Zhiguo He, Wenxi Jiang, and Wei Xiong, leading finance professors from Stanford University, the Chinese University of Hong Kong Business School, and Princeton University respectively, have published groundbreaking research that re-evaluates the informational efficiency of China’s stock market. Their recent paper, available on SSRN, suggests that while the A-share market exhibits a degree of short-term earnings predictability, this phenomenon is not solely a reflection of pure fundamental information. Instead, the research posits a complex interplay where high market valuations may incentivize listed companies to engage in earnings management, particularly through the strategic use of non-recurring gains and losses (NRGLs), to meet investor expectations. This creates a distinct pattern of short-run predictability followed by longer-run earnings reversals, indicating that price informativeness and earnings management can mutually reinforce each other in China’s evolving capital markets.
Background: China’s Evolving Capital Markets and the Debate on Price Informativeness
China’s A-share market, characterized by its rapid growth and significant retail investor participation, has long been a subject of intense scrutiny. Policymakers have aspired to transform it into a crucial platform for financing innovation, fostering corporate discipline, and enabling household participation in economic growth. However, persistent concerns regarding speculative trading, the dominance of retail investors, historical weaknesses in delisting mechanisms, and recurring questions about the quality of financial reporting have clouded this vision.
Against this backdrop, a growing body of academic literature has presented a more optimistic outlook. Pioneering work, such as that by Bai, Philippon, and Savov (2016), proposed measuring price informativeness by examining whether current market valuations predict future corporate earnings. Subsequent studies, including Carpenter, Lu, and Whitelaw (2021), found surprisingly high levels of price informativeness in Chinese stocks. Despite the market’s volatility and speculative reputation, these researchers observed that high-valued A-share firms subsequently reported higher earnings, suggesting that the market was, to a considerable extent, already fulfilling a core economic function by anticipating firm performance.
The "Manipulate to Cater" Hypothesis: A New Perspective
The research by He, Jiang, and Xiong (2026) revisits this optimistic interpretation, not to deny that Chinese stock prices contain useful information, but to propose an alternative mechanism. Their central argument is that in markets with less robust governance structures and more flexible accounting practices, stock prices might not only forecast future earnings but also exert pressure on managers to actively produce those earnings. This "manipulate to cater" hypothesis suggests that when a firm enjoys a high valuation, its management faces amplified incentives to justify that valuation. The result is a feedback loop where market prices influence accounting reports.
This perspective draws upon established financial theories. It echoes Stein’s (1989) insight that stock market pressures can lead to managerial myopia, where short-term stock price performance is prioritized over long-term fundamental value. It also aligns with Hirshleifer and Teoh’s (2003) argument that investor inattention can make distortions in financial reporting impactful on stock prices.
The distinction between prices reflecting fundamentals versus prices influencing reported earnings is critical because reported earnings are not synonymous with actual cash flows or shareholder payouts. If high stock prices truly signal strong underlying fundamentals, these firms should, over time, generate more cash and distribute greater value to shareholders. Conversely, if managers inflate reported earnings, the effects are likely to be concentrated in accounting components amenable to discretion, such as accruals and non-recurring items, and should weaken or reverse in the longer term, without a commensurate increase in dividends or share buybacks.
Empirical Evidence: A Divergent Pattern in China and the U.S.
To test their hypothesis, He, Jiang, and Xiong analyzed data from all non-financial Chinese A-share firms between 1995 and 2024, comparing their findings with those of U.S. S&P 500 firms. Consistent with earlier research, they confirmed that in China, firms with higher market-to-asset ratios subsequently reported higher earnings. This cross-sectional relationship persisted even in the extended sample period, although the magnitude of this effect was smaller in recent years compared to the earlier period ending in 2016. On the surface, this finding might reinforce the notion of price informativeness.
However, several additional patterns emerged, suggesting a more nuanced interpretation:
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Forecast Horizon Divergence: In the United States, the predictive power of valuation for future earnings generally increases with the forecast horizon. In contrast, China exhibits a pattern where predictability rises only in the short run and then flattens or even reverses at longer horizons. This divergence is difficult to reconcile with a purely "crystal ball" view of stock prices.
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Within-Firm Earnings Dynamics: When a Chinese firm’s valuation is unusually high relative to its own historical levels, its reported earnings tend to increase in the short term but then weaken over a three-to-five-year horizon. This reversal pattern is notably absent in the U.S. S&P 500 sample.
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Predictive Power for Payouts: Unlike in the United States, where valuation effectively predicts both future earnings and future cash distributions to shareholders (dividends and repurchases), high valuations in China demonstrate significantly weaker predictive power for actual cash payouts.
Deconstructing Earnings: The Role of Accruals and Non-Recurring Gains/Losses
The distinction between reported earnings and underlying cash flows becomes stark when earnings are decomposed. The research examined operating cash flows (which are less susceptible to manipulation), accruals (involving managerial discretion), and non-recurring gains and losses (NRGLs). NRGLs, such as asset sales, subsidies, restructurings, and other one-off items, have historically played a significant role in China. Before recent regulatory reforms, these items could be used by firms to meet earnings thresholds, thereby avoiding delisting.
The findings revealed a critical divergence:
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U.S. Market: In the U.S. sample, market valuation primarily predicts future operating cash flows, aligning with the expectation that prices reflect information about genuine business performance.
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Chinese Market: In China, the predictive power of valuation for operating cash flows was considerably weaker. Instead, valuation was much more strongly linked to the more manipulable components of earnings, particularly accruals and, most persistently, NRGLs. High-valued Chinese firms were significantly more likely to report future earnings that were artificially boosted by these one-off items.
Investor Inattention and the Persistence of Managed Earnings
The study further suggests that investors may not be fully discounting these managed earnings. If the market were perfectly rational and fully aware that NRGL-driven earnings are transitory and unsustainable, firms with high NRGLs would not be expected to earn predictably lower future returns. However, the research found precisely this: a two-standard-deviation increase in NRGLs was associated with approximately a 3 percent lower stock return over the subsequent year. This indicates that a segment of investors may be overly reliant on reported earnings figures, allowing earnings management to temporarily sustain overvaluation before prices eventually correct.
The Impact of Regulatory Reforms: Evidence from the 2020 Delisting Rule Changes
A significant policy change in China provides compelling support for the "manipulate to cater" hypothesis. In 2020, China implemented a reform of its delisting rules. Historically, delisting from the A-share market was relatively uncommon, partly because firms could leverage accounting tools to circumvent regulatory earnings thresholds. The 2020 reform specifically excluded NRGLs from the earnings calculation used for delisting purposes. This effectively increased the cost and difficulty of managing earnings through these one-off items.
The study’s analysis post-reform demonstrated a clear shift:
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Reduced NRGL Reliance: Firms that had previously relied more heavily on NRGLs significantly reduced their usage after the reform.
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Weakened Price-Earnings Predictability: Crucially, the relationship between market valuation and future reported earnings weakened considerably. This suggests that a portion of the previously observed price-earnings predictability in China stemmed from earnings management rather than purely fundamental information. No similar structural break was observed in the U.S. data, underscoring the impact of China’s specific regulatory environment.
A-H Dual-Listed Firms: Insights into Institutional Environment and Investor Sophistication
Further evidence comes from analyzing A-H dual-listed firms – companies listed simultaneously in mainland China (A-shares) and Hong Kong (H-shares). These firms operate within different disclosure and investor environments. The research found that their A-share valuations were less predictive of future earnings compared to firms listed solely on the mainland. Conversely, H-share valuations for these dual-listed firms exhibited stronger predictive power for future earnings than their A-share counterparts.
This pattern is difficult to explain if A-share prices were simply more informative. It is, however, highly consistent with the idea that the institutional framework and the sophistication of the investor base play a crucial role in determining whether stock prices reflect true fundamentals or contribute to sustaining accounting-based expectations through management. The Hong Kong market, with its more stringent disclosure requirements and greater institutional investor presence, appears to foster a more fundamental-driven pricing mechanism.
Policy Implications: Towards a More Reliable Price Discovery Mechanism
The findings of He, Jiang, and Xiong carry significant policy implications for the development of China’s capital markets. The research does not conclude that the Chinese stock market is entirely uninformative. Rather, it highlights that assessing price informativeness solely by examining the correlation between prices and reported earnings is insufficient. In an environment where managerial discretion over accounting practices is substantial and investors may exhibit inattention to earnings quality, reported earnings themselves become an outcome influenced by market pressures. This means prices can be simultaneously informative and distortive.
The path to strengthening price discovery in China requires more than simply expanding market size, boosting trading volumes, or encouraging more listings. It necessitates institutional reforms that make reported earnings more robust and easier to interpret. Key areas for improvement include:
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Delisting Reforms: Further strengthening delisting mechanisms to ensure that firms consistently meet fundamental performance standards, rather than relying on accounting maneuvers.
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Enhanced Disclosure: Improving the transparency and detail surrounding non-recurring items, allowing investors to better discern their transient nature.
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Robust Enforcement: Strengthening regulatory oversight and enforcement to deter and penalize instances of earnings management.
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Investor Education: Enhancing financial literacy among investors to foster a more critical assessment of reported earnings and an understanding of potential accounting distortions.
These measures are vital because they aim to break the potentially misleading feedback loop where high prices pressure firms into managing earnings, which in turn validates those high prices.
Conclusion: Breaking the Feedback Loop for Sustainable Value
A truly well-functioning stock market should not merely reward companies for meeting short-term earnings expectations. Its fundamental role is to allocate capital efficiently towards firms possessing durable cash-flow potential and genuine long-term value. China’s experience, as illuminated by this research, underscores the risk of superficial price informativeness masking a self-reinforcing cycle: high market valuations can induce pressure for managed earnings, which then temporarily prop up those valuations. It is only over longer horizons that underlying fundamentals tend to reassert themselves. Breaking this loop is paramount if the A-share market is to evolve not only into a large and liquid financial center but also into a reliable compass guiding capital toward sustainable corporate value.
Link to the full paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5327469
