Property Rights Protection, Information Acquisition, and Asset Prices: Theory and Evidence

Abstract

We study comovement of Chinese A and B shares (restricted to foreigners). A-B shares within rms commove surprisingly less than Bshares of di¤erent rms. Investor property rights protection (PRP), and several rms’opaqueness measures, explains these patterns. A reform allowing domestic investors into B-shares increases A-B comovement, specially for rms in low PRP cities. We o¤er a model with segmented markets where foreigners face information acquisition costs. In equilibrium, B-share prices are disconnected from fundamentals, lowering comovement with Ashares. Reducing market segmentation increases informed trading and A-B comovement, the more so for rms with higher initial information costs. JEL codes: G12, G14, K22. Keywords: Property Rights Protection, information acquisition costs, asset prices. We have bene ted from discussions with Robert Battalio, Jason Chen, Mara Faccio, Ravi Jagannathan, Dong Lou, Tim Loughran, Jianfeng Shen, Paul Schultz, David Solomon, Joshua Spizman, and Jianfeng Yu. Seminar participants at Loyola Marymount University, University of Notre Dame, and University of Southern California provided valuable feedbacks. Yongxiang Wang would like to thank CIBER at Marshall School of Business and USC-China Institute for nancial supports. Jianfeng Zhu provided outstanding research assistance. yContact: Elias Albagli, Central Bank of Chile, Research Department, (Email) ealbagli@bcentral.cl, (Tel) 562-26862688. Pengjie Gao, Mendoza College of Business, University of Notre Dame, (Email) pgao@nd.edu, (Tel) 574-631-8048; and Yongxiang Wang, Marshall School of Business, University of Southern California, (Email) Yongxiang.Wang@marshall.usc.edu, (Tel) 213-740-7650. How do legal and economic institutions a¤ect information e¢ ciency and asset prices? In an in‡uential study, Morck, Yeung, and Yu (2000) nd that stocks in the countries with poor property rights protection (PRP) exhibit a higher degree of price comovement. They conjecture that agents from these countries have less incentive to acquire and capitalize rm-speci c information, thus less rm-speci c information di¤uses into asset prices. In the presence of market-wide noise trader risk, higher uncertainty translates into a large price impact of these shocks, thus leading to excess comovement unrelated to fundamentals. In this paper, we theoretically formalize their intuitions and test the predictions from our model using a novel set of identi cations based on the withincountry variations of local city-level PRP in China. China provides a unique setting to test this idea at least for two reasons. First, there are substantial regional variations in property rights protection (PRP) in China. This is in sharp contrast to what one might expect for a relatively authoritarian country such as China. In fact, based on the World Bank’s rm-level survey evidence, Cull and Xu (2005) pointed out that, “...the institutions associated with contract enforcement, in particular the legal system, vary in their e¤ectiveness across regions in a country as vast as China.”1 Second, ninety rms headquarted in di¤rent cities in China have issued both A-shares and B-shares to investors as of December 2008. These two classes of shares have exactly the same voting rights and cash ‡ow rights. The only di¤erence between these two share classes is that B-shares were available only to foreign investors before February 19, 2001, whereas A-shares are available to domestic investors throughout the sample period.2 In the absence of market frictions, and under investor’s full rationality, classical theories predict that Aand B-shares should move in lockstep, and thus have return correlation close to one. It turns out that they do not. We nd a surprisingly low price comovement between A-shares and B-shares issued by the same rm. In fact, the typical return correlation between Aand B-shares issued by the same rm is even lower than the average B-share return correlation beCull and Xu (2005) provide some vivid contrasts. For instance, managers of private rms from Hangzhou resolve 21% of their disputes via the court system, yet the percentage is merely 0.1% for Dalian. Respondents report that business in Chongqing is twice as likely as in Wenzhou to uphold contract and property rights protection. The regional variations in PRP arise for a number of reasons, including the inter-judiciary competition that can result from the scal decentralization and capital mobility (Qian and Roland, 1998). Allen, Qian, and Qian (2005) discuss the roles of local government in during China’s economic reform, and contrast them to other transitional economies. After February 19, 2001, domestic investors are allowed to invest and trade in B-shares using their personal funds from their foreign currency saving accounts (i.e., “2001 B-share market reform”).