Stock market efficiency in China: Evidence from the split-share reform

• We assess valuation efficiency by studying price reactions to the 2005 reform of the Chinese stock market.
• The methodology is useful due to the short life of the Chinese stock market, a severe limitation from the point of view of statistical methods that need long time-series to produce reliable estimates.
• The reform entailed a process by which NTS holders paid compensation to TS holders in exchange for the right to sell their shares in the future.
• We measure cumulative abnormal returns (CARs) of stocks as well as turnover, with the aim of understanding whether the stock price reaction is consistent with rational models of pricing behavior.
• Risk-adjusted stock prices increase both in the very few days before the first suspension (more than 2%) and in the ten days after the first readmission (about 1.7%). Prices fall after the end of the reform, but compensation-corrected abnormal returns are not statistically different from zero for the ten subsequent days. Turnover increases substantially in all the event periods.
• Our findings are coherent with the existence of inside information. The most likely explanation for the increase in prices after the first readmission is the existence of a visibility (Merton) effect.

We perform an event study to investigate the efficiency of the Chinese stock market. We study the reaction of stock returns and trading volumes to the 2005–2006 structural reform which allowed the transformation of non-tradable shares (NTS) into tradable shares (TS) through payment of a compensation to holders of TS. We find evidence of positive abnormal returns in the few days before announcement of which companies will undergo the reform process, that can be explained by information leakage and not by a compensation risk premium, and in the ten days after the readmission to trading of participating companies following the determination of the compensation, which is consistent with a Merton visibility effect. We use a bootstrap procedure designed to replicate the actual degree of covariance across firms.