STOCK MARKET OPENNESS AND MARKET QUALITY: EVIDENCE FROM THE SHANGHAI–HONG KONG STOCK CONNECT PROGRAM

• Author: Deng Pan,Xuekui Zhang,Xinwei Zheng,Ke Xu,Li Xing
• DOI: http://doi.org/10.1111/jfir.12210
• Date: 01 May 2020
• Published date: 01 May 2020

The Journal of Financial Research Vol. XLIII, No. 2 Pages 373–406 Summer 2020

DOI: 10.1111/jfir.12210

STOCK MARKET OPENNESS AND MARKET QUALITY: EVIDENCE FROM

THE SHANGHAI–HONG KONG STOCK CONNECT PROGRAM

Ke Xu

University of Victoria

Xinwei Zheng

Deakin University

Deng Pan

Xiamen University

Li Xing

University of Saskatchewan

Xuekui Zhang

University of Victoria

Abstract

We study the impact of capital market openness on high‐frequency market quality in

China. The Shanghai–Hong Kong Stock Connect program (SHHKConnect) opens

China’s stock market to foreign investors and offers a natural experiment to

investigate this question. Using a difference‐in‐differences approach, we find that

market liberalization leads to lower quoted spread, lower effective spread, lower

market depth, and higher short‐term volatility. Our findings imply that opening the

markets to more sophisticated foreign investors is associated with higher competition

and more cross‐market arbitrage activities, narrowing the spread and reducing

liquidity providers’profits, but increasing the price impact and short‐term volatility

of connected stocks.

JEL Classification: G10

I. Introduction

The liberalization of financial markets through the opening of domestic stock markets

to foreign investors has controversial effects on different aspects of the economy.

Academic studies find that market liberalization leads to lower costs of capital by

We thank the editor Murali Jagannathan, an anonymous referee, Matti Keloharju, Xiaoyun Yu, and

conference participants at INFINITY Conference 2018 Asia‐Pacific, the Western Economic Association

International Conference 2019, and the International Workshop on Financial System Architecture and Stability

2019 for helpful comments. This work is supported by the National Science Foundation of China Grants

71673053, and the Social Sciences and Humanities Research Council (SSHRC) Grants 430‐2018‐00557. This

research is enabled in part by WestGrid (www.westgrid.ca) and Compute Canada (www.computecanada.ca).

Declarations of interest: none.

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© 2020 The Southern Finance Association and the Southwestern Finance Association

allowing risk sharing (Bekaert and Harvey 2000; Henry 2000), improved information

environment (Bae, Bailey, and Mao 2006), better market quality (Sun, Tong, and

Yan 2009), faster productivity growth (Bekaert, Harvey, and Lundblad 2011; Larrain

and Stumpner 2017), reduced agency problems, and enhanced governance quality

(Doidge, Karolyi, and Stulz 2004). However, market liberalization may also come with

some negative effects on the emerging economy. Stiglitz (2010) argues that the

possible contagion effect of disturbances spilling over from developed markets

destabilizes capital markets in emerging economies. Ng (2000) and Baele (2005) find

significant volatility spillovers from Japan and the United States to six Pacific‐Basin

equity markets and from the U.S. market to European equity markets.

Recently, the Chinese government formulated a sequence of policies to open

up its capital markets to foreign investors, creating an ideal environment for examining

the impact of increased foreign portfolio investment in developing equity markets. Our

empirical strategy uses difference‐in‐differences analysis to perform an event study of

the introduction of Shanghai–Hong Kong Stock Connect program (SHHKConnect).

We match stocks that are directly affected by the event (connected stocks) with stocks

that are not directly affected (nonconnected stocks) to control for unobserved changes

in market conditions. Our main focus is the influence of increased foreign investment

activities on six market quality variables: quoted spread, market depth, effective

spread, realized spread, price impact, and short‐term volatility. Quoted spread and

market depth are measures of displayed liquidity in the limit order market. Effective

spread reflects investors’actual trading costs. Realized spread measures liquidity

providers’profit. Price impact and short‐term volatility are effective indicators for

high‐frequency arbitrage activities.

In this article, we provide new evidence of capital market liberalization by

examining its effect on high‐frequency market quality using the introduction of

SHHKConnect. We find that, compared to nonconnected stocks with similar stock

characteristics, quoted spreads, effective spreads, and market depth all decrease after

SHHKConnect. Decomposing the spread into liquidity provider revenues (realized

spread) and adverse selection (price impact), we find that the decrease in spread is due

to a decrease in liquidity provider revenues. The short‐term volatility and price impact

of trades for connected stocks increase following the introduction of SHHKConnect,

indicating an increase in cross‐market arbitrage activities. The increase in price impact

is offset by a decrease in liquidity provider revenues; hence, overall liquidity is

improved. Market openness results in the trading costs of investors decreasing by more

than 0.8 basis points (bps), which is a decrease of about 6% relative to their pre‐

SHHKConnect levels.

Theoretical models of liquidity provision in limit order markets offer

ambiguous predictions regarding the impact of capital market openness. First, opening

the market to more foreign investors increases competition for liquidity provision

(competition channel). As competition increases, investors undercut each other’s limit

orders more aggressively to improve the chance of a trade taking place. Theoretical

models of liquidity provision argue that spread decreases and market depth increases as

the level of competition increases (Brogaard and Garriott 2014; Dutta and

Madhavan 1997; Ho and Stoll 1983). Second, with improved connectivity, more

374 The Journal of Financial Research

arbitrage opportunities become available. The more sophisticated foreign investors take

advantage of these arbitrage opportunities by trading fast on both the Shanghai Stock

Exchange (SSE) and Hong Kong Stock Exchange (SEHK). These arbitrage

opportunities impose a cost on liquidity provision because stale quotes can be picked

off by faster high‐frequency arbitragers. Theory predicts that more cross‐market

arbitrage activities increase adverse selection (adverse selection channel), therefore

putting upward pressure on spread, short‐term volatility, and price impact (Biais,

Foucault, and Moinas 2015; Budish, Cramton, and Shim 2015; Foucault, Kozhan, and

Tham 2017; Glosten and Milgrom 1985; Hasbrouck 2018; Xu 2019; Zhang 2010).

Hence, market liberalization has an ambiguous effect on spread, depending on which

mechanism dominates.

SHHKConnect can provide insights into the trade‐off between (1) increasing

competition in liquidity supply and (2) increasing adverse selection in liquidity

demand. We empirically investigate this theoretical ambiguity and ascertain which

channel dominates in China’s stock market. In particular, we are interested in the

following research questions: (1) whether the displayed liquidity in the limit order book

has improved, (2) how investors’trading costs change, (3) whether SHHKConnect has

a more significant effect on liquidity supply or liquidity demand, and (4) whether more

high‐frequency arbitrage activities occur.

As China accelerated the opening of its capital market, more international

investors, especially quantitative investor (or “quants”) became interested in investing

in China. Considering that it is more difficult to make money in ferociously

competitive and efficient developed markets, such as the United States, China’s retail‐

dominated stock market

1

could become “the industry’s new Klondike with market gold

readily available for mining.”

2

Domestic investors in China are well aware of this

situation and hence are concerned that opening the market to foreign investors will

increase cross‐market arbitrage activities, intensifying adverse selection. In this article,

we address these concerns by studying the net effect of competition and adverse

selection channels on the trading costs of investors.

On November 17, 2014, the Chinese government initiated SHHKConnect,

allowing investors in mainland China and Hong Kong to trade and settle eligible stocks

listed on the other market via the exchange and clearinghouse in their home markets.

SHHKConnect provides an ideal setting to investigate the effect of capital market

openness on stock market quality, which may be of interest to both domestic and

international investors, as well as to policy makers in China. To investigate these

questions, we use high‐frequency order‐level data on all firms listed on the SSE in

the China Stock Market and Accounting Research (CSMAR) database, providing

real‐time information about orders and executions on the SSE with millisecond time

stamps. We employ identification tests using the difference‐in‐differences approach.

We study the exogenous variation in market quality generated by SHHKConnect and

1

China’s stock market has long been dominated by retail investors, who account for roughly 70% of all trading

in China.

2

Robin Wigglesworth and Gabriel Wildau, “China’s Retail Investors Create Playground for Data‐Loving

Quants,”Financial Times (August 2, 2018), https://www.ft.com/content/4f66968a‐91bc‐11e8‐bb8f‐a6a2f7bca546.

375Stock Market Openness and Market Quality