Effects of Short-Sale Constraints on Stock Prices and Trading Activity : Evidence from Hong Kong and Mainland China

There has been extensive literature on effects of short-sale constraints. A most widely study is Miller (1997) who argues that given the short-sale constraints, investors with bearish information cannot trade in the market unless they already hold the stocks. As a consequence, stock prices reflect opinion of optimistic investors, but not of all pessimistic investors. The effect of short-selling on overvaluation has received some empirical support in the U.S. market. The objective of this paper is to examine the effect of short-sale constraint on pricing efficiency in the China market. Not only that we provide additional evidence outside the U.S., the unique setting in the China market makes it an ideal laboratory experiment for providing direct evidence on the effect of short-sale constraint on the stock valuation. Many Chinese companies are dually listed in the Mainland and Hong Kong, either as A-shares listed in Shanghai or Shenzhen, or as H-shares in Hong Kong. Until now, all A shares are prohibited from short-selling. On the other hand, for those H shares which are listed in Hong Kong, some can be sold short and some cannot. This leads us to develop two hypotheses. The first is that the A-H premium is higher for those H share stocks subject to less short-selling restriction than for those subject to more restriction. The second is that the A-H volume ratio is lower for those H shares subject to less short selling restriction than for those subject to more restriction. We conduct empirical analysis using data on companies that are listed in both the A-share and H-share markets from 1996 to 2008, and provide evidence consistent with the two hypotheses