Las reformas desde

China began to open its economy in 1978. After the successes of farm liberalization in the 1980’s China began to shift its focus to building stronger financial markets. To that end they opened the Shanghai Stock Exchange on December of 1990. It was followed in 1991 (a year later) by the Shenzhen Stock Exchange.20 Most of the original companies listed on the two exchanges were state-owned enterprises. The first shares traded on the exchanges were A-shares. A-shares are denominated in Renminbi (RMB) and are issued to local investors. In 1992 the two exchanges also began trading B-shares. B-shares are denominated in U.S. dollars and allowed foreigners, for the first time, to own and trade shares on the two mainland exchanges.

During this initial start-up period, the Hong Kong Stock Exchange had already

established itself as a major figure in the Asian financial markets. China knew of Hong Kong’s ability to raise large amount of capital and soon approached the Hong Kong Exchange with an offer. In 1993 China brokered a deal between the Hong Kong Exchange and the two mainland exchanges called the Memorandum of Regulatory Co-operation. This allowed Chinese

businesses to be listed directly on the Hong Kong Exchange. Since Hong Kong begins with the letter “H” the new shares were known as H-shares.

H-shares are stocks traded on the Hong Kong stock market and are denominated in Hong Kong dollars. In order to sell H-shares companies must meet certain requirements: (1) the company must be incorporated in mainland China; (2) the company must have a market capitalization of HK $200 million; (3) the company must have earned, 3 years prior to

application, a profit of HK $5 billion; this means a profit of HK $2 billion the year before the

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Shenzhen was designated by the state as a special economic zone in 1980. The stock exchange extended its growing financial flexibility.

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application and a total profit of HK $3 billion the two years prior to that; and (4) during the 3 year period prior to application management must have remained unchanged.

A-shares generally trade at a premium to H-shares, and this might be partially due to the fact that the Chinese government restricts mainland Chinese from investing abroad and

foreigners from investing in the H-share market in mainland China. In mainland China, there are three ways for individual investors to invest in H-shares: (1) individual investors can travel to Hong Kong to set up an account in Hong Kong to buy H-shares; (2) individual investors can buy H-shares through Hong Kong brokerage companies that have offices in China; (3) in selected cities, individual investors can purchase H-shares using a special service called “H-share Express” provided by the Bank of China.

In contrast, institutional investors on the mainland, such as mutual funds and social security funds, can invest in H-shares. State social security funds are large players in the Hong Kong market. However, Hong Kong and international investors can only invest in H-shares. According to the trading regulations in mainland China, Hong Kong and international investors are restricted to investing in A-Shares.

Historically Chinese domestic A-shares are divided into tradable and non-tradable shares, even though both types of shares have the same cash flow and voting rights. This unique split- share structure can result in divergent interests and incentive conflicts between tradable and non- tradable shareholders. It has long been recognized as a source of corporate governance problems in China. To help solve these fundamental governance problems, the Chinese government initiated a split-share structure reform program in April 2005. The aim of the reform was to convert non-tradable shares into tradable shares. The non-tradable shareholders gained from the reform as their shares become tradable (this increased liquidity and enabled controlling

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shareholders to sell at market prices). In contrast, tradable shareholders suffered in the short term since there was an extra supply of tradable shares in the market, and this lead to a steep decline in stock prices.

The roles of state shareholders and mutual funds in this reform are particularly interesting. The state is the largest non-tradable shareholder, while mutual funds are the largest type of institutional investor for tradableshares in China‘s stock market. Thus, non-tradable

shareholders need to offer compensation to tradable shareholders (including mutual funds) in order for the latter to agree to the reform. In theory, the interests of mutual funds should align with the interests of individual investors for tradable shares. Individual investors can therefore free-ride on the efforts of mutual funds in the belief that the funds will be looked after. However, in recent research (Mehran and Stulz (2007)), it has been shown that the incentives facing

financial institutions are complex and conflicts of interest and political pressures often arise. Regarding mutual fund growth in China, since 2000, the growth of the industry has been phenomenal. The voting rules set out by the CSRC21 Measures(2000) make mutual funds a powerful and influential party in the bargaining process because mutual funds frequently appear in the top-ten shareholders of many listed companies. The attitudes of the mutual fund

shareholders were therefore crucial to the passing of the proposed reform plan. As such, it is interesting to examine the impact that mutual fund shareholders have on a firm’s transparency and corporate governance, as well as the relative pricing of A-and H-shares.

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