ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY CAPITAL IN HONG KONG K. A.

Wong*

Introduction Stock markets influence the functioning of an economy in two principal ways. Firstly, of capital, but such a change is difficult to measure. Moreover, the empirical evidence on

market developments may affect the national income through their effect on the aggregate propensities to save and to invest. Secondly, with

the impact of stock price fluctuations on savings over set periods is not uniform and clear.1 For Hong Kong, since it is an industrialised city, which depends upon export markets and uses imported raw materials, the problem of how to effectively allocate available financial capital between competing uses should have priority over the problem of how much to increase the total volume of savings or investment. In order to maintain equilibrium in the balance of payments,- it has to produce continuously the right

a given level of savings and investment, market arrangements can result in a more or -less efficient allocation of financial capital, which has an effect on productivity and economic growth. An improvement in the propensities to save and to invest might be achieved by increasing the types of securities available for investors and by reducing the risk premium reflected in the cost
313-

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

goods at the right prices for foreign markets. To produce goods at the right prices depends largely on the efficiency of its industrial production, which in turn depends substantially upon effective allocation of the limited available resources to many competing investment opportunities. Therefore, the effective allocation of

control can be exercised over the foreign markets. As foreign demand for individual Hong

Kong products will be variable, the-only prophecy that can be made with considerable confidence is that the process of adjustment will be continuous and important. Thus, a mechanism

for the allocation of available resources to alternative industrial investment opportunities must be effective in operation, in order to enable Hong Kong industry to make the necessary adjustments with the minimum of friction, waste, or delay. This is an important function of an efficient stock market. The main and most direct impact of stock markets on economic development comes from the facilities which enable the issue of securities

financial capital in the corporate sector is of prime importance, yet it has received little attention. It may be argued that forecasts of demand from foreign markets can be made. However,

these forecasts may prove wrong in important particulars. When forecasts prove wrong, in-

dustrial production must be adjusted to actual foreign demand and not vice versa, since no

Chart 1: New Issues of Securities by Direct Sale and Sale Through Stock Markets

Securities Issuers
(e) Direct sale

Direct sale

Financial Institutions

314

ON THE STOCK MARKRT EFFICIENCY AND CORPORATE EQUITY.

by government and corporations, whereby financial capital is made available to them for real investment activities, which increase the rate of output. However, by no means all new issues

a direct sale to financial institutions that issue their own (predominantly indirect) securities to' savers, and invest the funds so obtained in the securities of. other issuers. The difference be-

of securities are sold initially through the stock markets; direct sale is an important alternative mechanism. As delineated in Chart 1, there

tween a direct sale and a sale through the facilities of a stock market is important. However,

as financial capital can be allocated efficiently only under the market criteria, it is the sale through the facilities of a stock market with which we are concerned in this paper.

are three alternatives for issuers to sell their securities: (a) a direct sale to savers, (b) a sale through the facilities of a stock market, and (e)

The Stock Market and Corporate Equity Capital The stock market is an elaborate structure geared to bringing buyers and sellers of securities together. It consists of a new issue market and a secondary market. The former is essentially a group of financial institutions (issuing houses, underwriters, and broker-dealer firms) which facilitate the distribution of new securities, while the latter consists of stock exchanges and over-the-counter markets which facilitate the trading of existing ones. The performance The performance of the stock market affects the national economy, since it is this market that provides information to facilitate effective decisions in real investment activities. Its economic characteristics render a profound influence on the allocation of capital resources. Firstly, the secondary market is one of the primary sources of information to corporate management about the cost and availability of financial capital, which are important in determining the appropriate level of investment for a firm to undertake. Events in this market provide the basis for the terms and conditions that will prevail in the new issue market. Firms

of the market in existing securities will influence the financial condition of a considerable proportion of the population. . Many people are engaged directly in buying and.trading securities, while many more people are affected since the funds of their retirement and insurance schemes are largely invested in corporate securities.

whose share prices are high in relation to their expected earnings are encouraged to obtain more equity capital for expansion. Further, the mar-

315

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

ket promotes the demand for new securities, since it provides the means through which subscribers can dispose of their holdings in future if they desire. Secondly, the secondary market permits long-term investment to be financed by funds of a short-term nature. Many savers wish to make their funds available for only a limited period, or to be able to withdraw them at will. Without a secondary market, funds available for .subscribing to new shares would be very limited, since any subscription would mean a long-term 'lock-in'. Thus, a well-functioning secondary

vision of liquidity for quoted securities also facilitates collateral lending, if the holders are not willing to dispose of the securities when they are in need of funds. Fourthly, the stock market encourages the growth of the size of enterprises, since it offers the advantage of accessibility to numerous enterprcneuers. Many of them possess only a re-

latively small amount of funds, and yet, by selling securities through the market, they can control increased quantities of funds and carry out large investment projects, as well as mass production plans to achieve economies of scale. Moreover, the issue of new shares by quoted companies for additional capital will be cheaper and easier, since the companies are generally known to investors, and their pre-emptive rights for privileged subscription usually have an immediate market. As corporations are the most important economic institutions in a free enterprise economy, they require large, amounts of capital to finance their far-reaching business activities.

market makes it possible for firms to sell their securities at a price that yields a lower rate of return than would otherwise be required. Thirdly, the secondary market offers a simple mechanism for the transfer of securities and hence of funds. The transfer imposes only a

minimum administrative effort upon the buyer and seller of securities. Prices of securities are determined by 'matching buying and selling orders, and actual transactions and quotations are continuously reported by the stock ex-

Though non-financial corporations are commonly financed by the issue of both debt and equity securities, they usually have a substantially

changes. Moreover, the exchanges bring about the regular release of much financial information on quoted companies, so that investors are able to make an evaluation of company performance before making a decision; The pro-

larger proportion of equity capital, -For example, in the U.S.A., non-financial corporations have, on the average, financed about two-thirds

316

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY.

of their assets by equity funds.3

In developing

rewards; that efficiency in operations and attractive future earnings prospects must apparently provide correspondingly attractive returns to investors so that no matter what the company's dividend policies, rationality will force investors to act in such a way that prices will be governed by the earnings ability of the companies."4 If the price of a share will not be affected by the dividend policy, it appears that the company should finance its investment out of its retained earnings as far as possible, due to the reasons of convenience and lower costs. Funds

countries, the proportion is expected to be higher due to the narrowness of the corporate bond and debenture markets. In Hong Kong, corpora-

tions are almost entirely financed by the issue of ordinary shares. Therefore, a pre-requisite to

efficient allocation of economic resources is an effective allocation of corporate equity capital. In a well-functioning stock market, companies whose earning power is higher, will have higher share prices (with due allowance for risk differences) which encourage them to obtain more equity capital for expansion, since management seeks information on the cost and availability of equity funds for its investment decisions basically from the market. By contrast,

can be obtained only discontinuously from the market, while retained earnings flow smoothly to , the company. learnings, The cost incurred by retained if any, is much lower than that in-

companies whose operations are unprofitable, will have depressed share prices which deny them access to the market for additional equity funds, or make funds available to them only on unfavourable terms. Thus, funds will be more readily available to companies which can best make use of them in terms of profitability. The argument that the price of a share will ultimately be determined by the earnings potential, and not the dividend policy, of the company seems to be supported by most investment analysts. Professor W. J. Baumol also con-

volved in floating a new issue. Thus, it seems rational that a growth company should distribute a small dividend and retain much of its earnings for business expansion.5 In this case, the role

of the stock market in allocating corporate equity capital will be significantly reduced.6 The market will have little power to police the efficiency of individual companies. However, this

argument does not seem to be well-grounded. . Since share, prices are governed. by the:

earnings ability of the companies, virtuous management will use the same criterion, that is the margin between the expected rate of return and

cludes "that virtuous management brings its own

317-

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

the cost of capital established in the stock market, in making its investment decisions no matter whether funds are generated from retained earnings or obtained from the market. If manage-

evaluation of the company's shares. Thus, the power of the stock market to police the efficiency of individual companies is not reduced, even though the market only constitutes a last resort for capital funds. Although the large size of a stock market is not necessarily synonymous with efficiency, it has significant bearing on the breadth and absorptive capacity of the market, which are the principal facets of such efficiency. If a stock

ment ignores the market performance of its company's shares, and continues to reinvest retained earnings regularly even when no profitable investment opportunities exist, the depressed share price would make the company become attractive to a takeover candidate, especially to those companies that have really profitable investment opportunities but lack sufficient funds to pursue them. By taking over the inefficient company, the acquiring company simultaneously meets its own needs for funds and helps to assure the efficient allocation of corporate equity capital.
7

market is narrow and shallow, its efficiency in allocating corporate capital funds and in overseeing company operations will consequently be reduced, since the activity in the secondary market may not provide reliable guidelines for the establishment of terms and conditions in the new issue market. Sporadic supply and demand provide inadequate liquidity for prices of securities to reflect the earnings potential of the companies. In developing countries, the lack of information, the low rate of savings, the small size of companies, the domination of commercial banks in the financial sector, and the preference of savers to hold real property are the main factors accounting for this situation.

Further, management usually aims at

stability in the share price of its company not only for public relations reasons, but also for the better terms on which it can obtain funds from other sources. For public relations, the

performance of the company's shares serves as the most publicized indication of its success. In

obtaining loans from various sources, lenders are likely to base their risk estimates, and hence their interest terms, partly on the market's

SI 8-

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY.

Breadth and Absorptive Capacity of the Stock Market In Hong Kong, as shown in Table 1, the number of domestic companies quoted on the Hong Kong Stock Exchange was much smaller than that on various exchanges in different countries. However, the market capitalisation of Though there are 68 quoted companies which were not listed on the Hong Kong Stock Exchange, they must have contributed only a minor proportion to the turnover volume of the three exchanges concerned, since they are mainly new and smaller companies. By taking the total

these companies at the end of 1972 and their turnover volume in the same year were greater than those on several of the other exchanges. Further, the turnover ratio (defined as the percentage of turnover volume to market capitalisation) in 1972 was 47.7% which is the highest among the exchanges listed in the table. As Hong Kong has four recognised stock exchanges, the above discussion is not the whole picture of the situation. This arises because of

turnover volume of the four exchanges for the period of September 1971 to August 1972, as a percentage of the total market capitalisation of all quoted share issues on August 18, 1972, the resulting turnover ratio was 73.4% which is much higher than that for the Hong Kong Stock Exchange alone. Thus, the Hong Kong stock

market is rather narrow, though it is not shallow. The absorptive capacity, or the depth of a market, depends on the ease with which a substantial volume of trading can be conducted for each issue without significantly affecting its currently quoted price. One important evidence of the absorptive capacity is the number of board lots traded for each issue in one trading day.

the 128 domestic companies quoted on the Hong Kong Stock Exchange, 91 are also quoted on one or more of the other three exchanges (the Far East, Kam Ngan, and Kowloon Stock Exchanges). Further, the turnover volume of these three exchanges accounts for about three quarters of the overall share turnover in Hong Kong.

3-19-

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

TABLE

COMPARISON OF NUMBER OF QUOTED COMPANIES, MARKET CAPITALISATION, AND TURNOVER RATIO OF VARIOUS EXCHANGES * ('000m.) No. of domestic companies Country Exchange London Melbourne New York Tokyo Paris Amsterdam Brussels Johannesburg quoted 3,500 Market capitalisation, Turnover 31st Dec. 1972 volume, 1972 Turnover ratio (%)

U.K.8
Australia U.S.A. Japan France Holland Belgium South Africa

60.1 13.6"
370.0

10.0
6.0

16.6 44.1
'

1,520 1,505 1,130

850 750 700 606 260 128

67.7 28.4
3.3 2.5 0.5

18.3 44.9 25.0 43.116.7

5.2 9.7

63.2 13.2
5.8 . 3.0

11.6
3.1 6.5

0.6
0.3 3.1

Singapore/Malaysia Singapore/Kuala Lumpur Hong Kong

a b

Hong Kong

47.7

Adjusted to remove double counting. At 3Qth June, 1972. R. G. P. Carss, "Hong Kong Birth of a market," The Investment Analyst (June 1973), p. 30.

Source:

To obtain this evidence, a sample of

five

lots traded in each issue for the four stock exchanges as well as for individual exchanges were calculated by dividing the number of shares traded by the number of shares in one board

days, which were at different levels of the Hang Seng Index of share prices, and on different days of the week, was selected. The number of board 320

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY.

lot for individual issues.

The result of this

the total issues traded which had a turnover of under 6 board lots. In general, the evidence

calculation is shown in Table .2- which is classified in terms of the number of round board lots traded. If we presume that to have a good

tends to indicate that the overall absorptive capacity of the Hong Kong market is sufficient for a reasonably large volume of trading. Since Hong Kong has four recognized stock exchanges which hav.e a comparable share of the turnover volume (except the Kowloon Stock Exchange), the above conclusion becomes ten-* tative. Table 2 also shows the percentage dis-

market absorptive capacity, an individual issue should have over 50 board lots traded in One trading day,8 then on the average, about 50% of "the individual issues traded in 1972 qualified according to this criterion, and 20% of these individual issues had over 200 board lots traded in one day. There were only about 13 % of

tribution of the number of board lots traded for

TABLE 2 ABSORPTIVE CAPACITY OF INDIVIDUAL EXCHANGES: DISTRIBUTION OF NUMBER OF BOARD LOTS TRADED FOR EACH ISSUE" (in per cent) No. of board lots
1 6 5

Hong Kong

Far

Kam

All

East

Ngan

Kowloon
. 26.9

exchanges

24.0 21.6 29.5 15.9

14.8 15.0 26.6 18.5 14.6 10.5 100.0

:

23.5 21.6 2S.1, 12.8 ..... 10.4

3.6 ...

13.2 14.1 22.4 14.8 15.4 20.0 100.0

15 50

24.0 30.3 10.0

16

51 100
101 200

4.0 5.0
100.0

6.8 2.0
100.0

More than 200 Total.

a

100.0

The average percentage distribution of a sample of 5 days in 1972", which include May

8, September 21, November 9, November 2'9, and December 29.

Sources: Computed from the Hong Kong Standard, and Year Books of the stock exchanges. 321

10
each issue in individual exchanges.

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

As there

Exchange, however, has a substantially larger absorptive capacity. It only had about 15% of

are many issues simultaneously quoted on all exchanges, the absorptive capacity of individual exchanges is substantially different from that of the overall market. With the exception of the

the total issues traded with a turnover of under 6 board lots, about 44% with a turnover of 50 board lots, and over 10% with a turnover of over 200 board lots in a trading day. This

Far East Exchange, about one quarter of the total issues traded in each of the other three exchanges had a turnover of under 6 board lots, about another quarter (about 19% for the Kowloon Stock Exchange) had a turnover of over 50 board lots, and only a few per cent of the total issues traded had a turnover of over 200 board lots in a trading day. The Far. East

evidence indicates that the existence of four independent stock exchanges has weakened . the absorptive capacity of the Hong Kong stock market. A merger of amalgamation of the four exchanges would improve the absorptive capacity.

Stock Market Efficiency A common concept of an efficient market is one in which a large number-of buyers and sellers react through a sensitive and efficient mechanism to cause every price to reflect fully and quickly all the available information about the prospects of the companies whose securities are being traded, and any new information cannot be used to obtain abnormal returns.
9

this subject. However, there are several difficulties with this concept. The essence of the concept is that in an efficient market, prices adjust rapidly to new information. But the problem is how to distin-

guish misinformation from the information which" is relevant to the earnings prospect of the company and the riskiness of its shares.' The data which is available to investors, consists of many items ranging from the reliable and highly relevant, to the misleading and irrelevant, so thatit is difficult to define, let alone distinguish between, information and,misinformation..' Further, investors place different degrees of re-

This

way of looking at things led to a change from the random-walk hypothesis, with which investigators started and concentrated on the issue of whether or not ordinary share prices follow a random walk, to the efficient market hypothesis which now dominates most discussion of

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY.

1 1

liability and relevance on the data, which may vary widely from its true value, though these disparities may be reduced to some extent by securities regulation. Share prices will also be influenced by the expectation of individual investors as to future price levels, though companies with a better earnings ability will have higher share prices provided that sufficient information is available for the investors. Fur-

and thus, the yield from the holding of securities, it will be able to maintain equivalent rates of return or costs of capital on comparable invest-' ments. This facet would ensure the flow of

funds from savers to those users who will us'e them most profitably. Indeed, the market would fail to serve as a means of disciplining management to maintain the efficiency of company operations, if security prices were divorced from corporate earnings prospects. The most satisfactory way of evaluating the ai locative efficiency of the market is to inquire whether the outcomes are the best obtainable with the information available at the time the decisions were taken. This evaluation can only be done after the event by assessing the extent to which the variations in market yield can be explained by differentials in risk. Though this assessment can provide a retrospective view of the allocative efficiency of the market, it is obviously impossible to tell how the outcomes compare with the best obtainable when the decisions were made. Therefore, the retrospective assessment cannot provide an adequate measure of absolute allocative efficiency of the market.11 Further, the underlying assumption that average realized return over a period should increase with the level of risk (by assuming that investors : are risk averse) may be questionable, since the

ther, the efficiency of the market will not be independent of the cost incurred, since the cost has a bearing on such vital matters as turnover and marketability which affect the terms and conditions of new issues. Thus, the efficiency of the market may be looked at from two points of view. One is to assess the quality of the

service rendered in determining prices, or looked at another way, yields from the holding of securities, since this is what governs the allocation of financial capital. The other is to measure the market's operational efficiency in terms of costs incurred.
10

Since it is the market yield differentials (with due allowance for differences in earnings prospect and risk) which ensure the flow of funds from one use to another, this yield forms the main guideline for the allocation of financial resources. If the market performs. its tasks

efficiently through determining the price level,

.323

12

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

empirical evidence on this relationship is by no means uniform or strong. In fact, a study of

ment advisors and portfolio managers; the development, disclosure, and dissemination of all possible relevant information; and a regulatory climate which minimises the opportunities for destabilizing speculation.14 Another measure,

the relationship between risk and returns on ordinary shares quoted on the New York Stock Exchange for the period 1926-68 shows that the results are sensitive to how returns are measured but not to the measure of risk. Further analysis of these results does not provide any consistent evidence that investors were able to obtain higher returns by holding more risky shares.!However, what is reasonably clear is that assuming the absence of all friction, and given complete mobility and instant transformability
*

which is of crucial importance, is to minimise the costs of issue to the issuer and of security transactions to the public, since such costs may be regarded as payments to attain allocative efficiency. Fortunately, the measurement of the market's operational efficiency in terms of cost is .a somewhat more direct and distinct approach to allocative efficiency. Although this approach is

of all resources, these resources will go into those uses with greater profitability than in any other.13 Though the stock market alone does

partial, it constitutes an important measure of allocative efficiency, since operational efficiency has an important bearing on the degree of market activity which provides signals for efficient allocation of investment funds. The relatively

not direct the overall investment of an economy since allocation of funds also proceeds by ways of direct investment and through public authorities, it can improve the efficiency of allocating that part of investment funds which goes through it. Thus, the larger the volume of investment

high costs of issue, and trading of securities not only distort market activity but also reduce the volume of funds flowing through the market. Of course, cost minimisation should be achieved through the pressure of competition without deteriorating the extent and variety of services furnished. Operational efficiency is concerned with the relative, cost of providing a given service. In

funds flowing through the market, the higher the efficiency of allocating financial resourcesThere are various measures which might contribute to the allocative efficiency of .the market, careful financial analysis by - the. issuing houses and related institutions prior to the- flotation of a new issue and subsequently by invest-

the new issue market, underwriting commissions

324

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY

13

and other flotation costs constitute the costs of intermediation between savers and issuers. In

two commissions but also the relevant regulatory costs paid. Both the costs of new issue and of trading will tend to vary inversely with the volume of commitments.15 Operational effi-

the secondary market, the costs of trading inelude all transaction costs in the public transfer of existing securities from a seller to a buyer. The transaction costs consist of not only the

ciency may be measured by these costs, and is an inverse function of them.

Costs of New Issue and Trading

The conventional costs of issue include underwriting commission, stock exchange quotation fees, printing and advertising costs, reporting accountant's fees, valuation and legal fees, and other administrative costs. Underwriting corn-

missions were paid with every issue in our sample, though in London, the placing method itself amounts to a form of underwriting and no separate underwriting commission is disclosed.15

Table 3 A Comparison of the Magnitude of the Conventional Costs of Issue and the Market Discounts in Hong Kong and London (as a percentage of the net size of issue) Weighted Average of Conventional Costs Weighted Average of Second-day Market Discount Offers for Sale: Hong Kong London Stock Exchange Placings: Hong Kong London

Method of Issue

Period

1970-73 1959-63 1970-73 1959-63

4.2 9.6 6.0 8.6

80.0 13.7 108.9 ' 19.2

Sources: K. A. Wong, The Stock Market in Hong Kong (unpublished Ph.D. Thesis, University of Liverpool, 1975), p. 257; A. J. Merrett, M. Howe, and G. D. Newbould, Equity Issues and The London Capital Market (Lond.: Longmans, Green & Co., 1967), pp. 141-42. -325

14

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

As shown in Table 3, total conventional costs of issue as a weighted percentage of net size of issue for offers, 4.2%, was considerably lower than that for placings, 6%. This is rather

However, the correlation coefficient between issue costs and issue size for both methods was high, being 0.869 and 0.829 respectively. Both were statistically significant (t test) at under the 0.1 % level. In general, the conventional costs of issue for either an offer for sale or a placing were lower in Hong Kong by compared with those in London. The difference between the issue price set by the issuing house and the subsequent market price when dealings on the stock exchange begin is termed as "market discount". The market

surprising at first sight, since it is against our expectation that the costs of placings should be less than the costs of offers in view of the economies of some items of cost in a placing, e.g., advertising expenses, and costs of allotment. In fact, the average costs of issue were 9.6% for offers and 8.6% for placings in the London market in 1959-63.17 However, the relatively

low average costs of offers can be explained by the substantially larger average size of issues made by this method in the period 1970-73, about 5.5 times of the average size of placings. If the costs of offers contain a sizable amount of fixed costs which are not affected by the size of issue, a larger average size of issues would result in a lower percentage of costs of issue. This reasoning is confirmed by regression analysis. For the 45 offers made in 1970-73, the estimated amount of fixed cost element was HK$0.584 million, while for the 99 placings it was only HK$0.146 million. Further, the size

discount as a whole is not purely the result of inaccurate pricing since many changes, which can affect the subsequent market price of the shares, may occur during the short period between the date of issue and the commencement of dealings on the stock exchange. However,

if we use the maximisation of the net worth of the existing shareholders as our basic criterion, the issuing house should minimise that part of market discount which is derived from inaccurate pricing of the shares in issue. Table 3 also shows the average size of the second-day market discounts as a percentage of the net size of issue for the period 1970-73, .which was as high as 80%. for offers and 108.9% for placings. This is striking if com-

of issue coefficient for offers, 0.0290, was much lower than the coefficient for placings, 0.0425; the variable costs rose much slower for offers than for placings when the size of issue rose.

pared with their counterparts in the London

326-

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY.

15

market, where the corresponding average was as low as 13.7% for offers and 19.2% for placings for the period 1959-63. However, the unusual

method, the public is invited to indicate the price at which it would be prepared to pay for certain quantities of the shares in issue. On the basis of this valuation, the issuing house fixes an allotment price for the shares. Thus, the

high market discounts must be to a large extent caused by the extremely buoyant and speculative market condition from October 1972 to March 1973, since the average market discounts were 11.1% for offers and 13.5% for placings in 1970-71.
18

loss suffered by the existing shareholders due to under-pricing the shares in issue can be minimised by employing the tender method. Fur-

ther, as the allotment price is fixed on the basis of the market valuation of the shares at the date of issue and this fact is known to the investing public when dealings begin, the public is likely to expect the immediate subsequent market price to approximate to the allotment price. Thus, the subsequent market price is

Further analysis indicates that the market discount was greatly influenced by the general condition of the stock market which varied from year to year. This variation implies that there might have been a different degree of speculative activity in each year and in each issue. The

market discount can largely be the effects of slagging, speculative activity, and psychological factors which push up the subsequent market price of the shares and create a keen demand from the investing public. This situation is in turn largely due to the change in market conditions, the manipulation of additional information available after the issue, and the causes and effects interaction in market activities. ' A n y method of issue, which has a characteristic of being able to reduce the market discount, is economically a more effective method, e.g., the offer for sale by tender. By using the offer for sale by tender

difficult to be significantly influenced by speculative activity. The cost of dealing in the secondary market is generally composed of two principal items, brokerage commission and stamp tax. Both the buyer and seller of securities are charged with a brokerage commission and a Ad Valorem stamp duty. As shown in Table 4, the commission

rate charged by stockbrokers in Hong Kong compares favourably with that in many other countries. If we accept the figures listed in the table, a substantial reduction of commission rates in most of the countries must occur before such rates become comparable to that in Hong

.327-

. 16 Kong.is

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII However, this comparison must be Kong seldom provide research materials and sophisticated investment advice for their clients.

treated with caution since stockholders in Hong

Table 4 COMPARISON OF BASIC COST OF A MEDIUM-SIZE SHARE TRANSACTION" (Percentage of the consideration)

Country United States United Kingdom West Germany Luxembourg Belgium France Italy Netherlands Hong Kong

Commission rate 1.70"

Stamp tax
0.1 Oc

Total

1.80 2.25 1.12 0.80 1.15 1.30 0.71 1.86 0.90

1.25 0.87 0.80 0.75 0.70

1.00 0.25

0.40 0.60
00125

070
0.66 0.50

1.20 0.40

" Transaction involving a consideration of about US$1,000. by both buyer and seller.
b

These charges are payable

This figure is misleading for the average share transaction on the New York Stock

Exchange amounts to almost US$5,000 for which the commission rate would be 0.89%.
c

New York State Tax paid by the seller applies to the transfer of shares in New York

State. Sources: Committee for Invisible Transactions, Capital Markets Study: General Report (Paris: OECD, 1967), p. 212; Hong. Kong Stock Exchange, Year Book 1974.

328

ON THE STOCK MARKET EFFICIENCY AND CORPORATE EQUITY.

17

Concluding Remarks As the number of quoted share issues is small and the overall turnover is relatively high in comparison with markets in other developed countries, stockbrokers in Hong Kong have maintained a reasonably close and efficient market for quoted shares. Since almost none of the stockbrokers provide investment information and sophisticated advisory services, they are able to charge a cost of trading lower than that in many foreign markets. Though the overall absorptive capacity of the market is sufficient for a reasonably large volume of trading, this capacity has been weakened by the existence of four separate stock exchanges. An amalgamation or merger will improve the capacity of the market. The efficient allocation of investment funds needs not only accurate signals from the trading market but also low issue costs in the new issue market. During the period 1970-73 as a whole, the average costs of issue as a percentage of net size of issue was 4.2% for offers and 6% for placings. However, both the offer and placing methods cannot avoid the market discount, which adds considerably to the costs of issue. Thus, the market should look to a more efficient method, the offer for sale by tender, which can minimise the market discount by referring to the actual demand in setting the issue price, and thereby reduce speculative activity in the aftermarket. Though the government has to some extent strengthened the operations of the secondary market through regulations and supervision, it should also help to develop new institutions that hold securities in their asset portfolios, e.g., pension funds and unit trusts, and regulate the asset portfolios of various classes of financial institutions. It is institutional investors that are most likely (in pursuit of profit) to be concerned periodically with reshuffling their portfolios,

and in that way to increase the turnover of the market and to foster the emergence of a flexible and consistent structure of yields.

329

18

NEW ASIA COLLEGE ACADEMIC ANNUAL VOL. XVII

*Dr. K. A. Wong is Lecturer in Accounting and Finance, New Asia College, The Chinese University of Hong Kong. i Robert H. Rasche, "Impact of the Stock Market on Private Demand," American Economic Review (May, 1972), pp. 220-28. - In recent years, the trade deficits (about 30% of total exports) have been largely compensated by tourist trade and net capital inflows. '' Richard R. West and Seha M. Tinic, The Economics of the Stock Market (N.Y.: Praeger Publishers, 1971), pp. 6-7. * William J. Baumol, The Stock Market and Economic Efficiency
p. 59.

and the Regulation of Corporate Securities, ed. by Henry G. Manne (Washington, D.C.: American Enterprise Institute, 1969), pp. 189-202; Irwin Friend, "The Economic Consequences of the Stock Market," American Economic Review (May 1972), pp. 213-18; W. A. Thomas, A United Stock Exchange The Road Ahead (Tilburg: S.U.E.R.F., 1973), pp. 8-9.
11

Though it may be used to analyse the impact

of specific financial developments and practices (e.g., securities regulation and institutional equity investment) on relative allocative efficiency.
12

Friend, "The Economic Consequences of the C. W. J. Granger and Oskar Morgenstern, Pre-

Stock Market," pp. 215-16.

13

(N.Y.: Fordham Univ. Press, 1965),

dictability of Stock Market Prices (Lexington, Mass.: D. C. Heath & Co., 1970), pp. 38-9.
14

s A small dividend or a small increase in the dividend is desirable, since this is an effective way of communicating a company's earnings potential between management and shareholders. Moreover, it will keep small investors happy.
K

Friend, "The S.E.C. and the Economic PerIbid., pp. 189-90; Thomas, op. cit., p. 9. In an offer for sale, the whole block of new In a stock exchange placing, the shares

formance of Securities Market," p. 191.

15 16

W. Arthur Lewis, The Theory of Economic West and Tinic, op. cit., p. 8. In terms of money value, 50 board lots have an

shares is offered to the public for subscription at a stated price. in issue are not offered to the public but placed with brokers on the stock exchange. In Hong Kong, the shares in issue are underwritten by the issuing house under both methods. " A. J. Merrett, M. Howe, and G. D. Newbould, Equity Issues and the London Capital Market (Lond.: Longmans, Green & Co., 1967), p. 113.
18

Growth (Homewood, 111.: R. D. Irwin, 1955), p. 267.

7 8

amount in the range from about HKS0.20 million to about HKS1.00 million, due to the difference in number of shares constituting a board lot for different issues. 9 E. F. Fama, 'Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance (May 1970), p. 383; James H. Lorie and Mary T. Hamilton, The Stock Market: Theories and Evidence (Homewood, 111.: R. D. Irwin, 1973), Chap.
4.
10

K. A. Wong, The Stock Market in Hong Kong - ' The stamp tax in Italy is much lower

(unpublished Ph.D. Thesis, University of Liverpool, 1975), p. 240.

19

In Luxemburg, no stamp duty is paid for share

transactions. Irwiu Friend, 'The SEC and the Economic

than that in other countries.

Performance of Securities Market," in Economic Policy

-=.330--