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's A‐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 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.
The Chinese government implemented the Qualified Foreign Institutional Investor (QFII) system in order to advance the quality of local capital markets by participation of foreign institutional investors. This paper identifies the channels through which foreign institutional investors influence the liquidity on the Chinese stock markets. Firstly, we find that market participation by foreign institutional investors promotes liquidity both for state-owned enterprises (SOEs) and non-SOEs. Secondly, foreign institutions influence liquidity through the informational frictions channel, but not through the real frictions channel. Thirdly, foreign institutions are not informationally disadvantaged when investing in SOEs. Finally, the link between foreign institutional participation and liquidity remains strong before, during, and after the recent financial crisis.
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