Are there Bubbles in the Defence Sector of China’s Stock Market (2005–2016)? New Evidence from Sequential ADF Tests

Abstract

During the past decade, China’s defence industry has experienced significant reforms, with increasing numbers of defence companies being listed on the stock market. Meanwhile, China’s stock market has suffered from dramatic fluctuations. This article, therefore, attempts to break new ground on an empirical research agenda to detect bubbles in the defence sector of China’s stock market and how these bubbles can be impacted by the entire stock market and defence industry. To explain this issue, sequential unit root tests are introduced to investigate the existence of bubbles in the defence sector using monthly frequency data from China’s stock market from January 2005 to June 2016. The empirical results show strong evidence of explosive behaviours in the defence sector during the past decade. Moreover, the number of bubbles has changed greatly when accounting for the entire stock market. The empirical results indicate that bubbles in the middle of 2006 and at the end of 2014 were driven by the defence industry because of the sharp increase of military expenditure and the release of innovative defence reforms. Finally, we suggest that the government could control the annual budget increase at a steady pace and implement defence reforms by carrying out experimental units gradually.

Keywords:

• Defence sector bubbles
• China’s stock market
• sequential ADF tests
• comparative analysis

JEL Codes:

• F52
• G12
• L52

Acknowledgements

The paper has benefited from the useful comments and constructive suggestions by anonymous referees. The usual disclaimer applies.

Notes

1. A bubble is defined as an upward price movement over an extended range that then implodes (Kindleberger 1978). There are two categories of bubbles: (1) Rational bubbles occur when asset price continue to rise because investors believe that they will be able to sell the overvalued asset at a higher price in the future (Flood and Hodrick 1990); (2) Irrational bubbles may attribute to investors being driven by irrationally optimistic expectations, fashion or fads (Shiller 2000). Importantly, the pricing of ration bubble is still rational and there are no arbitrage opportunities (Gürkaynak 2008).

2. SIPRI is an independent international institute dedicated to research into conflicts, armaments, arms control and disarmament.