Capital Account Liberalization and Dynamic Price Discovery: Evidence from Chinese Cross-Listed Stocks

Abstract

We analyze the effects of a recent financial reform that enables cross-market investment between Hong Kong and Shanghai stock exchanges. Using a vector error-correction model, we find that the reform announcement considerably narrows the equilibrium level of price disparity and strengthens the price comovement of shares that are cross-listed in both markets. First, there is a substantial increase in the number of cross-listed firms with cointegrated share prices, and the estimated equilibrium relationship is in support of the relative law of one price. Second, our model predicts that the price disparity narrows by as much as 40 percent in equilibrium. Third, we find that both markets adjust in response to a disequilibrium in price disparity, leading to a sizable error-correction activity. The Shanghai market contributes to approximately two-thirds of the price discovery process. Competition and informativeness of trading affect the relative role of price discovery in each market.

Keywords: Capital account liberalization, co-integration, vector error-correction model, cross-listing, Chinese A-H shares

JEL Classification: F36, G18, C32