It is tempting to try to find meaning in the so-called “A-share premium”. This is the persistent valuation gap between the shares of Chinese companies that trade in Shanghai or Shenzhen (known as A-shares) and the shares of the same companies that trade in Hong Kong (H shares).
For much of 2019 the A-share premium has been roughly 20-30 per cent, meaning that A-shares are 20-30 per cent more expensive than equivalent H shares. Some companies, such as Chinese brokers, trade at several times the price of their Hong Kong equivalents. While this premium has persisted for years, it can vary greatly, from 100 per cent in the great “pre-Olympic” stock market rally of 2007 to much smaller premiums, and even to small discounts, as happened briefly on three occasions.
Normally, when onshore and offshore markets are separated by capital controls — and arbitrage is restricted, as is the case in China — onshore markets trade at a discount to the major offshore markets. This makes the Chinese A-share premium all the more anomalous. So why is the same share worth so much more on the mainland than it is offshore?
One theory is that it reflects differing views on political risk, with mainlanders less worried than foreigners about the risk of a political “event” disrupting business prospects. Another theory is that it shows that mainland investors are more optimistic about Chinese growth prospects than offshore investors. A third theory is that it reflects an information asymmetry in which onshore investors have access to a higher quality of information than offshore investors, and so are able to discount future growth prospects at a lower rate.
But none of these explanations makes any sense. They all assume, incorrectly, that prices in the Chinese stock market reflect a fundamental “view” about growth prospects, measured as the present value of future expected cash flows.
They do not, and never have. It has been almost impossible during the past few decades to find a credible correlation between the performance of the Chinese stock market and any measure of growth prospects or profitability. Monthly surges or drops of 10-20 per cent or more occur far too often to suggest any relation with normal economic volatility.
It should not come as a surprise that mainland markets are so detached from economic fundamentals. A well-functioning stock market is one in which buying and selling is driven by an appropriate mix of at least three different types of investment strategies: fundamental or value investing, relative value investing, and speculation.
It is the first two that really align prices with growth expectations and that enforce consistency of pricing across assets. Speculative decisions to buy or sell, on the other hand, are driven by market technicals, investment fads, momentum trading, margin lending, and other factors that are irrelevant in aligning share prices with growth expectations or relative pricing consistency. What is more, speculative investing tends to be driven by expected changes in the market consensus, rather than by expected shifts in economic growth prospects.
The problem is that in a market in which macroeconomic data is questionable, financial statements are not credible, corporate governance is unclear, government intervention is unpredictable, and interest rates are repressed, it is impossible to be a fundamental investor except at very low prices, driven down by the high discount rates all this uncertainty requires. Investors whose effect is to drive capital according to its most productive use, in other words, are pretty much priced out of the mainland markets. That is why, for all the promises by local fund managers of their sophisticated fundamental selection process, mainland markets are wholly speculative.
In fact the Chinese stock market is really a Keynesian beauty contest: “winners” are rewarded not for choosing the best-looking contestants, but rather for their ability to figure out the consensus. Successful investors are not those who understand the economy, in other words, but rather those who are good at interpreting government signalling, recognising shifts in liquidity and, above all, quickly discerning or even setting off changes in market consensus.
In speculative markets it is these kinds of “technicals” that matter, not fundamentals. Academic studies have suggested that mainland investors show a strong preference for collectivistic investment behaviour. This is not an anomaly: it is exactly what we would expect from intelligent investors in a speculative market in which government signalling plays so prominent a role.
It takes many years for a stock market to develop the qualities that allow and encourage fundamental investing. Mainland Chinese markets are slowly moving in that direction, but for now share prices provide no meaningful information at all about China’s economy. The A-share premium probably reflects nothing more than excess domestic liquidity.
Michael Pettis is a finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Center in Beijing