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Short-sale Constraints and A-H Share Premiums Kalok Chan*, Hung Wan Kot and Zhishu Yang First draft: January 15, 2009 _______________ * Corresponding author. Chan is from Department of Finance, Hong Kong University of Science & Technology, Phone: (852) 2358 7681, E-mail: [email protected]. Kot is from Department of Finance & Decision Sciences, Hong Kong Baptist University, Phone: (852) 3411 7558, E-mail: [email protected]. Yang is from Department of Finance, Tsinghua University, Phone: (8610) 6277 1769, E-mail: [email protected]. We thank Baolian Wang for his capable research assistance. We acknowledge the financial support from General Research Fund of Hong Kong Research Grants Council (Project Number 242408). All errors are ours. Short-sale Constraints and A-H Share Premiums Abstract We investigate the effect of different short-sale constraints of the H-share stocks on the A-H share premiums, based on H shares from Hong Kong and A shares from Mainland China. When the market goes down, we find that the prices of shortable H-shares decrease faster than those of non-shortable H- shares. As a consequence, the premium of A-H shares becomes larger for the shortable H-shares. We also find that lagged premium of shortable stock portfolio leads the premium of non-shortable stock portfolio, but not vice versa Keywords: Short-sale constraints, overvaluation, Hong Kong market, China A-share market Classification: G12, G15, G18 2 1. Introduction During the financial tsunami in the final quarter of 2008, there are controversies over the short selling activity around the global equity markets. Many major financial markets have banned short- selling to a different extent, ranging from only the financial companies to the stock market as a whole. One justification used by regulators is that short-sale was used by speculators to sell down the companies, destabilizing the stock market. On the other hand, many industry practitioners voiced opposition against the short-sale ban, citing that short selling plays an important role in the price discovery process. They claimed that short-selling is the reaction of some market participants to negative information about the outlook of the economy. In other words, short-sellers do not make up the bad news, but are simply the messengers. The debate on short-selling is nothing new to the academics. There is no shortage of academic studies on the effect of short-selling on the market efficiency. A most widely study is Miller (1997) who argues that given the short-sale constraints, negative information cannot be immediately incorporated into stock prices. As a consequence, stock prices reflect only optimistic investors’ opinion, and not pessimistic investors’ ones, leading to overvaluation. The effect of short-selling on overvaluation has received some empirical support in the U.S. market. Chen, Hong and Stein (2002) use mutual fund holdings as a proxy for short-sale constraint, and find that higher short-sale constraints forecast lower future returns. Jones and Lamont (2002) use rebate rate for stock borrowing as a proxy for short-sale constraint, and find that stocks that are expensive to short or which enter the borrowing market have high valuations and low subsequent returns. Asquith, Pathak, and Ritter (2005) use short interest as a proxy for shorting demand and institutional ownership as a proxy for shorting supply, and find that short-sale constrained stocks underperform the less constrained ones. However, most of the previous studies are confined to the U.S. market. Furthermore, they might not be able to assess the effect of short-sale constraints accurately. This is because short sales are generally allowed in the U.S. markets, even though some stocks are more difficult to borrow. It is, however, not possible to find two stocks that are identical except that one has short-sale constraint while 3 the other does not. Thus, previous studies have to rely on various proxies to measure the extent of the short-sale constraints, and it is possible that these proxies might reflect other effects rather than short-sale constraints. The objective of this paper is to examine the effect of short-sale constraint on pricing efficiency in the China market. Not only that we provide additional evidence outside the U.S, the unique setting in the China market makes it an ideal laboratory experiment for providing direct evidence on the effect of short-sale constraint on the stock valuation. Many Chinese companies are dually listed in the Mainland and Hong Kong, either as A-shares listed in Shanghai or Shenzhen, or as H-shares in Hong Kong. For example, as of 2007, there are 53 Chinese companies that have both A shares traded in Mainland and H- shares traded in Hong Kong. As of today, all stocks in Mainland are not permitted for short-sale. Due to the short-sale restriction, no investor without holding existing shares can sell any shares during the stock market bubble in 2007 even if he is of the opinion that the stock market was overvalued. In fact, during the stock market peak in August 2007, the P/E ratio for the Mainland stock market has reached 60, becoming one of the highest in the world. On the other hand, for those H shares which are listed in Hong Kong, they are traded at a more reasonable P/E ratio of around 26 during the same period. As a result, the A-shares are typically traded at a premium of around 50% during the period. The premium might be a reflection of different investment opportunity set faced by Hong Kong and Mainland investors. Another potential explanation is that short-selling is not permitted in Mainland but allowed in Hong Kong. As a result, H shares are more fairly valued because both pessimists and optimists can participate, while A shares of the same company are overvalued because pessimists are less likely to participate. What makes our study more unique is that not every H share can be sold short. To be eligible for short-selling, a company must be a constituent stock of an index, or have underlying options or futures, or maintain high liquidity (market capitalization of not less than HK$1 billion and an aggregate turnover during the preceding 12 months of 40% of the capitalization). At the end of 2007, about 30% of H-shares are not permitted for short-selling. Consequently, for those H shares that are subject to short-sale restriction, the lower participation rate of pessimists could mean higher valuation of H shares, resulting in 4 a smaller discount relative to the corresponding A-shares (or a smaller A-H share premium). We therefore compare the A-H share premium between two groups of H shares, one eligible for short-selling and the other ineligible. If the short-sale restriction results in higher valuation for H shares, we will observe the A-H share premium to be higher for those H shares eligible for short selling than for those that are ineligible. The remainder of paper is organized as follows. Section 2 provides the background of Chinese enterprises list on HKEx. Section 3 provides the related literature. Section 4 contains the data and preliminary analysis. Section 5 presents the regression analysis. We conclude the paper in Section 6. 2. Overview of A and H shares Since the Chinese government decided to open the door to oversea investors in 1978, they are keen to shift from the central planning economy to the market oriented economy. With the growth of the economy, both state owned enterprises and private enterprises need huge capital for restructuring, expansion, and further development. The Chinese companies also need to integrate with the global economy and follow the international business practices. As the Mainland stock market is still segmented from the global market due to capital control, Hong Kong becomes the primary “overseas” market for the listing of Chinese enterprises. There are two channels for Chinese enterprises to be listed in Hong Kong. The first one is through the issuance of H-shares. The first state owned enterprise to be listed in Hong Kong, Tsingtao Brewery, issued H-shares on July 15, 1993. By 2008, 110 companies have H-shares listed on the main board of Hong Kong Exchanges (HKEx). The total market capitalization of H-shares is more than 2.5 trillion Hong Kong dollars, accounting for 26% of the market capitalization of HKEx main board. Another channel for listing in Hong Kong is via red chips. Defining “red-chip” stock is difficult, as the term “red chip” is financial jargon used in the securities market rather than the official terminology used in the HKEx. Red-chips are companies incorporated and listed in Hong Kong, although the source of capital and business are mainly from Mainland. By 2008, 89 red chips are listed on the main board of 5 HKEx. The total market capitalization of red chips is more than 2.6 trillion Hong Kong dollars, accounting for another 27% of the market capitalization of the HKEx. Because no red-chips are dually listed in the Mainland stock market, they are excluded from our analysis. Among these 110 companies that have H shares listed in Hong Kong, 52 are also listed in Mainland, via the issuance of A shares in Mainland, either in the Shanghai Stock Exchange or in the Shenzhen Stock Exchange. The A-share and H-shares are legally identical, enjoying the same voting rights and dividend streams. The main difference is that all transactions, dividend payments, trades, and quotes are conducted in different currencies –Renminbi (RMB) for A shares, and Hong Kong dollars for the H shares.

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