The Effect of China's Reform Policies on Stock Market Information Transmission

Introduction Since China opened its stock markets on December 19, 1990, the Chinese government has employed various policies in an attempt to reform its underdeveloped stock markets. The reforms are for attracting foreign investors and enhancing financial market development. Despite the fact that investors continue to raise questions about information transparency and corporate governance of Chinese companies, China's stock market has become the fastest-growing stock market in the world. According to the 2006 Yearbook of the Shanghai Stock Exchange, the market capitalization of public-listed A-share companies on the Shanghai Stock Exchange increased from 63.59 billion Chinese yuan with 29 listed companies in 1992 to 2571.97 billion Chinese yuan with 827 listed companies in 2004. The rapid growth of China's stock market has attracted the attention of various emerging market policymakers who are concerned about the impact of reform policies on their financial markets and ultimately on their economic growth. In addition, investment professionals looking for international diversification opportunities are interested in this available emerging equity market. Because the benefits of international diversification are decreasing on a global basis, diversification benefits currently result primarily from investing in emerging markets rather than in developed markets (Goetzmann et al., 2005). Much of the recent literature indicates that financial market liberalization will increase emerging markets' integration into global markets, will attract foreign investment, and will reduce the cost of equity capital thereby ultimately increasing economic welfare. See, for example, Phylaktis (1999), Henry (2000), Bekaert and Harvey (2000, 2003), and Bekaert et al. (2005). This paper focuses on the Chinese stock market because of its increasing global importance and changing regulatory environment. China's stock market presents a unique market structure with two national exchanges, Shanghai Stock Exchange and Shenzhen Stock Exchange, each with dual classes of stocks. A-share stocks are traded by domestic residents, and B-share stocks are traded primarily by foreign investors on both the Shanghai and the Shenzhen exchanges, effectively creating four separate markets. Because most B-share stocks also are listed as A-share stocks, the dual classes of stocks would be expected to move together, particularly after equity market liberalizations when domestic residents were allowed to trade B-share stocks (February 20, 2001) and when foreign investors were able to make their first trades in A-share stocks (July 9, 2003). Thus, this study investigates the Shanghai and Shenzhen exchanges and the relationships between A-share index returns and B-share index returns within each exchange and across the two Chinese exchanges. In addition, relationships between two selected regional markets (Hong Kong and Japan) and with two measures of global markets (the U.S. and the MSCI World) are studied. The degree of market integration is measured using correlation, Granger causality, and vector autoregressive (VAR) methodologies. Both return causality and volatility transmission of index returns are analyzed. Evolving market integration is investigated based on the event date of reforms (new policy effective date) using pre-event and post-event periods. (1) The study provides a perspective of what one can learn from the emerging Chinese stock market where the government has employed various policies in an attempt to reform its underdeveloped stock market. When reviewing reform policies, policymakers can decide whether or not to employ similar reform policies and which, if any, specific policies to pursue. The four major Chinese reform policies studied are: (1) daily price-limit regulation--December 16, 1996, (2) implementation of new People's Republic of China (PRC) Securities Law--July 1, 1999, (3) removal of trading restrictions allowing domestic residents to trade B-share stocks February 20, 2001, and (4) opening A-share markets to foreign investors--July 9, 2003. …