The Tale of Two Cities
December 5, 2012
The Tale of Two Cities
Over the past few month, the Chinese investors find themselves living in a time described by Dickens’ book A Tale of Two Cities – however, this time, the two cities being Shanghai and Hong Kong.
In Shanghai, shares are approaching the worst of times. The Shanghai Composite closed below 2,000 for the first time since January 2009, and is down two-thirds from its peak. On the contrary, Chinese shares listed in Hong Kong, are doing far better. Since the end of August, H shares have risen 15 per cent, despite of the fact that the shares of the same companies listed on the mainland, the matching A shares, are down over the same period. The following graphs describe the one year index performance and 3-month stock price performance of Air China and Sinopec listed on the Shanghai (A share) and Hong Kong Stock Exchanges (H share) respectively.
Shanghai Composite Index Hang Seng composite Index Source: Google Finance
Air China price on Shanghai Exchange Air China price on Hong Kong exchange
Sinopec price on Shanghai Exchange Sinopec price on Hong Kong Exchange Source: FT Financial Data
Cross listing is the listing of a company's common shares on different exchanges than its primary and original stock exchange for different investors. A company simultaneously listed in Shanghai Stock Exchange (A-share), and Hong Kong Stock Exchange (H share) is an example in case. Now a total number of 144 H shares with a total market capitalization of 4,516,176,075,114 (HK$) are listed on the Hong Kong Stock Exchange. Most of the H listed companies are large State Owned Enterprise domiciled in China.
Since the cross-listed H share and A share are shares of the same company, enjoying the same fundamentals, they should, therefore, have the same price, according to the rational Efficient Market Theory. However, as shown on the above graphs, A and H shares experienced the opposite performance over the past three months. In addition, A-shares are historically trading at a high premium than the H-shares. It is until recently, the stock prices of the two shares classes reverse but they never converge.
To track this, there is an index called “Hang Seng China AH Premium Index" which measures the absolute price premium between the A-shares and H-shares of dual-listed companies domiciled in Mainland China. When the AH Premium Index is higher than 100, A shares are trading at a premium to H shares. Conversely, when the AH Premium Index is lower than 100, A-shares are trading at a discount to H-shares. The following graph of AH Premium Index shows that A-shares as a group are currently trading at a different level over the H-shares.
Source: Bloomberg Hang Seng China AH Premium Index
Why do the shares of the same companies and same fundamentals have different prices? According the Efficient Market Hypothesis (EMH), because the cross-listed companies have the same future cash flows, their shares will converge at last. The fact that their prices diverge viciously should be due to the reason that Beta does not measure their risks properly. But the EMH school never gave the appropriate discount factor to incorporate the risks. This paper attempts to explain this phenomenon from a behavioral view, that this cross-listing anomaly represents the mispricing of the market.
I. Reasons for historic A-share premium
(1) Limits of arbitrage
The tight control of capital market makes no channel of arbitrage exists, making the arbitragers unable to profit from the price differentials and thus pressing no pressure for the price difference to narrow between the two markets.
(2) Limited investment opportunities for Chinese retail investors and institutions China’s economic growth has been maintained at an average rate of 8-9%...