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This is a summary of “Capital Market Liberalization and Investment Efficiency: Evidence from China” by Liao Peng, Liguang Zhang, and Wanyi Chen, published in the Fourth Quarter 2021 issue of the Financial Analysts Journal.


Overview

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This study examines the impact of capital market liberalization in China on corporate investment efficiency. It finds that a recent reform has restrained overinvestment and improved corporate information disclosure and corporate governance.

What’s the Investment Issue?

In recent years, China has embarked on a financial reform of capital market liberalization. In 2014, the country launched the Shanghai–Hong Kong Stock Connect, to promote the integration of its domestic and international capital markets. This allowed foreign investors to invest in some listed domestic companies.

This study focuses on the impact of these reforms on companies’ behavior.


How Do the Authors Tackle the Issue?

The authors propose the following hypothesis: All else being equal, stock market liberalization reform can improve corporate investment efficiency. To test this hypothesis, they use a difference-in-differences (DID) model, which essentially treats the implementation of the Shanghai–Hong Kong Stock Connect as a quasi-natural experiment.

They use data on A-share companies listed on the Shanghai and Shenzhen Stock Exchanges from 2011 to 2018. After applying various filters, the final sample includes 14,124 firm-year observations.

To measure the efficiency of a firm’s capital investment, the authors use a regression model to estimate expected capital expenditure. They then deduct actual capital expenditure. A positive residual value (where actual capital expenditure is higher than expected capital expenditure) suggests the company is more likely to overinvest; a negative residual value suggests it is more likely to underinvest.

The authors apply the DID model to test the impact of the Stock Connect policy on corporate investment efficiency. They also break down their analysis into two categories representing the reform’s impact on overinvestment and underinvestment.

Finally, the authors look at the impact of three characteristics of firms that might affect the relationship between capital market liberalization and corporate investment efficiency. These are, first, whether the firms have previously had any foreign ownership; second, their degree of analyst coverage; and third, whether they are privately owned. The authors also examine the transmission mechanism by which capital market liberalization might affect companies’ behavior.


What Are the Findings?

The authors’ main finding is that the implementation of the Shanghai–Hong Kong Stock Connect has had a positive impact on corporate investment efficiency. Their regressions show that the overall investment efficiency of listed companies significantly improved after 2014. The primary reason for this improvement was a considerable reduction in overinvestment. Conversely, underinvestment was not significantly affected by the capital market opening. These results held true following robustness tests to determine that efficiency improvements were not caused by factors other than the reforms, differences between listed and unlisted companies, or sample selection biases.

Companies with no former overseas ownership showed a marked increase in investment efficiency compared with companies that had previously issued foreign shares. Additionally, firms with lower analyst coverage and those that are privately owned received more substantial investment efficiency improvements from the reforms.

The authors identified two main channels through which capital market liberalization affects corporate investment efficiency. One is by improving the quality of information disclosure. This was measured by a reduction in discretionary accruals, meaning that management less seriously manipulated the companies’ profits and that higher-quality accounting information was released. A second channel is by raising standards of corporate governance. This was measured by a significant fall in management expense ratios after the reforms.


What Are the Implications for Investors and Investment Managers?

The authors identify implications for both domestic and overseas investors. They suggest that given the relative immaturity of the Chinese stock market, the gradual introduction of overseas investors can diminish the opportunism of companies, bolster investor protection, and foster better corporate governance.

Foreign investors will find new opportunities in China’s market opening policy with the recent launch of the Shanghai–London Stock Connect and the Shanghai–German Stock Connect in development. Additionally, they can now directly trade in stocks of Chinese-listed companies, which might provide opportunities to improve these companies’ efficiency and enhance firm value.


About the Authors

Keyur Patel

Keyur Patel is a London-based financial journalist.