Analysis of Chinese financial markets

This thesis comprises a series of four inter-related essays on the efficiency of Chinese financial markets, and on incorporating efficient markets into a small macroeconomic model. The first essay (Chapter 2) examines the extent of integration of the Shanghai and Shenzhen stock markets to determine which of these provides the better representation of share market behaviour in China. The preferred one is applied throughout the thesis. A test for cointegration of the Shanghai share price index with seven other international indices is then conducted. The increased extent of the integration between the representative index and seven selected international indices indicates increasing efficiency in the overall Chinese share market through time, and leads to the analytical focus of the second essay (Chapter 3). This focus involves the convergence of share prices of firms cross-listed on the Shanghai and Hong Kong exchanges in terms of the law of one price. The results indicate that, in recent times, firm-level share prices converge to the law of one price. The investigation of financial market integration is then extended to the bond market in the third essay (Chapter 4) where exchange rate convergence is examined using the Svensson model of the term structure of interest rate differentials. The mean reversion property of the exchange rate, as a feature of the Svensson model, is found in Chinese and US bond markets and provides complementary evidence of recent integration of Chinese financial markets. The results of the first three essays establish evidence of well-integrated financial markets in China, setting the scene for explaining the role of an efficient financial market in influencing output under a fixed exchange rate. In the final essay (Chapter 5), a model is developed, for this purpose involving the integration of efficient financial markets into an open-economy framework with perfect capital mobility, perfect foresight, and a fixed exchange rate. The dynamic behaviour of output, the exchange rate and the stock price in response to an unanticipated demand shock are characterised and validated by the simulated scenario of a negative demand shock occurring in China in 1997. The model is designed to capture the key features of the major dynamic forces shaping the fixed exchange rate regime and the major financial linkages governing the response of the economy. Articulation of asset market dynamics for a fixed exchange rate regime represents a major contribution of the thesis.