Foreign Ownership and Information Asymmetry

Authors


  • Acknowledgements: This article was developed based on parts of earlier articles under different titles presented at the 2006 Annual Conference of the American Accounting Association (AAA), the 2006 Symposium of the Journal of Contemporary Accounting & Economics, the 2008 Mid-Year Meeting of the International Accounting Section of the AAA, and the 3rd Symposium of the China Journal of Accounting Research. We would like to thank Dr Xijia Su, Dr Yuan Ding, the discussants, and the participants at these conferences for their insightful comments and suggestions. Any remaining error is the responsibility of the authors.

Corresponding author: Haiyan Zhou, University of Texas Pan American, 1201 W. University Dr., Edinburg, TX 78539, USA. Tel: +19566653334, Fax: +19566652407, email: zhaiyan@utpa.edu.

Abstract

Foreign ownership has two competing effects on information asymmetry. Short term investment horizon, superior information processing capability, controlling positions, and increased agency costs associated with foreign ownership increases information asymmetry, while demand for more disclosure, better accounting and auditing standards, use of international auditors, incentive alignments, long term investment horizon and greater monitoring decreases information asymmetry. In this article, we examine and find a significant and positive impact of foreign ownership on information asymmetry measured by bid-ask spread in China. On balance, foreign equity investors tend to enhance their informational advantages more than improving the general informational environments in local markets. These results have implications for transparency and disclosure policies as well as privatization in emerging markets.

1. Introduction

Corporate governance issues continue to attract attention from researchers, practitioners, and regulators alike. Accounting scandals, such as Enron and WorldCom, have brought debate about corporate governance issues to the forefront of the research agenda. A key conceptual issue in this context is to what extent managers and insiders can exploit their superior informational advantages relative to other investors in the market. Naturally, the two most common approaches in corporate governance—legal protection of minority rights and ownership structuring with large investors—have become mainstream issues in global corporate governance (see a survey in Shleifer and Vishny, 1997).

Several studies find that ownership structures influence information asymmetry (e.g. Yook et al., 1999; Su, 2004), some producing specific evidence that information asymmetry influences bid-ask spread (e.g. Brockman and Chung, 2000). However, few studies have investigated the relationship between foreign ownership and bid-ask spread. In this article we argue that foreign ownership can influence information asymmetry. This is in line with the prior literature, which has documented the link between inside and block shareholders and the information environment (Chiang and Venkatesh, 1988; Barclay and Holderness, 1991; Heflin and Shaw, 2000; Hope et al., 2009).

It is commonly thought that foreign investors are at an information disadvantage about a local firm compared with domestic investors (Choe et al., 2005). If so, foreign investors could be associated with a firm with low information asymmetry (Jiang and Kim, 2004). In this case, an increase in foreign ownership leads to an increased demand and pressure for increased disclosure by local firms, resulting in higher value relevance of accounting information (Sami and Zhou, 2004), strengthening shareholder activism and board representation (Choi et al., 2007), greater deployment of sophisticated valuation methods (Wei et al., 2005), or enhancing the privatization process of state-owned enterprises (Xu et al., 2005). Increased information transparency, such as better accounting standards and higher quality of auditors, can improve market liquidity (Lang et al., 2009), and reduce information asymmetry in the market.

In addition, foreign investors can employ an investment strategy by taking the position of block shareholders to directly and effectively monitor management actions or to enable a long investment horizon that encourages strong ties between the firm and outside providers of capital (Ellul et al., 2007). In such cases, information asymmetry should decline with an increase in foreign ownership while there is an increase in general transparency in the market.

However, it is also possible that foreigners have incentives to maintain or enhance their superior information status (Grinblatt and Keloharju, 2000). While foreign investors with a longer investment horizon should be able to reduce the information asymmetry (Ellul et al., 2007), those with a short investment horizon are likely to be associated with high information asymmetry. In the latter situation, foreign investors would be motivated to take advantage of their superior capability in information processing to engage in speculative trading.1 That is, foreign institutional investors may be superior in processing public information and producing private information than domestic individual investors in an emerging market. In this case, the role of foreign investors is essentially the same as financial analysts in capitalizing on information asymmetry. Chung et al. (1995), for example, show larger bid-ask spreads for stocks with more financial analyst following, suggesting that the presence of financial analysts is associated with high information asymmetry. If so, it is also plausible that foreign investors may contribute to high information asymmetry with their superior information processing capability.

In addition, if foreign shareholders are block shareholders, they could be viewed as informed traders from other traders' point of view. Since block shareholders are believed to have access to private, value-relevant information via their roles as monitors of corporate operations (e.g. Barclay and Holderness, 1991), it is likely that foreign block shareholders may wish to exploit their information advantages. Increased ownership concentration may then lead to greater entrenchment of managers, who are subject to less monitoring by boards of directors and less scrutiny by the market (Morck et al., 1988). Controlling shareholders may either engage in outright expropriation from self-dealing transactions or exercise de facto expropriation through pursuing personal interests rather than activities that maximize the firm value (e.g. Fan and Wong, 2002). Thus, an increase in ownership concentration can increase agency costs due to the positive association with private benefits of control (Dyck and Zingales, 2004). Block shareholders may further allow firms to limit their information disclosure to outsiders so as to avoid unwanted public scrutiny (Jensen and Meckling, 1992). This suggests that when taking a role of block shareholders, high foreign ownership could be associated with high information asymmetry; that is, a positive relationship between foreign equity holdings and information asymmetry.

In sum, foreign ownership can have two opposing effects on the information environment. Short-term investment horizon, superior information processing capability, high controlling positions, increased agency costs and information problems associated with high foreign ownership will work to increase information asymmetry. However, greater demand for disclosure, improved accounting and auditing standards, use of international auditors, incentive alignment, and more effective monitoring associated with high foreign ownership will work to decrease information asymmetry. That is, a priori the information content of foreign ownership is ambiguous. While Jiang and Kim (2004) and Grinblatt and Keloharju (2000) show that foreign investors may have certain informational advantage over domestic investors in Japan and Finland, respectively, Choe et al. (2005) show that domestic investors appear to have an informational edge in Korea.

In this article, we attempt to provide empirical evidence on the effect of foreign ownership on information asymmetry measured by bid-ask spread in the emerging markets of China and shed light on the information content of foreign ownership. Given their generally low information environments, emerging markets provide a unique setting to investigate the consequences of institutional characteristics changes related to the information environment (Verrecchia, 2001). Because the information content of major corporate strategies, such as changes in ownership structure, is likely to be more pronounced in emerging markets than in rich information settings such as the United States, it would be easier to detect the marginal effect of information embedded in corporate strategies in emerging markets. A notable feature of the Chinese capital markets is a surge in foreign investment inflows, coupled with government regulation requiring local firms eligible for foreign investments to meet the disclosure requirements of international accounting standards (Sami and Zhou, 2004).

We believe that this is the first study of its kind that examines the effect of foreign ownership on bid-ask spread in China. Several studies of Chinese capital markets have examined the impact of foreign investors on firm value. For instance, Sun and Tong (2003) and Wei et al. (2005) examine the effect of privatization and ownership changes on firm valuation. In addition, Cull and Xu (2005) show that property rights and private ownership influence profit reinvestment by Chinese firms. Our study contributes to the literature by incorporating the role of foreign investors in the information dissemination process of public companies.

Our results are consistent with a market perception that foreign investors, on balance, may have worked to exploit their specific information advantages more than to enhance general market-wide transparency in an emerging market. A study of international listing of Mexican firms by Domowitz et al. (1998) found that implicit spreads decreased for Mexican firms after their cross listings in U.S. markets. Their study focuses on the effect of international listing on bid-ask spread and does not include international ownership as an explanatory variable. Our article directly examines the link between foreign ownership and information asymmetry and finds that bid-ask spreads increase with foreign ownership. We also extend the general ownership literature on ownership, agency cost and firm value (e.g. Morck et al., 1988; Barclay and Holderness, 1991; Bethel et al., 1998) to the market microstructure literature by documenting the relationship between ownership structure and information asymmetry risk. The results can be useful in understanding the role of information in major ownership changes such as privatization in emerging markets.

The remainder of the article is organized as follows. Section 'Institutions and Hypotheses' presents an overview of institutional background and develops hypotheses. Section 'Research Methodology' discusses research methodology, and Section 'Data and Descriptive Statistics' presents data and descriptive statistics. Section 'Basic Empirical Results' discusses basic empirical results, and Section 'Further Examinations' explores further empirical issues. Section 'Conclusions and Implications' concludes the article.

2. Institutions and Hypotheses

2.1. Ownership Structure in China

Companies in China are allowed to issue shares to domestic investors (called A-shares) and foreign investors (called B-shares) through the two national exchanges, Shanghai Stock Exchange and the Shenzhen Stock Exchange, after 1992. Up to December 2000, 114 Chinese companies had issued B-shares, with market capitalization of 61.1 billion RMB.2,3 Moreover, Chinese companies may cross list on other stock exchanges, such as H-shares on the Hong Kong Stock Exchange and other shares traded in the United States, United Kingdom, and Singapore (Sami and Zhou, 2004).

In addition to individual domestic shares (A-shares), and foreign shares (e.g. B-shares and H-shares), companies may also issue other shares: state, legal person, and employee shares. State shares are shares owned by the government entities or agencies, which are authorized to invest in enterprises on behalf of the government. Legal person shares are shares owned by Chinese domestic legal entities, including domestic state-controlled enterprises (with state-ownership larger than 50%) and other domestic institutions, such as securities companies, insurance companies, depository institutions, investment companies, endowment funds, and mutual funds. Employee shares are offered to managers and directors, as well as staff of listed companies at a discount rate. While individual shares (A-shares) are owned by individual Chinese citizens, foreign shares (e.g. B-shares and H-shares) are shares owned by foreign investors, as well as residents of Hong Kong, Macau, and Taiwan.

As common types of foreign shares, B-shares are listed and quoted in US dollars on the Shanghai Stock Exchange or in Hong Kong dollars on the Shenzhen Stock Exchange (Sami and Zhou, 2004), while H-shares are shares traded on the Hong Kong Stock Exchange. Foreign shares account for a limited portion of total shares for a pooled sample (on average less than 7% of total shares in our sample), but are substantial for firms with foreign investors.

2.2 Hypothesis Development

A number of studies have found that ownership structure influences information asymmetry. For instance, Yook et al. (1999) found that insider trading and insider ownership are related to the choice of payment methods for acquisition, and conclude that information asymmetry exists in takeover markets and influences the payment method for takeover. Su (2004) found significant correlation between underpricing of initial public offerings of Chinese companies and insider ownership, suggesting that insider ownership affects investors' perception of information asymmetry.

Meanwhile, various studies have provided evidence that information asymmetry influences bid-ask spread. Starting with Demsetz's (1968) theory on security transaction cost and Bagehot's (1971) theory on informed trading, the literature has used bid-ask spread as a proxy for information asymmetry among investors. On a typical market, informed traders trade on private information that is not currently reflected in price, while uninformed traders trade for reasons other than private information (e.g. Copeland and Galai, 1983). Dealing with informed traders, uninformed traders tend to increase their bid-ask spreads in order to recover losses, regardless of whether they are market makers or dealers in quote-driven markets or traders in order-driven markets (Brockman and Chung, 2000). Also, information asymmetry exists between managers (in a firm) and outside investors (in the market). When investors suspect that managers and controlling shareholders hold inside information about a firm's future prospects, they tend to widen bid-ask spread to manage information asymmetry risk. Hence, the bid-ask spread can proxy for the level of information asymmetry (Lev, 1988).

Therefore, a direct relation between ownership structure and bid-ask spread should exist. As the market participants perceive that insiders have superior access to a firm's information, they tend to widen bid-ask spread to cover the information asymmetry cost, suggesting a positive impact of insider holdings on bid-ask spread (Chiang and Venkatesh, 1988). Institutions are generally perceived as liquidity traders (rather than informed traders like insiders), indicating a negative relationship between bid-ask spread and institutional ownership in general (Kini and Mian, 1995), although certain types of institutions, such as banks and investment management companies, are believed to have more advantage in accessing private information than other investors, suggesting a positive relation between these institutional holdings and bid-ask spread (Fehle, 2004).

In this article we propose that foreign ownership could influence information asymmetry, which is in line with the literature that documents that information asymmetry could increase with insider and block ownership because insiders and block shareholders are believed to have superior access to a firm's private information in the market (Chiang and Venkatesh, 1988; Barclay and Holderness, 1991; Heflin and Shaw, 2000). Foreign investors are usually believed to have an informational disadvantage about a local firm compared with domestic investors. For instance, Choe et al. (2005) found an informational edge for domestic investors in Korea. Similarly, Jiang and Kim (2004) argued that the information risk is lower when foreign investors invest in a firm with low information asymmetry. Thus ceteris paribus, foreign investors are more likely to be attracted to firms with lower information asymmetry as they have a higher demand and pressure for increased disclosure by local firms. Not surprisingly, Sami and Zhou (2004) found that the value relevance of accounting information in the B-share market of China (where foreigners invest) is generally higher than in the A-share market (where domestic investors trade). It suggests that the presence of foreign ownership may help to improve the general information environment of public companies. This argument is in the line with the literature that has shown that foreign investors can contribute to firm performance through a variety of activities, such as strengthening shareholder activism and board representation (Choi et al., 2007), using more sophisticated valuation methods (Wei et al., 2005), and enhancing the privatization process of state-owned enterprises (Xu et al., 2005). The increased information transparency, as indicated in better accounting standards and higher quality of auditors, can improve the market liquidity (Lang et al., 2009). One of the economic consequences of information transparency, or increased disclosure as defined in Verrecchia (2001), should include a reduced level of information asymmetry in the market.

Moreover, when foreign investors employ an investment strategy by taking the position of block shareholders, they could directly and effectively monitor management actions and enable a long investment horizon, which allows the building of strong relationships between the firm and outside providers of capital (Ellul et al., 2007). Therefore, information asymmetry would be lower for firms with higher block foreign ownership while there is general transparency.

On the other hand, the literature also indicates that there is an incentive for foreign investors to maintain their superior information (Grinblatt and Keloharju, 2000). In contrast to foreign investors with a long run investment horizon, who should be able to lower information asymmetry, foreign investors with a short investment horizon should be associated with high information asymmetry. Foreign (institutional) investors may have a superior capability to process public information into private value-relevant information than that of domestic individual investors. As the value of private information increases with information asymmetry, foreign investors might be associated with firms with high information asymmetry. In this case, the role of foreign investors could be the same as financial analysts in capitalizing on information asymmetry, as documented by Chung et al. (1995), which indicates that bid-ask spreads are greater for stocks with more financial analyst following and suggests that the presence of financial analysts is associated with high information asymmetry.

In addition, if foreign shareholders are block shareholders, they could be viewed as informed traders from other traders' point of view. Since block shareholders have access to private, value-relevant information via their roles as monitors of corporate operations (e.g. Barclay and Holderness, 1991), it is likely that foreigners may exploit their information advantages. Increased ownership concentration may entrench managers, because they are less subject to governance by boards of directors and to scrutiny by the market (Morck et al., 1988). Controlling shareholders may either engage in outright expropriation from self-dealing transactions or exercise de facto expropriation through pursuing goals that are not maximizing the firm value in return for personal interests (e.g. Fan and Wong, 2002). Thus increased concentration can increase agency costs via the positive association with private benefits of control (Dyck and Zingales, 2004). Block shareholders may further allow firms to limit their information disclosure to outsiders so as to avoid unwanted public scrutiny (Jensen and Meckling, 1992). Consistent with this notion, Fan and Wong (2002) found that concentrated ownership is associated with low informativeness of accounting earnings. This suggests that in the case of block shareholders, high foreign ownership could be associated with high information asymmetry.

In summary, foreign ownership can have two types of effects on information environment. Short term investment horizon, superior information processing capability, controlling positions, increased agency costs and information problems associated with foreign ownership will increase information asymmetry. However, greater demand for disclosure, better accounting and auditing standards, global auditor type, incentive alignment, long term investment horizon, and greater monitoring will decrease information asymmetry.

Our primary interest is to investigate the effect of foreign ownership in an emerging market setting with underdeveloped institutional features. With less restrictive disclosure environment and less investor protection, foreign investors are more likely to seek to position themselves as superior information holders to capitalize on information asymmetry in emerging markets than in developed markets. In China, there are only a limited number of firms with foreign investors. Of 271 sample firms with data available during the whole sample period, only 51 firms have shares held by foreign investors. However, among these firms, the foreign influence can be substantial, with a maximum of 66.4%. The average foreign ownership is only 6.8% for the entire sample, while for firms with foreign ownership, the average is 29.6%. In addition, most foreign investors in emerging markets are institutional investors with sophisticated skills and experience. In such a case, when foreign ownership is high, financial transparency can play a less important role in reducing agency costs and financial transparency matters less (i.e. only when foreign investors could benefit from public disclosures but not when they have superior information to other investors in the market). Therefore, in emerging markets with less investor protection and a less restrictive disclosure environment, we predict that foreign investors will attempt to exploit their information processing advantage and increase information asymmetry. Thus we state our hypothesis as follows:

Hypothesis 1. There is a positive relation between foreign ownership and bid-ask spread.

We include state ownership as a control variable given its prominent role in Chinese governance (e.g. Sun and Tong, 2003; Choi et al., 2010; Sami et al., 2011). Therefore, when state ownership leads to adverse selection by managers and induces a deviation between control and ownership, the magnitude of state ownership should be positively associated with the level of information asymmetry. Such a deviation may compromise general transparency and increase information asymmetry, which is similar to the entrenchment effect found in a family firm (Claessens et al., 2002). In such situations, firms with higher state ownership would be less likely to commit to full corporate disclosure, especially when informed shareholders expropriate other shareholders' interests.

However, it is also plausible that, as a promoter for the maximization of public welfare, the government can exert pressure to increase the general transparency of corporate disclosure. As a controlling shareholder, it could be easier and more efficient for the government to directly monitor management actions and thus reduce agency costs for state-owned companies. Strong relationships between the firms and external stakeholders are more likely to exist when state shareholders enable a long investment horizon (Ellul et al., 2007). In this case, the overall information environment of the market would improve, that is, the information transparency would increase and information asymmetry would decline. Choi et al. (2010) found positive associations between state ownership and information asymmetry.

Other ownership types could also influence informational environments. For instance, the literature has documented the profitability of insider trading in the United States (Seyhun, 1992; Bris, 2000). Since insider holdings are perceived to have potential for adverse selection, insider ownership could drive up bid-ask spreads (e.g. Chiang and Venkatesh, 1988; Chung and Charoenwong, 1998). Although insiders, including managers, board members and private owners, may retain a larger portion of shares to signal their confidence about the firm's prospects (Su, 2004), in China managers are usually selected from government officers and the extent of managerial ownership in China is limited. This may moderate the influence of insider ownership.

Firms with high institutional holdings have a high level of analyst coverage, which leads to information dissemination and lower information asymmetry (O'Brien and Bhushan, 1990). However, the effect of institutional ownership also depends on the nature of institutions (Lakonishok et al., 1992). While the effect of institutional ownership on bid-ask spread is generally negative (e.g. Van Ness et al., 2001), it is positive for certain types of institutions such as banks and investment management companies (Fehle, 2004). Because the institutional mechanism is not well developed in emerging markets, the role of institutional investors in information dissemination in China may be limited. When corporate governance system is weak, institutional investors may then have an incentive to use private information obtained by monitoring to take advantage of minority shareholders rather than to contribute to information dissemination. Hence, we also control for the role of institutional investors, though its net effect is less clear in emerging markets.

Block shareholders can have private information because of their role as a monitor of corporate operations (e.g. Bethel et al., 1998). Thus firms with higher block ownership, either by managers or external entities, have larger bid-ask spreads for United States firms (Heflin and Shaw, 2000). However, block shareholders may help reduce agency costs through the monitoring of management actions and implement a long-term investment perspective to encourage the building of strong contracting links between the firm and its investors. This could facilitate an improved information environment and increased information transparency (Hope et al., 2009), and hence reduce information asymmetry. Therefore, we also control for its effects on information asymmetry in our study.4

3. Research Methodology

Following the literature (Leuz and Verrecchia, 2000; Choi et al., 2010), we adopt the following model to examine the effect of foreign ownership on bid-ask spreads:

display math(1)

The dependent variable, SPREAD, is measured, in percentage, by an average weekly bid-ask spread (ask minus bid divided by the average of these two prices) of firm i in year t.

As the explanatory variable of our primary interest, foreign ownership (FOREIGN) is measured by the percentage shares held by registered foreigners and foreign institutions. Other types of ownership are included as ownership-based controls. These include state ownership (STATE) measured by the percentage of shares held by government and government agencies; insider ownership (INSIDER) measured by the percentage of shares owned by managers and directors; institutional ownership (INST) measured by the percentage of shares held by securities companies, insurance companies, depository institutions, investment companies, endowment funds, and mutual funds; and block ownership (BLOCK) measured by the percentage of shares held by stockholders with no less than 3% equity ownership.5

As volume turnover is likely to affect bid-ask spread negatively (e.g. Copeland and Galai, 1983), and return volatility is positively related to the trading gains of informed traders in an order-driven market (Aitken and Frino, 1996), we include TURNOVER, the average weekly turnover measured by the value of trading volume divided by market value of the equity during year t, and VOLATILITY, an average of 52-week standard deviations of daily returns of firm's stock during year t. In addition, large companies tend to have lower spreads (Greenstein and Sami, 1994), and analyst following and media coverage increases with firm size (Chiang and Venkatesh, 1988). Hence, we include firm size, a logarithm of average weekly market value of the firm's equity during the year, to control for a firm's information environment (Leuz and Verrecchia, 2000). The indicator variable for year and its interaction terms are included to control for the intertemporal effects of institutional and regulatory changes over time.

The single equation specification above assumes an exogeneity of all explanatory variables. However, it is plausible that information asymmetry reflected in the ownership structure can also influence some of these variables, especially volume turnover and volatility. To address this concern, we use the three-stage least squares to estimate the following two equations on volume turnover and return volatility endogenously along with bid-ask spreads:

display math(2)
display math(3)

Besides the control variables discussed above, in the volume turnover model we include INDEX, which is one if the company's stock is included in the composite share index on the Shenzhen Stock Exchange or in the SH180 index on the Shanghai Stock Exchange, and zero otherwise. Included in the volatility model is BETA, which is a measure of the firm's systematic risk and is estimated with weekly returns for the 52-week period.

4. Data and Descriptive Statistics

Our sample selection starts with the entire population of firms listed on either the Shanghai Stock Exchange or the Shenzhen Stock Exchange at the beginning of 1995—bid and ask prices began to be available from 1995 in the Taiwan Economic Journal Database (TEJ). These firms are then subject to the following screening criteria: (i) daily last bid and ask prices as well as daily closing price data are available for the period of 1995–2000 in the TEJ database; (ii) annual corporate reports (with known report dates) are available from a Chinese website, http://quotes.money.163.com; and (iii) information on trading volume and publicly held shares are available from TEJ. This screening procedure resulted in 1549 firm-year observations for a pooled cross-sectional analysis for the period 1995–2000 (Table 1).

Table 1. Sample selection
Sample selection procedureNumber of firms or observations
Firms issuing A-shares with stock price information available since January 1995287
Less: Firms with disclosure dates not available from the Taiwan Economic Journal Database (TEJ) or from their annual reports10
Less: Firms withe bid or ask prices not available from the Taiwan Economic Journal Database (TEJ)6
Total firms available for analysis271
Total weekly observations for calculating yearly average of market microstructure variables85 474
Total firm-year observations for pooled cross-sectional analysis for the period of 1995–20001549

Table 2 presents the descriptive statistics for variables used in empirical work. The mean bid-ask spread across all sample firms is 0.272 (median is 0.252). The mean value of INDEX is 0.248, indicating that about a quarter of companies in the sample are included in the Shenzhen composite share price index or in the Shanghai SH180 index. Both the mean and median of systematic risk are about one, which shows the efficacy of our sample in mimicking the market portfolio. The mean insider ownership is only 0.3% but the maximum reaches 38.7%. Institutional ownership is more sizable, with a mean of 22.9%. In our sample of “privatized” firms, the average share of government ownership is still about 30%, which is comparable to those reported elsewhere (e.g. Chen et al., 2009). The average foreign ownership is only 6.8% for the entire sample, but for the sample of firms with foreign ownership, the foreign influence can be substantial, with a maximum foreign ownership reaching 66.4%. The remainder of shareholders other than these four categories should be largely domestic individual investors. However, block ownership with at least 3% ownership has a mean of 52.5%, which indicates a degree of concentration in the Chinese stock markets.

Table 2. Descriptive statistics
VariablesMaximumQuartile 3MedianMeanQuartile 1Minimum
  1. SPREAD = average weekly bid-ask spread in percentage during the year; SIZE = log of average weekly market value of the firm's equity during the year; TURNOVER = average weekly share turnover during the year where share turnover is defined as the dollar amount of trading volume divided by the market value of the equity of the firm; VOLATILITY = average of 52-week standard deviation of daily returns during the year; INDEX = 1 if the company's stock is included in the composite share index on Shenzhen Stock Exchange or in the SH180 index on Shanghai Stock Exchange (and 0 otherwise); BETA = systematic market risk of the firm, estimated from weekly return for the 52-week period; INSIDER = the percentage of common equity shares held by managers and directors; STATE = the percentage of common equity shares held by government agencies or institutions, which represent the government to make investment decisions; INST = the percentage of common equity shares held by institutions, such as securities companies, insurance companies, depository institutions, investment companies, endowment funds, and mutual funds; FOREIGN = the percentage of common equity shares held by registered foreign individuals and institutions; BLOCK = the percentage of common equity shares held by stockholders with no less than 3% ownership according to the annual report.

SPREAD 0.9140.3350.2520.2720.190.075
VOLATILITY 9.9093.1552.7122.7432.2611.196
TURNOVER 16.2852.7281.8952.2701.2220.173
SIZE 10.3518.0317.477.5066.9235.442
INDEX 1000.24800
BETA 2.2131.2041.0521.0140.8980.066
INSIDER 0.387000.00300
STATE 0.8860.5060.3220.30100
INST 0.9070.390.1620.2290.0090
FOREIGN 0.664000.06800
BLOCK 0.8610.640.5240.5250.4160

Prior to estimating the regression equation, we computed the Pearson correlation coefficients among explanatory variables included in equation (1). Somewhat surprisingly, there is little correlation (0.023) between institutional ownership and block ownership (Table 3). Similarly, there is little correlation between insider ownership and any of the other ownership variables. However, state ownership and institutional ownership have high negative correlation (–0.747), indicating that the majority of privatization cases may involve a sale of SOE shares to institutional investors. However, we compute variance inflation factors (VIF) for all equations, and the results suggest that multicollinearity is not a serious problem, as none of the VIF values is greater than the suggested benchmark of 10 (Gujarati, 1995, p. 339). In addition, volume turnover and volatility have a relatively high correlation. Hence, as sensitivity tests, we also included these variables separately in estimation, with no appreciable differences from those obtained when both variables are included. Later, the relation between turnover and volatility is further directly estimated using the 3SLS. Again, tests of multicollinearity for all explanatory variables in the bid-ask spread equation using the methods by Belsley et al. (1980) and Gujarati (1995) indicate no serious multicollinearity problem.

Table 3. Pearson correlation matrix of major variables
  SPREAD VOLATILE TURNOVER SIZE INDEX BETA INSIDER STATE INST FOREIGN BLOCK
SPREAD 1          
0          
VOLATILITY 0.2111         
00         
TURNOVER 0.0140.7191        
0.57300        
SIZE −0.565−0.293−0.1641       
0000       
INDEX −0.183−0.126−0.1120.4091      
00000      
BETA 0.004−0.2540.005−0.0220.0091     
0.88700.8590.3830.7260     
INSIDER 0.0780.025−0.015−0.0630.0220.0011    
0.0020.3350.5570.0140.3880.9760    
STATE 0.0620.0260.0440.144−0.036−−0.019−0.0571   
0.0140.3110.08100.1550.4450.0240   
INST 0.1450.0920.014−0.1700.0110.0080.070−0.7471  
000.57200.6780.7450.00600  
FOREIGN 0.037−0.046−0.0070.200−0.0490.008−0.0580.074−−0.1791 
0.1430.0690.78400.0540.7650.0220.00400 
BLOCK 0.1090.0700.0540.142−0.091−0.022−0.0500.3970.0230.1021
00.0060.034000.3870.05100.36500

5. Basic Empirical Results

5.1. Single Equation Estimations

Table 4 reports the OLS results of equation (1). The coefficient of foreign ownership is significant and positive, confirming Hypothesis 1. Lins (2003) and others suggest that in an emerging market in which basic corporate governance infrastructure is insufficient, foreign investors can perform some of these functions. However, in China and as it relates to information environments, the present result indicates that this is not the case. Despite the adoption of international accounting standards required for firms with foreign ownership, the present result shows that, on balance, from the market perspective, superior information processing capability, high controlling positions, increased agency costs and information problems associated with high foreign ownership will encourage foreign investors to maximize their profits in capitalizing on information asymmetry. That is, in emerging markets with less investor protection and a less restrictive disclosure environment, foreign investors appear to work to extract rent by increasing their information advantages rather than working towards improving general transparency for all.

Table 4. The effect of foreign ownership on the bid-ask spread
Explanatory variablesCoefficientt-statisticsTwo-tail p-value
  1. ***significant at 0.01, **significant at 0.05, *significant at 0.10, respectively (two-tail test). See Table 2 for definitions of data and variables.

INTERCEPT 0.684***28.51<0.0001
FOREIGN 0.126***8.46<0.0001
STATE 0.140***8.84<0.0001
INSIDER −0.020−0.210.8310
INST 0.132***7.97<0.0001
BLOCK 0.0130.830.4087
VOLATILITY 0.0071.230.2187
TURNOVER −0.016***−7.73<0.0001
SIZE −0.055***−19.46<0.0001
YEAR1 −0.009−1.040.2973
YEAR2 −0.081***−10.79<0.0001
YEAR3 −0.112***−15.76<0.0001
YEAR4 −0.074***−9.13<0.0001
YEAR5 −0.120***−13.93<0.0001
Adjusted R256.35%  
F-value154.73***  

In addition, the result shows a positive and significant relationship between state ownership and bid-ask spread. This indicates that firms with a higher foreign ownership have a higher information asymmetry as reflected in bid-ask spread. This is consistent with earlier findings that firms with higher state ownership tend to have a greater deviation between cash flow rights and control rights (e.g. Wei et al., 2005). When state ownership is high, political influence and ineffective management monitoring can play a greater role in increasing costs associated with agency and information problems. Our findings are consistent with a notion that the government, as a partial owner of the firm, tends to engage in selective and unscrupulous policies pertaining to information conveyance, which increases information asymmetry rather than enhancing general information environments for all. Therefore, in the emerging market settings, firms with higher state ownership will be associated with a higher level of information asymmetry.

Regarding other ownership variables, we find no significant relationship between insider ownership and bid-ask spread. The weak result on insider ownership is consistent with the result of Kini and Mian (1995) for United States firms. Similarly, the coefficient of block ownership is statistically insignificant. Similar results are obtained with alternative measures of block ownership, such as the percentage of shares owned by stockholders with 1% or more equity ownership, and the percentage of shares owned by the top ten stockholders. However, the effect of institutional ownership is highly significant and positive. This suggests the development of corporate governance systems in the emerging markets of China, in which institutional investors may then have incentives to use private information obtained by monitoring to extract rent from minority shareholders rather than to contribute to information dissemination.

There is evidence that the bid-ask spread has narrowed over time due to an improvement in the general information environment, as indicated by the negative and significant coefficients of YEAR variables after year one (1995). In addition, the F-tests for the joint effects of ownership and interaction terms involving ownership and time (not reported) show that the net intertemporal effects of state and foreign ownership are all positive and significant. That is, even considering the intertemporal changes over time, state and foreign ownerships are shown to raise the bid-ask spread due to information asymmetry. To the extent that the information consequence of state and foreign ownership is selective rather than general, it presents a challenge for Chinese policymakers in terms of their privatization and market liberalization as to how a general information environment can be improved rather than the selected few.

As expected, volume turnover has a significant and negative effect on bid-ask spread. Return volatility has a positive coefficient as expected, although it is not statistically significant. As expected, firm size is shown to lower the bid-ask spread. Additional analysis, including interaction terms with a time-trend variable, indicates that the effect of turnover on bid-ask spread has increased over time while that of volatility has decreased.

5.2. Endogeneity

Table 5 reports the results of 3SLS where volume turnover and volatility, along with bid-ask spread, are endogenously estimated. The result in Panel A for bid-ask spread confirms the result from the single equation estimation in Table 4. Again, the effects of state and foreign ownership are significant and positive. In addition, the effect of institutional ownership on bid-ask spread is significant and positive, while insider and block ownership are statistically insignificant. One difference from Table 4 is that the coefficient of volume turnover is statistically insignificant. These results remain the same when we perform additional analysis including interaction terms between ownership variables and a time-trend variable.

Table 5. 3SLS analysis of the effect of foreign ownership on the bid-ask spread
VariablesCoefficientt-statisticsTwo-tail p-value
  1. ***significant at 0.01, **significant at 0.05, *significant at 0.10, respectively (two-tail test). See Table 2 for definitions of data and variables.

Panel A: Bid-ask model
Intercept 0.422**2.220.0263
FOREIGN 0.104***4.50<0.0001
STATE 0.116***4.61<0.0001
INSIDER −0.018−0.170.8646
INST 0.129***6.66<0.0001
BLOCK −0.031−0.890.3711
VOLATILITY 0.0070.540.5871
TURNOVER 0.0621.180.2370
SIZE −0.026−1.280.1998
YEAR1 −0.288−1.500.1327
YEAR2 −0.173***−2.660.0078
YEAR3 −0.167***−4.38<0.0001
YEAR4 −0.177**−2.450.0144
YEAR5 −0.201***−3.650.0003
System weighted R258.59%  
Panel B: Volume turnover model
Intercept 3.619***5.77<0.0001
FOREIGN 0.2951.240.2157
STATE 0.3301.310.1919
INSIDER 0.0220.020.988
INST 0.0500.190.8501
BLOCK 0.583**2.400.0165
VOLATILITY −0.074−0.450.6559
SIZE −0.390***−7.28<0.0001
INDEX 0.0140.230.8151
YEAR1 3.652***16.77<0.0001
YEAR2 1.240***7.89<0.0001
YEAR3 0.712***6.32<0.0001
YEAR4 1.378***8.87<0.0001
YEAR5 1.027***7.42<0.0001
System weighted R258.59%  
Panel C: Return volatility model
Intercept 3.532***34.59<0.0001
FOREIGN −0.027−0.340.7338
STATE 0.149*1.730.0838
INSIDER 0.4710.940.3456
INST 0.1221.360.1731
BLOCK 0.221***2.690.0071
SIZE −0.166***−11.13<0.0001
BETA −0.120***−17.57<0.0001
YEAR1 1.153***31.70<0.0001
YEAR2 0.703***18.83<0.0001
YEAR3 0.088**2.330.0199
YEAR4 0.598***14.53<0.0001
YEAR5 −0.214***−4.85<0.0001
System weighted R258.59%  

Panels B and C explore the impacts of ownership structure on turnover and volatility. In Panel B, foreign ownership has no significant effect on volume turnover although the coefficient is positive. In Panel C, foreign ownership has no significant effect on price volatility although the coefficient is negative. Thus, we did not find any evidence to support the popular sentiment about the potentially destabilizing influence of foreign investors. This is consistent with the finding by Choe et al. (1999) who report no evidence that foreign investors had a destabilizing effect in Korean stock markets during the Asian financial crisis. As to other ownership variables, although no effects of block ownership on bid-ask spreads are found, block investors are shown to increase turnover and volatility. Insider and institutional ownership have no significant effect on volume turnover or price volatility.

6. Further Examinations

6.1. The Adverse Selection Component of Bid-Ask Spread

In the empirical work above, we used the total bid-ask spread as a measure of information asymmetry as influenced by specific corporate ownership variables. However, one can argue that total spread includes several components (order processing, inventory holding, and adverse selection), of which only the adverse selection component measures information asymmetry. To check for the sensitivity of our results, we have estimated the adverse selection component of bid-ask spread based on the method used by George et al. (1991). The correlation between the total spread and the adverse selection component is 0.86. Then equation (1) is re-estimated using the adverse selection component as the dependent variable, by OLS and also 3SLS. The results, presented in Table 6, are not materially differently from those reported earlier using the total spread.

Table 6. The effect of foreign ownership on the adverse selection component of the bid-ask spread
VariablesCoefficientt-statisticsTwo-tail p-value
  1. ***significant at 0.01, **significant at 0.05, *significant at 0.10, respectively (two-tail test). See Table 2 for definitions of data and variables.

Panel A: OLS analysis
Intercept 0.456***40.91<0.0001
FOREIGN 0.043***6.22<0.0001
STATE 0.065***8.85<0.0001
INSIDER −0.055−1.30.1952
INST 0.064***8.36<0.0001
BLOCK −0.003−0.480.6303
VOLATILITY 0.0010.210.8313
TURNOVER −0.006***−6.57<0.0001
SIZE −0.045***−34.34<0.0001
YEAR1 −0.010**−2.390.0168
YEAR2 −0.040***−11.35<0.0001
YEAR3 −0.060***−18.03<0.0001
YEAR4 −0.043***−11.55<0.0001
YEAR5 −0.053***−13.12<0.0001
Adjusted R272.30%  
F-value281.91***  
Panel B: 3SLS analysis
Intercept 0.568***6.67<0.0001
FOREIGN 0.052***5.04<0.0001
STATE 0.075***6.72<0.0001
INSIDER −0.055−1.150.2515
INST 0.066***7.62<0.0001
BLOCK 0.0150.920.3556
VOLATILE −0.002−0.420.6755
TURNOVER −0.037−1.560.1193
SIZE −0.057***−6.26<0.0001
YEAR1 0.1031.190.2323
YEAR2 −0.001−0.040.9671
YEAR3 −0.038**−2.210.0273
YEAR4 −0.001−0.020.9822
YEAR5 −0.021−0.860.3880
System weighted R258.35%  

6.2. Sub-Sample Estimation without Foreign Ownership

One salient result of ownership variables discussed above is that the coefficients of foreign ownership in the bid-ask spread model are most robust, in terms of their magnitude and significance, across different specifications. In this section, we investigate whether the insignificant results of other ownership variables, such as insider and block holdings, are influenced by the presence of foreign investors, who may play an important role in the information environment of public companies. To address this possibility, we re-estimate the bid-ask spread in a single equation and simultaneous system framework for firms without foreign ownership and firms with foreign ownership separately in Table 7 and Table 8, respectively. There are 1191 firm-year observations in the sample without foreign ownership, compared with 358 firm-year observations in the sample with foreign ownership.

Table 7. The effect of ownerships on the bid-ask spread: the sample of firms without foreign ownership
VariablesCoefficientStandard errort-statisticsTwo-tail p-value
  1. ***significant at 0.01, **significant at 0.05, *significant at 0.10, respectively (two-tail test). See Table 2 for definitions of data and variables.

Panel A: OLS analysis
Intercept 0.6500.02823.10***<0.0001
YEAR1 −0.0150.010−1.520.1298
YEAR2 −0.0860.008−10.42***<0.0001
YEAR3 −0.1060.008−13.73***<0.0001
YEAR4 −0.0730.009−8.14***<0.0001
YEAR5 −0.1060.010−10.86***<0.0001
VOLATILE 0.0190.0072.81***0.0051
TURNOVER −0.0170.002−7.32***<0.0001
SIZE −0.0540.003−16.90***<0.0001
INSIDER −0.0110.087−0.120.9029
STATE 0.1060.0185.98***<0.0001
INST 0.1000.0185.66***<0.0001
BLOCK 0.0220.0181.200.2300
Adjusted R258.29%   
F-value138.3***   
Panel B: 3SLS analysis
Intercept 0.8380.1167.19***<0.0001
YEAR1 −0.1660.187−0.880.3766
YEAR2 −0.0900.050−1.80*0.0727
YEAR3 −0.1540.039−3.90***0.0001
YEAR4 −0.0930.052−1.80*0.0724
YEAR5 −0.2120.061−3.50***0.0005
VOLATILE −0.1170.046−2.54**0.0111
TURNOVER 0.0700.0641.080.2800
SIZE −0.0470.015−3.11***0.0019
INSIDER 0.0600.1240.480.6306
STATE 0.1110.0254.51***<0.0001
INST 0.1300.0333.98***<0.0001
BLOCK 0.0010.0370.040.9705
System weighted R256.76%   
Table 8. The effect of ownerships on the bid-ask spread: the sample of firms with foreign ownership
VariablesCoefficientStandard errort-statisticsTwo-tail p-value
  1. ***significant at 0.01, **significant at 0.05, *significant at 0.10, respectively (two-tail test). See Table 2 for definitions of data and variables.

Panel A: OLS analysis
Intercept 0.7290.06112.00***<0.0001
YEAR1 −0.0030.021−0.130.8988
YEAR2 −0.0740.017−4.39***<0.0001
YEAR3 −0.1260.016−7.86***<0.0001
YEAR4 −0.0780.018−4.33***<0.0001
YEAR5 −0.1410.019−7.61***<0.0001
VOLATILE −0.0090.009−0.980.3269
TURNOVER −0.0170.004−3.86***0.0001
SIZE −0.0650.006−10.26***<0.0001
INSIDER 0.5110.8520.600.5489
STATE 0.3300.0398.39***<0.0001
INST 0.3480.0477.48***<0.0001
FOREIGN 0.1560.0473.32***0.001
BLOCK −0.0310.028−1.110.2692
Adjusted R257.44%   
F-value38.17***   
Panel B: 3SLS analysis
Intercept 6.5553.1872.06**0.0405
YEAR1 5.4202.9671.83*0.0686
YEAR2 1.9141.0891.76*0.0796
YEAR3 1.0940.6711.630.1041
YEAR4 2.7231.5331.78*0.0766
YEAR5 2.3531.3691.72*0.0864
VOLATILE −0.1620.092−1.75*0.0804
TURNOVER −1.5230.825−1.85*0.0658
SIZE −0.7810.393−1.99**0.0473
INSIDER −29.37216.764−1.75*0.0806
STATE 1.7860.8142.19**0.029
INST 1.6240.7272.23**0.0261
FOREIGN −0.0030.224−0.010.9897
BLOCK 1.1350.6501.75*0.0815
System weighted R249.08%   

For firms without foreign ownership, the OLS results in Panel A of Table 7 show that state ownership is significant and positive as well as institutional ownership, which is the same as in Table 4. The 3SLS analysis in Panel B reports similar results as in Panel A. The results indicate that state and institutional ownership play important roles in the information dissemination process for firms without foreign investors but no other types of ownership.

For firms with foreign ownership, the OLS results in Panel A of Table 8 show that state and foreign ownership variables are significant and positive as is institutional ownership, which is the same as in Table 4. The 3SLS analysis in Panel B reports similar results on state and institutional ownership as in Panel A. However, after controlling for the simultaneous effects of ownership variables on bid-ask spread, trading volume and price volatility, the result on foreign ownership is insignificant while the result on block ownership is significant and positive and that on insider ownership is significant and negative. It indicates that in firms with foreign investors, foreign investors may have incentives to maintain their superior information and monitor the firms through block holdings or insider holdings.

6.3. Other Robustness Checks

In the present estimation, we included firms listed on either the Shanghai Stock Exchange or the Shenzhen Stock Exchange. To check whether the results are sensitive to listing in particular exchanges, we re-estimated Table 4 including a dummy variable for exchange listing (and also separately for each of the two samples listed in these exchanges). The results are similar to those reported in our study.

Another issue concerns audit quality, which may influence the quality of some corporate variables used in the bid-ask spread model. Audit quality is usually proxied by firm size or by the market share of auditors that may correlate with audit quality (e.g. Gul et al., 2002). DeFond et al. (2000), in particular, examine the effect of auditor independence on audit market concentration in China. Following their specification, we included an audit dummy variable, which is one if the company is audited by one of the ten largest accounting firms (including the Chinese and Big Four accounting firms and their joint ventures) in terms of the total combined assets of client firms, and zero otherwise. The results of ownership variables are qualitatively the same as reported.

7. Conclusions and Implications

Foreign ownership might have two competing effects on information asymmetry. Short term investment horizon, superior information processing capability, controlling positions, increased agency costs and information problems associated with foreign ownership will increase information asymmetry. In contrast, more demands for disclosure due to local investor's advantage, better accounting and auditing standards, auditor type, incentive alignment, long term investment horizon, and effective monitoring by foreign investors will decrease information asymmetry. In this article, we examine the effect of foreign ownership on information asymmetry measured by bid-ask spread in China. We find that foreign investors have significant and positive impacts on bid-ask spread.

Among the various possible reasons for the two competing effects of foreign ownership, one of the major reasons is the investment horizon of foreign investors. Our findings suggest that foreign investors have a short term investment horizon in China during the sample period. The positive impact of foreign ownership on information asymmetry also could be relevant to the emerging market settings with underdeveloped institutional features. Given they are operating in a less restrictive disclosure environment with less investor protection, foreign investors are more likely to want to become superior information holders to capitalize on their information asymmetry than working to improve general informational environments.

By examining the connection between ownership and information asymmetry, we extend the market microstructure literature to incorporate governance and information transparency. This article provides direct evidence on the relationship between ownership and information asymmetry in emerging markets. Beyond that, the article has several important policy implications. Our result that high foreign ownership is associated with high information asymmetry suggests policies should be devised in such a way that institutional investors, including foreigners, are encouraged to contribute to information transparency rather than acting as another agent to exploit their specific informational advantages at the expense of other investors. In addition, the privatization of state enterprises, among other things, can contribute to economic efficiency by reducing the cost of information asymmetry and hence, lower the cost of capital.

Notes

  1. 1

    The investment horizon of foreign investors can influence information asymmetry in two ways due to various reasons. One of the possible explanations could be investment horizons of foreign investors. Future study could investigate the role of trading strategies of foreign investors in information environment and whether the longer the investment horizon of foreign investors, the greater the reduction in market-wide information asymmetry. We owe our thanks to the anonymous reviewer for addressing this issue.

  2. 2

    According to the China Daily Press (2 June 2001), on 25 May 2001, the value of market capitalization of the two Chinese exchanges exceeded that of the Hong Kong Exchange for the first time. This made the Chinese stock market the second largest Asian capital market, second only to Japan. According to the Wall Street Journal (5 February 2011), the two exchanges have a market capitalization of $3.572 trillion, second only to the New York Stock Exchange.

  3. 3

    Both A-shares and B-shares convey equal rights to the same company although they are different in terms of ownership.

  4. 4

    Block shareholders are most likely state shareholders, institutional shareholders or foreign shareholders in our study. We use the block ownership variable as a control for the effects of any other types of shareholders who take the controlling position of a firm. As an alternative, we also use the residual from a regression of block ownership on state, foreign and institutional ownership to control for the same issue.

  5. 5

    We use the same definition of institutional ownership as most empirical studies of corporate finance. We also use a broader definition for institutional shareholders as Wei et al. (2005), which include domestic state-controlled enterprises as well as financial institutions. The results again are similar to those reported. We also use alternative measures of block ownership such as the percentage shares held by stockholders with no less than 1% ownership, and the percentage shares held by top ten stockholders, but find no appreciable qualitative differences.

Ancillary