Is Equity Market Liberalization Beneficial?

By Wentong Chen, PhD Student, Cornell University Department of Economics

Equity Market Liberalization: A Growing Trend in Emerging Markets

Equity market liberalization is an important step in increasing capital account openness. In recent decades, several emerging markets have implemented equity market liberalization step-by-step, aiming to attract long-term and high-quality foreign investment to stimulate economic growth and promote risk-sharing. In 2002, China introduced the Qualified Foreign Institutional Investor (QFII) program to allow foreign institutional investors to trade “A-shares” in China’s stock exchanges, which were not available to international investors previously. As of May 2020, the total QFII-approved investment fund had reached 825.62 billion RMB, or around 112 billion USD.

I wanted to investigate the QFII program’s impact on firm performance, and the Emerging Markets Institute at the Cornell SC Johnson College of Business generously awarded me a grant for my project, “Is Equity Market Liberalization Beneficial? A Close Look at the Qualified Foreign Institutional Investor Program (QFII).”

Impact of the Qualified Foreign Institutional Investor Program

My project studies the micro-level impact of the QFII program. Using novel firm-level investment data, I find that QFII promotes capital investment. Surprisingly, however, I also find significant and persistent 5 percent declines in stock prices and a 0.08 RMB decline in earnings per share of firms that receive QFII investment relative to those that do not.

This price decline is not consistent with the international finance literature. The past literature states that firms increase capital investment due to an interest rate decline by international risk sharing after the equity market liberalization. My paper shows that three possible channels contribute to this puzzling result:

1. QFII investment increases firms’ confidence and triggers firms to invest in research and development, which hurts short-term profits to refine the production process. And the data shows that firms with the QFII investment have around 500 more patent grants four years after the investment relative to those with no WFII investment.
2. Firms face agency problems because of the ownership of the QFII foreign intuitional investors. Since QFII investors are less informed when it comes to participating in firms’ management decisions, managers invest in riskier projects and misallocate their funding. The decline of 0.2 RMB in firms’ earnings per share after the QFII investment relative to those with no QFII investment supports this. Also, firms’ profitability, calculated by the ratio of operating revenue over operating expense, decreases by 0.05 until the sixth quarter. When the market observes this, they withdraw funding from QFII firms. Those reallocations result in an aggregate equity demand decrease and a persistent firm stock price decline in the following periods.
3. QFII investors are less informed and bid up the price too much, causing the selected firms’ stocks to be overpriced. The price decline is just restoring the price.

In my paper, I also do robustness checks to ensure that the stock price declines are not explained by the supply channel, given that firms issue fewer new stocks after the QFII. Also, the price decline is not a result of other capital account opening projects that allow domestic intuitional investors to invest in foreign markets, such as the Qualified Domestic Institutional Investor Program (QDII).

Emerging Markets Institute support

Thanks to the EMI grant, I am able to continue this project by gaining access to the data I need and by seeking feedback from experts in the field. EMI’s grant has enabled me to present my paper in front of large audiences and gain valuable feedback at the Emerging Markets Theme PhD Research Day conference at the Tata Innovation Center on the Cornell Tech campus, and at Cornell University’s Third Year Research Seminar and Macro Lunch.

The grant also supported my travel and accommodations to attend the 3rd Workshop on International Capital Flows and Financial Policies, hosted by the International Monetary Fund in Washington, D.C., which included discussions of academic papers covering several international capital flow topics. During the workshop, I communicated with academics and policymakers and got feedback on how to further polish my project. Moreover, I learned new perspectives on international capital flow policies and how to use an appropriate mix of policy tools, including foreign exchange policies, to address global challenges. These discussions have guided the future direction of my research.

Much of my work would not be possible without EMI’s support. The monetary resources, confidence in my work, and support from the EMI team have allowed my expected research contributions to come true.

About Wentong Chen

Wentong Chen is an Economics PhD student at Cornell University. Chen’s research interests are in international finance, macroeconomics, and banking. Her research focuses on the pass-through of monetary and foreign exchange policies to different markets and how price and quantity dynamics in these markets interact with (and have feedback effects on) each other. Chen’s research aims to formally model the frictions in and spillovers between these markets and to characterize the underlying mechanisms in environments with various forms of market incompleteness and frictions.