How regulatory changes affect IPO underpricing in China

Abstract

This paper examines the underpricing of IPOs in the Chinese A-share market during the period 1992–2006. Since its inception, the Chinese IPO market has transformed from a tightly-controlled system to a more market-oriented system. Reforms include the abolishment of listing quotas and fixed issue price determination; allowing for more market participation in IPO pricing. The regulatory changes of Chinese IPO market, though improving over time, actually are not monotonic. The regulatory framework started from over-restrictive to over-unrestrictive, then fine-tuned with additional restrictions. This study documents the regulatory reforms during the sample period and investigates how these regulatory changes affect IPO underpricing in China. During this period, we find that Chinese IPOs exhibit a huge underpricing. The size of the underpricing, however, decreases over the sample period. This study further finds that the IPO pricing method before the regulatory changes, which was based on a fixed P/E ratio pre-determined by the regulators, contributed significantly to the IPO underpricing in China. After adopting a series of regulatory reforms allowing underwriters discretion in the determination of issue price, this regulatory underpricing component vanishes. This study has policy implications in demonstrating the impacts of regulatory frameworks on IPO underpricing.

Introduction

Initial public offerings (IPOs) are generally underpriced. This underpricing phenomenon has been well documented in the US market¹ and can also be found in other markets. Loughran Ritter and Rudqvist (1994), for example, document short-run underpricing in 25 countries. Short-run underpricing of IPOs is found in all 25 countries, although the magnitude of underpricing varies. Few papers focus on the Chinese IPO market because the Chinese equity market is relatively new. Those that do, however, document a huge IPO underpricing in China. While this paper investigates the short-term underpricing of IPOs in China, the purpose of this study is not to simply add another piece of evidence for this phenomenon. Rather, we address the impacts of the regulatory framework on the IPO underpricing.

China has experienced rapid economic change since the start of economic reform just over 30 years ago. The development of the Chinese stock market has been the foundation for corporate sector reform. The Chinese stock market has developed rapidly and has transformed itself from a centrally controlled market to a market-oriented market. During the course of this development, there has been a series of regulatory changes in the Chinese IPO procedure. These reforms include the abolishment of listing quotas and fixed issue price determination. The regulatory changes of Chinese IPO market, though improving over time, actually are not monotonic. The regulatory framework started from over-restrictive to over-unrestrictive, then fine-tuned with additional restrictions. This study aims to investigate the characteristics of the Chinese IPO market after the some regulatory changes. In particular, how the regulatory changes affect the underpricing phenomenon of Chinese IPOs. China has provided a useful experimental field for the design of IPO process. This has policy implications for transition economies during the privatization process.

As a major initiative of economic reform, two stock exchanges were established in mainland China, in Shanghai and Shenzhen, in 1990 and 1991, respectively. The Chinese authorities played a dominant role in the early stages of the stock market development. The China Securities Regulatory Commission (hereafter, CSRC)² decided who should be listed and how issue prices should be determined. These controls distorted the market mechanism and may have contributed to the huge IPO underpricing. Originally, a fixed price earnings (P/E) ratio method, pre-determined by the CSRC, was used to determine the issue price of an IPO. This IPO pricing method has gone through several transformations from the fixed P/E method to a book-building approach, giving underwriters more discretion in the determination of issue price. A brief history of the regulatory changes is summarized in the next paragraph.

In July 1999, the CSRC introduced a cumulative auction method for determining IPO pricing. Under this method, underwriters set a price range and seek investor bids within that range. In theory, this method should bring the IPO pricing more in line with market demand and better reflect a new issuer's valuation. This may work well for developed markets but did not work in the Chinese IPO market. Investors, in particular retail investors, were not capable of judging a new issuer's valuation. This resulted in some overheated IPOs with very high P/E ratios in 2000.³ The cumulative price inquiry method with an upper limit set for the offering's P/E ratio was introduced in July 2001. The objective was to cool down overheated IPOs with excessively high P/E ratios by putting a cap on the IPO's P/E ratio. However, this restriction was applied across all industries, ignoring the characteristics of different industries. This distorted the market mechanism and created an imbalance in market supply and demand. In January 2005, the cumulative price inquiry from institutional investor method was introduced for pricing IPOs. This method allows underwriters to seek bids from institutional investors and the final negotiated price is used for the retail offering.

Our sample consists of 1446 IPOs listed on the Shanghai and Shenzhen stock exchanges from 1992 to 2006. The sample period covers the beginning stages of the equity markets in China. Over this period, Chinese regulators introduced a number of changes to the rules governing the listing of companies. These changes are found in the Listing Rules, Company Law, and Securities Law that affect the application, approval, and listing process of new issues. The objective of these listing rules is to improve market transparency and to provide better investor protection. One of the most important changes involved switching the issue price determination from the fixed P/E ratio method to a book-building method. This allows the market mechanism to play a more important role in the determination of IPO prices.

This study examines the impacts of regulatory changes on IPO underpricing. These reforms are designed to provide investors with a more accurate determination of an issuer's valuation. As IPO underpricing is a well documented world-wide phenomenon,⁴ these reforms may not completely eliminate IPO underpricing in China. In theory, however, these reforms should bring the offering price more in line with the market situation and should reduce IPO underpricing.

In this study, we divide the sample period into four sub-periods based on the regulatory changes. We examine how the regulatory changes affect the dynamic between the IPO underpricing and the underlying factors during the different sub-periods. Our findings are consistent with the existing literature that Chinese IPO underpricing was occurring during the sample period and that the size of the underpricing decreased over the sample period. The results show that IPO underpricing is significantly related to: P/E ratio differential (negative), capital raised (negative); offer price (negative); and the 30-day cumulative pre-market return before listing (positive). The relations between the IPO underpricing and factors including capital raised, offer price, and pre-market performance are consistent for all sub-periods. The P/E ratio differential (the ratio between the pre-set IPO and industrial P/E ratio on the listing date) is used to measure the regulatory distortion on IPO underpricing. Interestingly, our findings show that the P/E ratio differential was only an important determinant for IPO underpricing in sub-period 1. This shows that the fixed P/E ratio pricing method contributed significantly to IPO underpricing. Its importance in underpricing vanishes after the regulatory change.

The rest of the paper is organized as follows. Section 2 gives a brief review of the existing literature. Section 3 describes the regulatory framework of the Chinese IPO market. Section 4 develops the hypotheses tested in this paper. Section 5 discusses the data used in this study. Section 6 presents the empirical findings. Section 7 concludes the paper.