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.