Using a comprehensive dataset of Chinese corporate bond issuances, we uncover substantial evidence of issuance overpricing: the yield spread of newly issued bonds at their first secondary-market trading day is on average 5.35 bps higher than the issuance spread. This overpricing is robust across subsamples of bond issuances with different credit ratings, maturities, issuance types, and issuer status. We further provide extensive evidence to support a hypothesis that competition among underwriters drives this overpricing through two specific channels—either through rebates to participants in issuance auctions or through direct auction bidding by the underwriters for themselves or their clients.

The Chinese stock market has grown very rapidly, but is often distorted by government regulation, and this is especially true for the initial public offering market. The average underpricing of Chinese IPOs is 247 percent, the highest of any major world market. We model this extreme underpricing with a demand-supply analytical framework that captures critical institutional features of China’s primary market, and then empirically test this model using a sample of 1,397 IPOs listed on the Shanghai and Shenzhen Stock Exchanges between 1991 and 2004. The pricing of IPO shares is subject to a cap set by the government, and the supply of IPO shares allowed on the market is also set by the government through the Chinese quota system. The government regulator even controls the timing of flotation of shares onto the stock exchange--after the initial public offering is executed--and there is usually a long time lag between the IPO and the actual listing of shares for trading. A special feature of the Chinese IPO market is that the government is by far the largest issuer. In our sample, 66 percent of the IPOs in our sample are pure share issue privatizations (SIPs), in which the government sells part of its ownership in state-owned enterprises (SOEs) to the public; fully 88 percent would be considered privatizations under a more expansive definition that included state-connected owners. Insider theft of corporate assets is also a big concern of IPO subscribers in China, and IPO shares must also be discounted for significant tunneling risks. We find that insider shareholdings are a negative determinant of initial returns. We suggest that investment risks in China's primary markets are greater than in other new issues markets, and these risks partly explains the extreme levels of Chinese IPO underpricing. However, the principal cause of the this underpricing is government regulation. The supply restricting measures traditionally adopted by the Chinese regulatory authorities turn IPO shares into hot commodities, which are fiercely bid for, and this leads to corruption and a reallocation of wealth from firms and investors to politically connected individuals and groups.