set standard for what the ideal sector allocation in a market should be, a truly diversified market with balanced sector allocations may suffer less during the transitions between business and economic cycles. And as the sector-based investment gains popularity, a balanced market may be more attractive to investment portfolios. 13. Disappointing Earnings of Companies The high P/E ratio of China’s Views vary greatly on the size of the bubble in China’s stock market, but it is market, when considered in con- indisputable that the low earnings posted by most companies are a prevailing junction with its P/B ratio, indi- problem, which leads to high valuations. The price-to-earnings ratio (P/E) is cates that the market is seriously the simplest and most common way to measure a stock’s valuation, with trail- overvalued. ing P/E based on the company’s real earnings for the previous 12-month period and projected P/E based on its expected earnings for the coming 12 months. Table 33 displays both statistics for the blue-chip indexes in China and a range of other regions and developed markets. Since no international securities analysts cover the class A share market so far, there is no projected P/E available for the Dow Jones China 88 index.

Table 33. P/E of Blue-Chip Indexes in Several Major Markets Global Europe Asia Japan Canada Australia HK Singapore China 88 No. of Stocks 50 50 50 100 40 30 30 30 88 Trailing P/E 23.4 24.5 25.3 35.9 22.1 19.5 17.6 19.9 44.2 Projected P/E 21.9 21.6 22.4 27.4 17.9 16.3 15.2 21.9 – Source: Dow Jones Indexes. As of January 31, 2002.

The trailing P/E for the China 88 at 44.2 is well above that of any of the other indexes shown in Table 33. The fact that this figure represents the index’s valuation after a 40% drop from its peak in June 2001 indicates that the index’s P/E may have reached as high as 70 before the market crash. Such a high P/E ratio is a red flag. The latest academic research has unveiled a quantitative relationship between P/E and future stock return based on the 1949-2000 statistics of S&P 500 Index. The average annual rate of return in

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the stock market over the next five years according to Trevino and Robertson is 20.67 minus the product of 0.57 and the trailing P/E.3 This means that the higher the trailing P/E is, the lower the future return. Although the result is obtained based on the data in the U.S. market over the past five decades, it is meaningful to China’s market as a reference. The relative P/E ratio is one of the most important indicators for global investment. Some international investors periodically adjust their portfolios in accordance with the economic conditions and market valuations in different countries. For instance, the trailing P/E was 63.2 for the S&P 500 Index at the end of January 2002 and unavailable for the Nasdaq-100 Index due to the negative earnings.4 This was one of the major reasons why many global investors were retreating from the U.S. market. Japan was another market they avoided because of overpricing and a pessimistic economic outlook. This extreme valuation would normally indicate the possibility of a stock- market bubble, but this is not necessarily the case. China’s stock market is unique in its independence and isolation from international markets. The non-convertible RMB acts as a high wall separating China from the rest of the world’s markets. Since capital cannot move across the border, Chinese investors have no alternatives—they are operating in a closed or insulated market. Such encapsulation has resulted in a huge difference between the P/E ratios of China’s companies listed in domestic and overseas markets. Most of companies operating in China but listed elsewhere have normal P/Es. For example, those for CNOOC, China Mobile, China Unicom and Legend—all components of the Hang Seng Index—range between 11 and 29. China’s high stock prices will remain until competitors and challengers come up. The P/E ratio is by far the most widely used measurement for stock valuation, but it has its limitations. For instance, rather than being an isolated figure, the P/E ratio is subject to the influence of a number of factors, such as economic cycles, interest rate levels, market sentiment, and investors’ expec- tations. The P/E ratio is often related to the sector or industry classification of a company. Information technology and biotechnology stocks tend to have higher P/E ratios than industrial and manufacturing companies because people are willing to pay more for their future growth potential. This tendency makes China’s market, with its heavy industrial slant, look all the more unusual for its high valuation. It indicates that China’s manufacturing companies are far behind the global standard in terms of profitability, probably because of low efficiency or poor management, or both.

3 Trevino, Rubin & Fiona Robertson, “Price/Earnings Ratios and Expected Returns,” Journal of Financial Planning, February 2002. 4 The projected P/E was 69.1.

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Because both are contributing factors, prices or earnings figures are the source of any extreme P/E ratios. An extremely low price in October 1979 pulled The Dow’s P/E down to 6, while in August 1933 the virtual absence of earnings drove it up to a jaw-dropping 931! To have achieved a normal P/E of 20 at that time, The Dow would have had to close at 2.15, 95% lower than its close of 40.94 on its day of inception in 1896. To determine if China’s market is currently suffering from over pricing or overly low earnings, we will look at another indicator: the price-to-book value ratio, or P/B.5 As shown in Table 34, while the P/B ratio for the Dow Jones China 88 Index is somewhat high, it is still well within the normal range, thereby indicating that low earnings instead of high prices may be the driving factor for the high P/E in China. Given this, rather than discussing China’s high valuation or calling it a “overvalued market,” it might be more appropriate to refer to low company earnings or label them “low-profit companies.” Put in another way, the disproportionate relationship between P/E and P/B ratios reveals the extremely low profitability of China’s listed companies.

Table 34. P/B of Blue-Chip Indexes in Several Major Markets Global Europe Asia Japan Canada Australia HK Singapore China 88 No. of Stocks 50 50 50 100 40 30 30 30 88 P/B Ratio 3.32 2.34 1.82 1.64 2.12 2.42 1.51 1.62 2.43 Source: Dow Jones Indexes. As of January 31, 2002.

Although such factors as economic news, market rumors and speculative mentality may cause market swings in the short term, it is the company’s profits and earnings that will eventually drive the stock price. In other words, a company’s earnings are inevitably reflected by its stock price. P/E and P/B ratios usually move in tandem within the same industries and within the same markets, and yet the ratios for China’s stock market deviate significantly, providing a hint of what has caused the high valuation of the market. A similar case existed in Japan. As shown in Table 35, the P/E and P/B ratios of the Tokyo Stock Price Index (TOPIX) were both very high in 1989 as the Japanese market closed at a record high. However, ten years later, after the bursting of the economic bubble, they moved in opposite directions —its P/E more than doubled from 71 to 171, while its P/B dropped 78% from 5.4 to 1.2 by 2000. The high P/E and low P/B, after the drastic fall in the index, indicated that companies were suffering from extremely low earnings.

5 The book value is simply defined as company’s assets minus liabilities.

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42 DOW JONES INDEXES September, 2002

It is a similar case in today’s Chinese market. Table 35. P/E and P/B The deviation between P/B and P/E shows that of TOPIX in Japan two heavily industrial countries are plagued by Year P/E P/B the problem of low corporate earnings. The only 2000 170.8 1.2 difference is that Japanese companies are in 1999 – 1.6 even worse shape. It should be noted that, while 1998 103.1 1.2 TOPIX uses a different formula to calculate the 1997 37.6 1.2 index P/E and P/B ratios, taking the median for each ratio from among its components rather 1996 79.3 1.8 than the aggregate, it is still appropriate to use 1995 86.5 1.9 it for a basic trend analysis within the same 1994 79.5 2.0 market. 1993 64.9 1.9 Like P/E, P/B also tends to vary with sector and 1992 36.7 1.8 industry designations. The large assets of indus- 1991 37.8 2.5 trial and financial services companies typically 1990 39.8 2.9 result in low P/B ratios. Japan, with a significant 1989 70.6 5.4 industrial presence, and Hong Kong and Source: Yearbook of Tokyo Singapore, both with strong financial services Stock Exchange. sectors, have the lowest P/B ratios in Table 34. China is dominated by manufacturing and industrial companies, but its P/E and P/B ratios were 48% and 23% higher than those in Japan. This indicates that China’s stock market is already overvalued, and the problem looks even worse when the market’s poor corporate profitability is factored in. Another method of measuring a market’s valuation is the market/GDP ratio. Table 36 shows the eight-year history of China’s market/GDP value, and, curiously, it is at the low end of the global standard, which would normally indicate that China’s markets were never overvalued.

Table 36. Ratio of Stock Market Capitalization Over GDP in China 2001 2000 1999 1998 1997 1996 1995 1994 Full-Value/GDP 44.2 53.8 32.3 24.9 23.5 14.5 5.9 7.9 Float-Value/GDP 14.7 18.0 10.0 7.3 7.0 4.2 1.6 2.1

Source: Dow Jones Indexes; Bloomberg; China Statistical Yearbook.

However, this method of valuation measurement comes with its drawbacks. For one thing, it is inappropriate to compare market/GDP ratios across markets, because capital markets in different countries have different laws, history and culture, all of which can affect market structure. Also, even within the same market, over time, it is not necessarily a reliable measure. The U.S. market/GDP ratio broke 100% for the first time in 1957 and has never fallen

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below that level despite the fact that the U.S. market has experienced numerous market cycles since. And finally, the more than one thousand listed companies in China are far outnumbered by the tens of thousands of companies that are not listed — a gap caused by the government quota that restricts the number of stocks listing each year. It makes no sense to compare the market value of less than 1,500 companies with the total value of products and services produced by all of the listed and unlisted companies in China. 14. Low Dividend Yield While the payout percentage and Price appreciation and dividend income are the two primary sources of payout ratios of China’s market are investment returns. Cash dividend plays a crucial role in long-term invest- in the normal range when ment. The average annual dividend yield since 1930 is 4.3% for the DJIA compared to the world’s developed with a record high of 10.8% at the end of 1931. This is one of the reasons markets, its dividend yield is signif- global index providers have started to calculate total return versions of their icantly lower than the average. stock indexes that account for the reinvestment of cash dividends. An index’s dividend distribution can be measured in three different ways. Payout percentage measures how many constituent companies in the index have paid cash dividends in a particular time period. Payout ratio is the percentage of earnings paid to shareholders in cash. Finally, dividend yield measures the percentage of dividend income from the current investment. These three measurements are not directly related to each other. But unlike payout percentage and payout ratio, which are entirely determined by a company’s fundamentals and dividend policies, dividend yield is constrained by stock prices. Table 37 summarizes the payout percentage over the past two years for several markets in the DJGI family. At 44.6% the payout percentage for China’s market indicates that nearly half of the component companies have issued cash dividends in 2000 and 2001 in the Dow Jones China Index. While this figure is far below that of Japan or Australia, which both have payout percentages of more than 70%, it is quite close to those for the U.S. and Hong Kong and even higher than those for Europe and Singapore. According to the current policy in China, no company is qualified for a follow-up or secondary offering unless it pays a cash dividend. This requirement helps the market’s payout percentage to stay within a reasonable range.

Table 37. Summary of Index Payout Percentage Over the Past Two Years U.S. Europe Japan Canada Australia HK Singapore China No. of Components 1,676 1,167 704 203 148 133 90 549 Dividend Payout 779 464 496 110 112 66 26 245 Percentage (%) 46.5 39.8 70.5 54.2 75.7 49.6 28.9 44.6 Source: Dow Jones Indexes. As of January 31, 2002.

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Table 38 demonstrates the payout ratios of some blue-chip indexes around the world. The 43% payout ratio in the Dow Jones China 88 Index is posi- tioned in the middle of the spectrum, suggesting the component companies paid nearly half of their profits to shareholders as cash dividends. Therefore, in terms of both payout percentage and payout ratio, China’s market looks no different from other markets in the world.

Table 38. Payout Ratio and Dividend Yield of Some Blue-Chip Indexes Global Europe Asia Japan Canada Australia HK Singapore China No. of Components 50 50 50 100 40 30 30 30 88 Payout Ratio (%) 36.8 51.4 32.8 31.0 39.0 58.6 53.3 41.6 42.8 Dividend Yield (%) 1.58 2.07 1.30 0.86 1.76 3.01 3.02 2.12 0.75

Source: Dow Jones Indexes. As of January 31, 2002.

Using payout percentage and payout ratio as criteria, a stock market can be classified into one of four categories. A “many paying more” designation means many companies pay out a big chunk of their earnings in the form of a cash dividend. This is true of Australia’s market with its 76% payout percentage and 59% payout ratio. By contrast, Singapore is a good example of the “few paying less” model, with only 29% of companies paying dividends and a payout ratio of 42%. Japan falls into the “many paying less” category, because 71% of companies pay cash dividends, but the payout ratio is as low as 31%. Finally, Europe fits the “few paying more” model. While less than 40% of companies issued dividends, the ones that did paid out more than half of their earnings. In China, the 45% payout percentage and 43% payout ratio look normal and reasonable. However, as shown in Table 38, China’s dividend yield of 0.75% is dramati- cally lower than the rest of the world, although its payout percentage is just slightly lower and the payout ratio even stands at the upper scale in the Asia- Pacific region. This yield is also terribly low in comparison with other investment vehicles in China. For example, in the current global environment of low interest rates, the dividend yield normally exceeds the rate of money market fund by 1% in developed markets, but in China the dividend yield of 0.75% is far lower than the 3-month CD rate of 1.71%. Such a low dividend yield may also partly explain why China has the highest savings rate in the world. Besides, this is the dividend yield as of January 31, 2002, after China’s market tumbled 40% from its peak in June 2001. It suggests that at the market peak, the dividend yield was as low as 0.50%, which the 20% tax on investment returns would reduce to an after-tax return of 0.40%. Moreover, this is the dividend yield of the blue-chip index, the Dow Jones China 88. With smaller

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stocks included, a broad market index most likely has even lower yield for two reasons. First, the smaller a company is, the lower the possibility that it will pay a meaningful dividend. And second, speculation and manipulation in China’s small-cap market means the stocks are more likely to be overvalued. Traditionally considered value stocks, manufacturing companies tend to have higher payout percentages, payout ratios and dividend yields, compared with technology-oriented “New Economy” firms. As a consequence, all three figures are always higher in the DJIA than in the S&P 500, which in turn has higher results for those figures than the Nasdaq Composite Index. With this in mind, it seems even more unusual for China’s industrial-driven market to have a dividend yield as low as 0.75%. But it does provide additional evidence of the low profitability and high valuation of China’s equity market. Since the payout percentage and payout ratio are both within the normal range in China’s market, its low dividend yield can only be driven by excessively high stock price or excessively low corporate earnings. To raise the dividend yield, the ratio of cash dividend to stock price, either the dividend must rise or the stock price must drop. The Chinese government regulates that no listed company is eligible for a secondary rights issue unless its rate of return exceeds 6% for three consecutive years. This policy has prompted some companies to lower their net asset value by paying out more dividends, thus paving the way for a share increase in the future. But despite such incentives from the government, the dividend yield in China is still consider- ably low. The current policy simply stimulates the increase of payout percentage in the market, but does nothing to increase the dividend yield. Dividend payments made for the purpose of raising new capital are a short-term corporate deci- sion, and do not necessarily turn into a long-term dividend policy. Furthermore, if a company is forced to pay dividends to meet the requirement for raising new capital, it will try to pay out as little as possible and to stop paying as soon as the goal of new capital is realized. Given this, the low payout percentage and dividend yield are rooted in the market’s poor corporate earnings. Additionally, the accounting system and dividend policy in China includes some different types of “dividends” involving rights issuances and share exchanges, among other things, that are not accepted as substitutes for cash dividends in global markets. They lack the value of a regular cash dividend.

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Conclusions China’s stock market has made great strides forward over the past ten years. While China’s stock market has In Japan, the number of investors had grown to 30 million as of the end of enjoyed extraordinary growth, that 2000, from 5 million in September of 1950 when the Nikkei 225 was intro- growth has been very uneven. The development of a traditional market duced. In the U.S., 53 million households owned stocks and mutual funds, as structure, increased profitability reported by the Federal Reserve in 2000. But in China, the number of invest- among its companies and modifica- ment accounts has grown from nothing to 65 million over a ten-year period. tion of the government’s superviso- Also, as shown in Table 39, China is cur- ry objectives would allow it to oper- Table 39. Comparison of Several rently well ahead of other emerging mar- ate and compete successfully at New Emerging Markets kets of similar age, both in terms of the the global level. number of listed companies and total mar- Number Market Value ket capitalization. Country of Stocks (USD Bil.) China 1131 524.3 As a young emerging market, China has its Russia 245 62.9 own unique characteristics. Among the 14 Israel 654 63.2 special features discussed in this research, the pyramid structure is the major obstacle Poland 228 26.8 curbing healthy market growth and stand- Czech 138 9.7 ing in the way of developing tradable Hungary 58 8.9 index-based products such as derivatives. Egypt 80 7.1 Therefore, adjustment of the current mar- Slovenia 130 4.0 ket structure is crucial in reforming the market. The elimination of these structur- Source: Dow Jones Indexes. As of January 31, 2002. al deficiencies will help curb manipulation and speculation, shore up market confidence and alleviate regulatory difficulties and pressures, thus promoting the sound and continuous development of the stock market. What China’s stock market needs most at present is achieving long-term stable development, rather than just getting out of the current plight. Given this, China should make it a priority to foster and introduce as soon as possible a batch of industry leaders with real profitability, solidify the market foundation and optimize the market structure. Not surprisingly, China has a long way to go to commercialize its financial markets. Increased government supervision, increased profitability of its companies and the development of a normal market structure are three necessary short- and mid-term goals that must be achieved by China’s stock market if it is to grow and operate successfully at the global level.

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China Stock Market in a Global Perspective