ChiNext’s initial performance looked very much like a bubble, a common phenomenon in China’s financial markets (see a MERICS blog on the topic here). Once stock prices left bubble territory performance deteriorated. ChiNext has underperformed the Shanghai Stock Exchange since 2017. There is more than one likely reason why this is the case.
One problem faced by the kind of smaller firms which might list on a tech board is poor access to credit as state banks generally prefer lending to SOEs. This problem has been covered extensively (for example by me here).
A lesser known problem is Stock Price Synchronicity, when stock prices move together. This phenomenon, caused primarily by a lack of reliable firm-specific information, is common in emerging markets. The most cited scientific study on the topic found that 80 percent of Chinese stocks move together in a given week (compared to 56 percent in the US).
This following example illustrates how this phenomenon can distort the market, and hurt the performance of companies with unique business models:
Imagine a skilled investor who is considering buying shares in a company which is developing industrial robots. Despite being very different from most listed companies the share price of this company will, because of stock price synchronicity, often move in a similar way. The investor would, however, still bear the risk of losing his entire investment. This could happen if, for example, it was discovered that company’s robots did not work, causing it to go out of business. While the returns are distorted, the risk of losing everything is the same. Under these circumstances the investor might decide to buy into a fund which tracks the market instead. The returns on his investment would often be similar, but without the risk of losing the whole investment.
Scale this example up to the whole market, and it becomes clear how stock price synchronicity can cause investors to systematically avoid risky stocks, contributing to them underperforming the market.
Reasons for optimism
Several developments make it likely the new board will perform better than ChiNext:
Firstly, as mentioned in the first part of this piece, new rules will improve the listing process.
Secondly, increasing foreign investment can help address stock price synchronicity. Research shows that the stock price of companies with large degrees of foreign ownership is more closely related to fundamentals and less driven by the market. This is likely because foreign ownership leads to a greater number of independent analysts covering the stock. China’s inclusion into the MSCI index and the establishment of the stock connect programs are examples of recent changes which will attract more foreign investment.
Finally, the government is pressuring banks to lend more to the private sector, this should also help the performance of stocks on the new board.
It would be surprising if Shanghai’s New Tech Board did not at least have a good start. Chinese investors have limited investment options, so the new board will be welcomed. Additionally, the government is guaranteed to lend a hand with promotion. At the very least a few impressive companies should make the board their home. However, there is a large risk that an initial stampede of investors could cause stock price overvaluations and subsequent crashes.
This text was first published by the China Economic Review.