Is the Stock Market Just a Side Show?

The following post comes to us from Murillo Campello, Professor of Finance at Cornell University; Rafael Ribas of the Department of Economics at the University of Illinois; and Albert Wang of the Department of Finance at the Chinese University of Hong Kong.

The 2005 split-share reform allowed for restricted stocks worth hundreds of billions of dollars to become tradable over a short period, sharply increasing liquidity in the Chinese stock market. In our paper, Is the Stock Market Just a Side Show? Evidence from a Structural Reform, which was recently made publicly available on SSRN, we use this episode as a way to flesh out links between stock market activity and real business activity.

We evaluate the impact of the 2005 reform exploiting various institutional features associated with its implementation. One of such feature is a pilot experiment conducted at the beginning of the reform schedule. Another is the gradual, large-scale share conversion that took place within a 16-month window. These features are unique and present both opportunities and challenges for our empirical tests. It is possible, for example, that better-managed firms were chosen to participate in the pilot trial that initiates the conversion program because of political motivation to showcase the reform. In addition, after the pilot stage, firms were free to join the reform at the time of their choosing. Thus, the treatment assignment might also be endogenous due to self-selection. To minimize these concerns, our analysis employs quasi-experimental methods that make the outcome variation before and after conversion conditionally independent from the compliance date.

We find that 2005 Chinese split-share reform had largely positive effects on corporate outcomes. Unlike previous reforms, the state loosened its control over local companies by allowing all of their shares to be traded in organized secondary markets. The elimination of dual-structure ownership, as well as the easier access to financing, gave new incentives for shareholders and managers to increase firm performance. Our results suggest that sales, profitability, and value increase because of the reform. The increase in business performance is accompanied by an expansion of capital investment, followed by improvements in productivity. The reform also allowed firms to have greater access to equity financing and prompted them to engage in more corporate acquisition deals.

The results we report shed a unique perspective on the role of public stock markets in the economy. In particular, they reveal the extent to which restrictions on secondary equity transactions can be detrimental to corporate growth. While our tests build on features that are particular to the Chinese equity markets, we believe our findings have broad implications for understanding the impact of governmental interventions and the trend towards capital markets liberalization. Our study indicates that trading in secondary equity markets have significant connections with outcomes observed in the real economy. Policies that ease restrictions on these markets may have positive effects.

The full paper is available for download here.

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