Tutor : Ph . D . Göran Hägg February 2001 THE CHINESE EQUITY MARKET An Economic Inquiry into Investment Opportunities and Risks Master ’ s Thesis in Economics Authors : Jens

The emerging market China is currently one of the most attractive and promising markets in the world. Many investors want to benefit from the high growth and promising economic outlook and therefore invest in China equity funds. However, both opportunity and risk factors need to be taken into consideration, and we have concluded that most of the Chinese market’s opportunities can be derived back to economic structure and trade conditions, whereas most risk factors can be derived back to political and institutional conditions. The final aim of this thesis is to evaluate these opportunities and risk factors, more precisely, in terms of pros and cons of investing in China, and also to elaborate an optimal portfolio strategy. The methods we have used is partly qualitative and partly quantitative, and our analysis is backed up by a broad analytic toolbox of macroeconomic theory, portfolio theory, institutional theory and research on emerging markets that have enabled us to analyse China from different perspectives. Our conclusion is that there are mainly three pros for investing in China: (1) the economic liberalisation and reforms of the institutional framework which creates further incentives for growth; (2) the Chinese market’s huge potential and the high-growth sectors IT and telecommunications that lead the way for China’s expansion; (3) a favourable macroeconomic climate and an impressive development. However, there are also mainly five cons for not investing in China: (1) the mismanagement of the state-run companies constitutes a large risk; (2) the mainland exchanges’ intra-year volatility discourages short-term investments; (3) the export sector’s performance might decline as the economic outlook for China’s biggest trade partners has been marked down by the IMF; (4) the institutional framework is largely responsible for many risk factors such as scarce market information, lack of insight and public control; (5) a tougher competition climate after the entry in the WTO may affect several of China’s industries and cause bankruptcies and mergers but also a speeding up of the institutional framework. We have studied the effects of three different portfolio combinations: a World/Hong Kong portfolio, a World/Shenzhen portfolio or a World/Shanghai portfolio. Our calculations indicate that only the Hong Kong Stock Exchange is positively correlated with the World Index, whereas both mainland stock exchanges are negatively correlated. They also show that it is the World/Shanghai portfolio that has the highest expected return and standard deviation. The World/Hong Kong and World/Shenzhen portfolios’ expected returns and standard deviations are roughly the same. Thus, our argumentation on an optimal portfolio strategy suggests that less risk-averse investors may want to consider the World/Shanghai portfolio, whereas the World/Shenzhen portfolio might instead better suit the preferences of more riskaverse investors.