Do Foreign Investors Destabilize Stock Markets? A Reexamination of Korea in 2008

• Author: Cheol‐Won Yang
• Date: 01 October 2017
• Published date: 01 October 2017
• DOI: http://doi.org/10.1111/ajfs.12189

Do Foreign Investors Destabilize Stock

Markets? A Reexamination of Korea in

2008*

Cheol-Won Yang**

School of Business Administration, Dankook University, Republic of Korea

Received 3 January 2016; Accepted 13 April 2017

Abstract

Motivated by Choe, Kho, and Stulz (1999) (CKS), this paper reexamines whether foreign

investors destabilize the Korean stock markets during the 2008 global financial crisis. Consis-

tent with CKS, large sales by foreigners don’t result in significant negative returns over the

next 25 minutes of trading. However, when the price impact is measured per trade, the

impact of foreigners increases sharply during the crisis, and even surpasses that of Korean

individuals and institutions. This is particularly pronounced in the permanent components,

and in large, liquid stocks. The influence of foreigners therefore is not negligible in emerging

markets, although it does not destabilize the whole market on its own.

Keywords Global financial crisis; Foreign investors; Individual investors; Order imbalance;

Price impact

JEL Classification: G01, G15, G18

1. Introduction

The effects of foreign investment on emerging markets have long been debated by

academics and policy makers. This is related to the issueof capital market liberalization.

The last three decades have witnessed the increasing liberalization of equity markets

across the world. Many empirical studies show that this liberalization and the inflow of

foreign capital are beneficial for emerging economies because they reduce the cost of

*The author is grateful to Sung C. Bae, Woojin Kim, Kuan-Hui Lee, and seminar participants

at the 2013 joint conference of five Korean finance associations, the Korean Academic Associ-

ation of Business Administration, and Dankook University for their helpful comments. This

work was supported by the Dankook University research fund of 2017.

**Corresponding author: Cheol-Won Yang, Associate Professor of Finance, School of Business

Administration, Dankook University, 152 Jukjeon-ro, Suji-gu, Yongin-si, Gyeonggi-do 16890,

Korea. Tel: +82-31-8005-3437, Fax: +82-31-8021-7208, email: yang@dankook.ac.kr.

Asia-Pacific Journal of Financial Studies (2017) 46, 734–759 doi:10.1111/ajfs.12189

734 ©2017 Korean Securities Association

capital, stimulate economic growth, increase market efficiency, and improve corporate

governance.

1

However, despite growing evidence, many emerging markets still remain

reluctant to fully open their capital markets.

2

This is because emerging markets fear the

instability caused by large capital flows from foreign investors during globally turbulent

periods (Stiglitz, 2000; Jotikasthira et al., 2012; Schnabl, 2012). If these costs exceed

precedent benefits,then the fruit of liberalization cannot be realized.

Choe et al. (1999) (hereafter CKS) show that the cost, namely, the negative

effect induced by foreign investors, is small during a crisis period. They investigate

Korean stock returns during the Asian financial crisis of 1997 and conclude that

trades by foreign investors did not destabilize the market. Since 1997, Korea has

experienced another financial crisis emanating from the subprime mortgage crisis

in the USA and the bankruptcy of Lehman Brothers. In the space of a month, the

KRW/USD exchange rate increased by 30%, and the Korea Composite Stock Price

Index (KOSPI) fell by 40%. I revisit this crisis period because I think that the con-

clusion reached by CKS is likely to be premature to conclude the debate.

3

This is

due to ownership restrictions on foreign holdings that existed during the CKS

sample period (November 1996–December 1997). The ownership limit for individ-

ual foreign investors is only 7% (the aggregate limit is 26%). In addition, during

the CKS sample period, the average percentage of daily trading volume by foreign-

ers was only 4.44%, which is much lower than that of Korean individuals

(81.54%) and institutions (12.87%) (Table 1 in CKS, 1999, p. 235). It is not

surprising then that such a low percentage is not able to destabilize the whole

market.

This paper examines the influence of foreigners during the global financial crisis

from September 2008 to February 2009, and contributes to the literature in three

ways. First, examination of the Korean stock market in 2008 provides an opportunity

for a natural experiment on a perfectly open equity market setting. Korea lifted the

limits on foreign ownership for both individual and aggregate investors on May 25,

1998, and experienced a financial crisis in 2008. Until then, foreign investors

1

See, for example, Bekaert and Harvey (2000), Henry (2000b), and Chari and Henry (2004)

for the cost of capital; Henry (2000a), Bekaert et al. (2001, 2003, 2005), Quinn and Toyoda

(2008), and Gupta and Yuan (2009) for economic growth; Kim and Singal (2000) for market

efficiency; and Stulz (1999) for corporate governance.

2

For example, Chinese A-shares listed on the Shanghai and Shenzhen exchanges are not avail-

able to foreign investors. Foreign investors can buy mainly H-shares of Chinese firms listed

on the Hong Kong stock exchange. For more information, see the MSCI Global Market

Accessibility Review (available at www.msci.com).

3

Other studies have offered different results from CKS. Kim and Wei (2002) find strong posi-

tive feedback trading during the crisis by using month-end shareholding data on foreign

investors. Ghysels and Seon (2005) show the destabilizing effect of foreign investors in Korea,

emphasizing the role of derivatives during the Asian financial crisis. Richards (2005) argues

that foreign investors have a greater impact on emerging markets than reported in previous

research by analyzing the daily trading of foreign investors in six Asian equity markets.

Do Foreign Investors Destabilize Stock Markets?

©2017 Korean Securities Association 735