Not all stock markets are created equal. Every country’s stock market has its own distinct set of listing requirements, trading rules, securities governing entity, the degree of technological advancement and composition of investor types (retail and institutional) to name a few.
For instance, less developed stock exchanges may have lower listing requirements relative to a more developed market to attract domestic businesses to list at home rather than abroad as well as foreign capital.
Companies can choose to list at home, abroad or both depending on the management’s view on the best course of action. In the years post-financial crisis, the NASDAQ has won several big IPOs from domestic and foreign technology firms such as Facebook (2012), Alibaba (2014) and more recently Snap (2017) because it offered Weighted Voting Rights (WVR) for founders that want to have greater control over the company they built from the ground up, influencing its long-term goals and direction.
This was the primary reason why Alibaba refused to list on the Hong Kong Exchange since they did not offer WVRs, sticking to an outdated “one share, one vote” system.
Theory of Same Stock Price Equality
These differences account for the different valuations and market sentiment toward the country’s market. But what about the price of shares of a company? In theory, the stock price of a company that is listed on different exchanges should be equal after converting into common currency because the share price performance is based on the group’s consolidated financial statements from its operations globally. If so, the share price reflects all publicly available information regardless of which exchange the stock is listed on. In this case, there should be no need to distinguish between fundamental or technical trading.
This theory somewhat holds true to some extent. The share prices of the same company are roughly similar after accounting for exchange rates. Small differences exist but are treated as negligible. Furthermore, they exhibit very similar patterns and movements at varying levels of volatility. One example is Rio Tinto, the Australian-British metals and mining company. It is listed on both the London Stock Exchange and the New York stock exchange as the same entity. After converting into common currency based on the end-of-day exchange rate, there is a small difference of 1 to 2 dollars, but these small differences may be attributed to the imperfect markets.
AH Share Premium
Where the theory does not apply well is when one looks at the share price of companies in the Hong Kong and Mainland China stock exchanges. Chinese companies often choose to list in Hong Kong as opposed to the Mainland because Hong Kong’s stock exchange market is more developed, has a large foreign investor population, offers a better legal environment and functions as close to a laissez-faire economy as anywhere in the world.
For the Chinese companies listed in both Hong Kong and either Shanghai or Shenzhen, investors classify those shares as H-shares and A-shares respectively. The number of H-share companies is equal to 248 (Main Board = 224, Growth Enterprise Market = 24), and thus there is an equivalent number of A-shares.
Below is a graph of the Hang Seng AH Premium index which tracks the average price difference of A-shares over H-shares for the largest and most liquid Chinese companies:
If there was no price difference between A-shares and H-shares, then the index would be at 100. Over the last five years, particularly in between 2012 and the end of 2014, the index has fluctuated between 90 to 115. Although there was volatility, the index alternating between premium and discount suggests these price differences are mostly systematic.
Over the past three years, however, the AH premium index has consistently been above 100, currently hovering around 120 which indicates A-shares are at a 20% premium to H-shares. Interestingly, the AH premium jumped 30 points after the introduction of the Shanghai-HK (“SH-HK”) stock connect program in late 2014. The Shenzhen-HK (“SZ-HK”) stock connect, launched in late 2016, has had almost no effect.
The Stock Connect programs should have narrowed the premium or discount because it allowed foreign investors to buy A-shares and other Mainland-listed stocks through the Hong Kong exchange, so investors do not have to purchase H-shares just to gain exposure to that company. If there were any price differences, investors may identify that as an arbitrage opportunity and swiftly eliminate the price difference.
Factors from Empirical Studies
There have been several studies that aim to understand this phenomenon. One study by Tingting Wu and Xiaoying Gao titled “Factors of Price Difference between A-Shares and H-Shares under SH-HK Stock Connect“, identified four important factors:
- Asymmetric Information – There are two sides to this argument. On the one hand, Mainland companies register and operate in China, where certain factors such as geography, culture, and differences in regulation may affect H-Share investors from accessing information. On the other hand, the H-Shares market may contain more information due to closing behind the A-Shares market. For an A-H dual-listed company for = 1, 2, … , the combined total market capitalisation expressed in renminbi is used as a proxy for asymmetric information. It is predicted that a larger combined total market capitalisation would reduce asymmetric information and therefore narrow the AH price difference.
- Liquidity – The A-Share market is assumed to have greater liquidity than the H-Share market because of the large retail investor population in China and A-Shares being the first choice of equity investments due to narrow investment channels. The turnover of H-Shares over A-Shares is used as the proxy for liquidity. It is predicted that an increase in liquidity of H-Shares would reduce the AH premium.
- Differential Demand Elasticity – Hong Kong investors have many investment channels, but A-Shares are almost the only choice for Mainland investors. Furthermore, while Hong Kong and overseas investors can trade Mainland-listed securities without restrictions, Mainland investors can only trade if their accounts hold an aggregate balance of RMB 500,000 in cash and/or securities. Not many people can satisfy this criterion, so it creates a situation where they can only invest in A-Shares. The proportion of H-Shares in total outstanding shares is used to express elasticity of demand; greater elasticity is expected to reduce the AH premium.
- Differential Risk Preference – The paper distinguishes A-Share and H-Share investors by their investment-horizon; A-Share investors focus on short-term profits from speculation, and H-Share investors focus on long-term returns and dividends. It is a reasonable explanation for the inherent volatility in Mainland markets, remember the 2015 Shanghai stock market crash, anyone?
The study runs a panel data regression model to test the above factors’ relationship with and significance against the A-H price ratio. The results confirm all but the differential risk preference hypothesis; This makes sense because the Stock Connect programs have diversified the investor pool investing in A-Shares, whom bring their experience from overseas markets to China and extending the investment time horizon.
The paper concludes with straightforward policy recommendations, for example, making A-Share investors more educated, speeding up financial innovation to establish effective arbitrage mechanisms, and launch the SZ-HK Stock Connect (already in place by the time of writing).
When will the price difference be eliminated? It is difficult to envision when this may happen, but it will be highly dependent on initiatives to further reduce capital flow frictions, improve information systems for transparency, and open more investment channels to Mainland investors for a more level playing field. Because no two stock markets are equal, their respective market properties can affect stock valuation.
Although China’s economy has become more open from its past communist regime, it is nowhere near to the economic freedom enjoyed in Hong Kong. The government’s helping hand has turned China into an economic superpower. To continue reaping the benefits of globalisation, it should strive to make itself the global choice for equity investors.