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The University of Western Australia Business School Assistant Professor Jing Yu, along with researchers from Australia, China and the United States, has received the 2011 TCFA Award for the Best Paper on Chinese Financial Markets from The Chinese Finance Association (TCFA).

Their research paper, titled "The Role of Foreign Investors in Stock Liquidity around the World," analysed data from 27,976 firms across 39 countries between 2003 and 2009.

It found that while large foreign investors may bring knowledge and experience to local companies, the downside of large foreign investment includes lower stock liquidity and raised cost of capital.

The study also found significant differences between foreign institutional investors who typically hold a fraction (less than 5%) of a local firm's shares, and large foreign shareholders who are mainly non-institutional investors and hold at least 5%.

While large foreign investors caused a company's stock liquidity - the ease with which shares can be bought and sold with minimum impact on share price - to decrease, investment from foreign institutions, such as investment banks and superannuation funds, caused stock liquidity to increase.

‘The opposing liquidity effects of foreign block and non-block investors indicate that foreign investors can not be simply lumped up as one investor group and the size of their investment matters to local stock liquidity,' said Assistant Professor Yu.

The reason for large foreign block investors causing a decrease in stock liquidity can be attributed to two factors: inactive trading activity, and information asymmetry.

‘Foreign block owners may choose to hold the stock for a long term, leading to the inactive trading of a large block of shares,' explained Assistant Professor Yu. ‘The inactive trading activity inevitably renders liquidity costs to other market participants, since large blockholdings greatly reduce the number of shares tradable, inflate the price impact of trades, and ultimately lead to low stock liquidity.'

In addition, foreign block owners bring new knowledge and methods to local companies, and many local investors may be unfamiliar with such "foreign" changes. ‘Overall, we show that large foreign block ownership is associated with high information asymmetry,' said Assistant Professor Yu. ‘More importantly, the negative effect of foreign blockholders on liquidity tends to be more pronounced in less transparent information environments, implying that foreign blockholders may dampen stock liquidity via their information advantage over other outside investors.'

Why is stock liquidity important?

Past research has shown that liquidity improves firm value and performance, reduces managerial opportunism, facilitates accumulation of shares and encourages trade by informed investors.

However, the disadvantages of reduced stock liquidity that large foreign investors bring are offset by the improvements in the long-term performance of companies.

‘We contend that the large stakes of foreign blockholders are likely better informed than outside investors because they interact with senior management and therefore obtain superior knowledge of these companies - for example, through sitting on the board. Moreover, with large stakes, foreign blockholders are more inclined to monitor firm management. They bring their unique skills, international expertise, and knowledge to the firm,' said Assistant Professor Yu.

‘Our results suggest that firms face a critical trade-off between depressed stock liquidity and enhanced business monitoring when having foreign block ownership. On one hand, foreign block ownership leads to lower stock liquidity, which in turn enlarges implied cost of equity capital. On the other hand, firms with foreign block ownership benefit from their management expertise and gain the improvement in their cash flow status in the long run.

‘Our findings, however, suggest that the monitoring benefits of large foreign investors more than offset the liquidity cost of trading the shares.'

With growing numbers of companies around the world opening up opportunities to foreign investors, the effects of foreign investment will become even more critical.

The 2010 World Investment Report showed growing levels of both foreign direct investment (now $1.14 trillion) and portfolio net equity inflows from foreign investment (now $744 billion). Meanwhile, the proportion of firms with foreign block ownership varies from around 6.4% in China, through to 93.4% in Ireland.

In Australia, the merits of foreign block investment in mining, resources and other companies are still being debated. Assistant Professor Yu warns that any regulatory changes must be made with prudence. ‘Our results also offer a cautionary point for policymakers contemplating the policies of attracting foreign investments in hope of developing local capital markets,' she said. ‘Foreign equity investments bring both benefits and costs to local stock markets. How to efficiently balance the cost-and-benefit trade-off of foreign large investments is the question for future research.'

Media references

Heather Merritt
Director, External Relations
UWA Business School
T: +618 6488 8171
M: 0419 950 027
E: [email protected]

Verity Chia
Communications Officer
UWA Business School
T: +618 6488 1346
E: [email protected]