Foreign Institutional Investment, Ownership, and Liquidity: Real and Informational Frictions

Date01 February 2017
Published date01 February 2017
The Financial Review 52 (2017) 101–144
Foreign Institutional Investment,
Ownership, and Liquidity: Real
and Informational Frictions
Mingfa Ding
Central University of Finance and Economics
Birger Nilsson
Lund University
Sandy Suardi
University of Wollongong
The literature widely documents the negative liquidity impact of foreign participation in
firms that permit high foreign institutional ownership. This paper employs a unique setting for
the limited participation of qualified foreign institutional investors (QFIIs) in China’sA-share
market and examines how this impacts on stock liquidity in emerging markets. Contrary to the
findings in the literature, foreign investor participation helps enhance the liquidity of affected
stocks by promoting trade activities and price discovery. The improvement in liquidity does
not occur through the information friction channel, but rather the real friction channel. Our
Corresponding author: Chinese Academy of Finance and Development, Central University of Fi-
nance and Economics, 39 South College Road, Haidian District, Beijing, P.R. China 100081; Phone:
(86)13716925636; Fax: (86)1062288779; E-mail:
We wouldlike to thank Richard Warr (the Editor) and an anonymous referee for constructive and detailed
suggestions. We also appreciate the helpful comments and suggestions offered by Bj¨
orn Hagstr¨
orn Hansson, Tu Nguyen and seminar participants at Lund University.Our research has also benefited
from comments made by participants at the 2013 Swedish Finance PhD Workshop in Stockholm, the
2nd Annual Conference on Global Financial Stability in Sydney, and the 2013 World Finance & Bank
Symposium in Beijing. All remaining shortcomings are our own responsibility.
C2017 The Eastern Finance Association 101
102 M. Ding et al./The Financial Review 52 (2017) 101–144
results are robust to endogeneity issue and the possible influence of the global financial crisis,
industry effects and the stock exchange. Further, the liquidity improving effects of QFII are
even stronger when the analysis is performed on a subsample of QFII firms.
Keywords: liquidity, foreign institutional investor,QFII, real friction, informational friction
JEL Classifications: G12, G18, G32, C23
1. Introduction
China is by far the world’slargest emerging market. Unlike in many other emerg-
ing markets, China’s financial marketis not completely open to foreign investors and
it operates under policies that differ from those of other emerging economies. In this
paper, we take advantage of this unique institutional setting to reexaminehow foreign
institutional investors and increased market liberalization influence liquidity.
In an effort to diversify the domestic financial market’s investor base, the Chi-
nese government has implemented policies to encourage the participation of foreign
institutional investors. Under the current legal framework, foreign investors can in-
vest in A-share listed companies by applying for a qualified foreign institutional
investor (QFII) license.1Nevertheless, the approach taken by the Chinese govern-
ment to liberalize the financial market is a cautious and conservative one. Unlike
many emerging economies where foreign institutional investorsare permitted to hold
more than 50% of the free-float value of the equity market, China’s QFII scheme is
restrictive: the total shares held by each (all) QFII in one listed company is not per-
mitted to exceed 10% (20%) of the total outstanding shares of the company.2China’s
QFII scheme presents an interesting case study on the relationship between foreign
institutional participation and stock market liquidity in an environment characterized
by low foreign institutional ownership.This issue has never been previously examined
since most emerging market studies focus on firms with high foreign institutional
1China allows foreigners to invest in A-share stocks through the QFII system instituted on December 1,
2002. The approved QFIIs were able to make their first trades in A-share stocks on July 9, 2003. The
QFII system is regulated by the China Securities Regulatory Commission (CSRC) and the People’s Bank
of China. The QFIIs are defined as overseas fund management firms, insurance companies, securities
companies, and other asset management institutions approved by the CSRC to investin China’s securities
market. They are granted investment quotas by the State Administration of Foreign Exchange. Term 18
of the Provisional Measure states that QFIIs can invest in A-shares, treasuries, convertible bonds and
corporate bonds listed in China’s stock exchanges and other financial instruments as approved by the
CSRC. This system permits overseas institutional investors to buy domestically listed stocks in the A-
share market. Prior to the QFII system, foreign investorscould invest only in the B-share market. However,
the B-share market is much smaller than the A-share market. Foreign institutions want to apply for QFII
status because this allows them to invest in the much largerA-share market.
2Rhee and Wang(2009) document that foreign institutional investors hold as much as 70% of the free-float
value of the Indonesian equity market, or 41% of the total market capitalization.
M. Ding et al./The Financial Review 52 (2017) 101–144 103
ownership (see Rhee and Wang, 2009; Ng, Wu, Yu and Zhang, 2011; Prasanna and
Bansal, 2014).
A well-known stream of literature argues that large ownership is negatively
associated with liquidity. Some attribute this negative liquidity effect to the greater
adverse selection cost induced by large shareholders (Heflin and Shaw,2000; Rubin,
2007; Brockman and Yan, 2009). Still others argue that a large shareholding with
inactive trading results in fewer free-float shares available to the public, thus gener-
ating real friction in the stock market (Brockman, Chung and Yan, 2009). Consistent
with these studies, Rhee and Wang (2009) argue that the negative association be-
tween foreign institutional investors and liquidity in Indonesia is mainly attributable
to information asymmetries between domestic and foreign investors (an adverse se-
lection effect) and foreign inactive trading (a real friction effect). Likewise, Ng, Wu,
Yu and Zhang (2011) provide evidence that foreign blockholders are perceived to
be informed traders and that their presence also dampens trading activity through
their inactive trading. Taken together, these studies demonstrate a well-documented
negative liquidity effect of foreign investors’ participation arising from large foreign
Studies that demonstrate the positive liquidity effect of foreign institutional
participation are few and far between. Foreign institutional investorscould potentially
increase liquidity by improving the informational environment and enhancing trading
activity in the market. One possible reason for failing to demonstrate this evidence is
that past studies that focus on foreign institutional investors and liquidity could not
separate out this positive effect from the large negative foreign ownership effect. In
this sense, China’s QFII scheme of restricted foreign ownership provides a unique
setting for measuring the liquidity effect of foreign institutional participation in an
environment of low foreign ownership.
Another important insight to be gained from the study of foreign institutional
investors in the Chinese A-share market is that there are different types of for-
eign investors: those who invest through other policies3that are not part of the
QFII scheme. These non-QFIIs are long-term strategic investors and are subject to
fewer government restrictions on their shareholding ceiling. Consequently, the for-
eign ownership associated with these foreign investors is much higher than that of
QFIIs. It is in this context that China’s A-share market provides an ideal setting
for examining the different liquidity impacts of foreign institutional investors’ par-
ticipation with different foreign ownership levels. The results of this study can be
3Toattract long-term foreign investment, the relevantChinese authorities (such as the Securities Regulatory
Commission) have so far enacted the following measures: the notice of the relevantissues concerning the
transfer of state-ownedshares and corporate shares of listed companies to foreign investors since November
1, 2002 (expired); interim provisions for foreign investors to merge domestic enterprises since March 7,
2003 (revised); decision of the ministry of commerce on amending the provisions on the merger or
acquisition of domestic enterprises by foreign investors since June 22, 2009 (effective);and the measures
for the administration of strategic investment in listed companies by foreign investorssince December 31,
2005 (effective).

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