Does exposure to foreign competition affect stock liquidity? Evidence from industry-level import data

https://doi.org/10.1016/j.finmar.2017.12.002Get rights and content

Highlights

  • Industry-level import penetration has a negative effect on firm's stock liquidity.

  • Reduction in information transparency due to increased foreign competition is driving the result.

  • The negative relation is more evident for firms that are more prone to higher foreign competition.

  • The negative relation is weaker for firms which are better monitored.

  • The negative relation is less evident for firms which have greater analyst coverage.

Abstract

We document a negative association between foreign competition and stock liquidity. Our results are robust to addressing endogeneity concerns. We identify deterioration in the information environment in response to an increase in foreign competition as the channel behind the main result. Specifically, we find that the negative association is more evident among firms that are more susceptible to the negative consequences of foreign competition and firms that are poorly monitored and have lower analyst coverage. Our paper contributes to the understanding of the externalities of trade liberalization for financial market quality.

Introduction

Stock liquidity is an essential element of a well-functioning market (Stiglitz, 1981, Sadka and Scherbina, 2007, Chordia et al., 2008). Among other things, stock liquidity has implications for firm performance (Fang et al., 2009), the cost of capital (Amihud and Mendelson, 1986), and the level of corporate innovation (Fang et al., 2014). A key determinant of a firm's level of stock liquidity is the information environment in which it is traded (Glosten and Milgrom, 1985, Kyle, 1985, Diamond and Verrecchia, 1991). In this paper, we examine how stock liquidity is affected by foreign competition, which we identify as an important factor influencing a firm's information transparency.

We hypothesize a negative association between foreign competition and stock liquidity. We argue that the negative effect that foreign competition has on the profit margins of domestic firms (Xu, 2012) can negatively influence a firm's disclosure policy in at least three ways. First, Bustamante and Donangelo (2017) show that intensified competition reduces profit margins, which buffer adverse shocks, resulting in higher operating leverage and hence greater exposure to risk. Bertomeu et al. (2011) develop a model in which greater risk exposure coupled with higher leverage results in a more limited optimal disclosure policy. Second, a large empirical literature shows that more competitive product markets display greater management turnover (DeFond and Park, 1999, Fee and Hadlock, 2000). To reduce the possibility of poor firm performance causing the manager's compensation package to shrink and/or his job to be terminated, the manager hides bad information to manipulate investors' beliefs (Kim, 1999, Kothari et al., 2009, Rogers et al., 2014, Li and Zhan, 2016). Third, a number of recent studies show that firms tend to respond to an intensification of competitive pressures by distorting the information they release to their shareholders by “managing” earnings releases (Markarian and Santalo, 2014, Karuna et al., 2015, Lin et al., 2016). The implication of all these studies is that managers are less transparent and more likely to send distorted signals to the market when faced with increased competitive pressures.

We argue that this foreign competition-induced reduction in information quality has implications for capital markets in the form of reduced stock liquidity. Traditional models of the price formation process (Copeland and Galai, 1983, Glosten and Milgrom, 1985) show that, when the dealer (uninformed market participant) suspects an increased degree of information asymmetry, the dealer will widen the bid–ask spread (the bidder's source of revenue and a primary measure of liquidity) to offset the heightened expected losses stemming from trading with informed traders. During times when firms disclose less information or engage in distorted information disclosure, the wedge between the level of information possessed by informed and uninformed investors increases, which should lead market makers to widen the bid–ask spread. Indeed, empirical studies on the relation between voluntary and mandated disclosures in various settings document a positive association between the level of information disclosure and stock liquidity (Diamond and Verrecchia, 1991, Welker, 1995, Healy et al., 1999, Leuz and Verrecchia, 2000, Heflin et al., 2005, Shroff et al., 2013, Balakrishnan et al., 2014, Schoenfeld, 2017). We therefore expect that firms affected by foreign competition or the threat of foreign competition will be less informationally transparent and will therefore experience greater reductions in stock liquidity.

An alternate view is that foreign competition improves stock liquidity. For example, the increased threat of bankruptcy and associated personal losses due to intensified competition provide strong incentives for managers to exert efforts that increase firm value (Holmstrom, 1982, Grossman and Hart, 1983, Nalebuff and Stiglitz, 1983). Indeed, a number of recent papers have shown that bad corporate governance appears to be a problem that exists primarily in less competitive industries (Giroud and Mueller, 2010, Giroud and Mueller, 2011, Balakrishnan and Cohen, 2014, Alimov, 2017). In addition, Chung et al. (2010) find a positive association between corporate governance oversight and stock liquidity, arguing that better corporate governance regimes mitigate information asymmetries.

Furthermore, a large literature on the U.S. listings of non-U.S. firms shows an improved trading environment for these cross-listed firms (larger and more positive share price reactions (http://www.sciencedirect.com/science/article/pii/S0304405X05002357 Foerster and Karolyi, 1999, Miller, 1999), increases in the number of analysts following and media hits (Baker et al., 2002), greater analyst coverage, improved forecast accuracy, and higher valuations (http://www.sciencedirect.com/science/article/pii/S0304405X05002357 Lang et al., 2003). In addition, the firm that lists on an overseas market attracts the attention of global investors and brings greater visibility, credibility, and liquidity to the other stocks trading on local markets.1 Although foreign competition exposure is not equivalent to cross-listing, the need to compete with foreign firms can result in greater visibility among investors and therefore improved stock liquidity. It is therefore possible that foreign competition improves stock liquidity by acting as an alternate disciplining mechanism and by enhancing a firm's visibility.

We test these competing empirical predictions using a large sample of U.S. firms during 1993–2012. Following Bertrand (2004) and Xu (2012), we use industry-level import penetration data to capture the extent of foreign competition to which individual firms are exposed.2 We utilize three liquidity measures: the inverse of the natural logarithm of the annual Amihud ratio (Inv_Ln (Amihud)), the inverse of the natural logarithm of the annual quoted spread (Inv_Ln (Qspread)), and the inverse of the natural logarithm of the annual effective spread (Inv_Ln (Espread)). In our analysis, we find a negative association between the intensity of foreign competition in a firm's industry and the firm's stock liquidity. Our results hold after controlling for a large set of firm-level accounting- and market-related characteristics, the inclusion of industry and year fixed effects, as well as firm and year fixed effects. Our baseline results are not only statistically significant but also economically significant. For example, an increase in import penetration from the 25th to the 75th percentile is associated with a reduction in liquidity equivalent to roughly 14% relative to its cross-sectional mean.

Throughout our analysis, we control for product market power to ensure that our results are not driven by firms with monopolistic power capable of insulating their profit and reducing the uncertainty faced by shareholders regarding their future earnings (Peress, 2010, Kale and Loon, 2011). Our results are therefore not driven by firms with monopolistic power whose earnings volatility is lower compared with firms without monopolistic power.3

To overcome concerns that either omitted factors are driving our results or that our results are determined by reverse causality, we conduct a number of additional tests in which we utilize exogenous variations in import penetration. Specifically, we follow Frésard and Valta (2016) and use large cuts in import tariffs as exogenous shocks to foreign competition in a difference-in-difference (DiD) framework. We also utilize the granting of the Permanent Normal Trade Relations status to China in 2001 as an exogenous shock to competitive threats from China. Finally, we use the exogenous increase in the value of the U.S. dollar between 1995 and 2002 as a quasi-natural experiment. We find consistent results in all additional tests, highlighting the robustness and causal nature of our effect.

Having established a negative association between foreign competition and stock liquidity, we examine the underlying channel driving the negative association. Specifically, we test whether our results are stronger among the sample of firms whose profit margins are negatively influenced by intensified import penetration (roughly 60% of our sample). In addition, we examine whether our results hold more strongly among the sample of firms that engage in earnings overstatement. In both cases, we find evidence suggesting that the negative association between import penetration and stock liquidity is likely to be driven by firms reducing their information transparency in response to intensified competition from foreign firms.

We further test the information channel by examining whether the results are stronger among firms whose managers have a greater ability to send distorted signals to the market due to weaker market oversight. We distinguish firms based on their level of oversight by monitoring institutional investors as well as equity analysts. Graham et al. (2005) report that, of 401 chief financial officers surveyed, 90% considered institutional investors and financial analysts the two most important groups influencing their decision making and behavior. In the context of institutional ownership, numerous studies report that the presence of institutions curbs managers' ability to reduce the quality and quantity of information disclosed to the market (Bange and De Bondt, 1998, Bushee, 1998, Chung et al., 2002, Jiambalvo et al., 2002, Velury and Jenkins, 2006). Consequently, if the negative association between foreign competition and stock market liquidity is driven by a reduction in the quality of information that managers publically disclose, the baseline results should be stronger among firms that have fewer institutional investors dedicated toward monitoring corporate managers.4 This is indeed the result we find, with the negative association between foreign competition and stock market liquidity being primarily observed among firms with lower levels of monitoring institutional holdings.

In the context of equity analysts, numerous studies show that analysts are important capital market intermediaries who play an essential role in alleviating information asymmetry and agency problems between managers and outside investors through information collection and dissemination (Easley and O'Hara, 2004, Bowen et al., 2008). Supporting their positive influence on the informational environment, Yu (2008) shows that firms with greater analyst coverage engage in less aggressive earnings management. Once again, if our baseline results are primarily driven by the effect that foreign competition has on the quality of information that managers disclose, we would expect to observe a more prevalent negative association among firms covered by fewer analysts. Indeed, our findings reveal that the negative effect of foreign competition on stock liquidity is considerably stronger among firms that are followed by fewer equity analysts.

Our paper makes significant contributions to the literature in at least two ways. First, it contributes to our understanding of the consequences of foreign competition. Prior studies use exogenous reductions in import tariffs to show the effect of foreign competition on firms' cost of debt (Valta, 2012), investment (Frésard and Valta, 2016), and earnings management (Lin et al., 2016). Another stream of literature focuses on the effect of import competition from China on unemployment, labor force participation, wages (Autor et al., 2013, Pierce and Schott, 2016), and firm innovation (Autor et al., 2016). We extend these studies by highlighting the impact of foreign competition on financial markets in general and stock liquidity in particular. Relying on both large reductions in import tariffs and intensified import competition from China as identification strategies, our findings point to the perverse effects of trade liberalization in reducing stock market liquidity. Our paper therefore is part of a small but growing body of literature that highlights the “dark side” of foreign competition (Aghion et al., 2005, Cummins and Nyman, 2005, Karuna et al., 2015).

Second, our paper extends the literature on the effect of disclosure and informational transparency on stock market liquidity. Prior studies focus on the impacts of disclosure quality (Welker, 1995, Heflin et al., 2005), variations in firm disclosure policy due to switching to an international reporting regime (Leuz and Verrecchia, 2000), and loss in analyst coverage (Balakrishnan et al., 2014) on stock liquidity. We extend this literature by providing evidence that the deterioration in the information environment in response to an increase in foreign competition is the channel through which foreign competition impacts liquidity. Our findings are particularly important given the importance of stock liquidity for the efficient operation of equity markets (Sadka and Scherbina, 2007, Chordia et al., 2008), corporate value and growth (Amihud and Mendelson, 1986, Fang et al., 2009, Fang et al., 2014), and economic growth (Levine, 1996, Acemoglu and Zilibotti, 1999).

Our paper is closely related to that of Kale and Loon (2011), who show a positive association between product market power and stock liquidity. However, our paper differs from theirs in many important aspects. First, while Kale and Loon (2011) concentrate on the implications of the relative power that a firm has in an industry, our focus is on foreign competition. In our empirical analysis, we therefore control for product market power and examine any incremental effect that trade liberalization has on stock market liquidity. Our inferences are therefore not based on whether monopolistic power is good for financial markets but, rather, whether trade liberalization has negative implications for the effective operation of financial markets.

Second, our partitioning results show that the underlying driver of the negative relation between competition and liquidity is different for foreign competition compared with product market power. While market power influences liquidity via its effect on profit volatility, foreign competition influences liquidity by altering managerial incentives with respect to disclosure policy. Our paper therefore makes a fundamental contribution to the literature by not only highlighting the negative consequences of trade liberalization on financial markets, but also by identifying the different channels through which various forms of competition influence liquidity. In our final empirical test, we show that the effect that foreign competition has on stock liquidity is influenced by a firm's market power, with the strongest effect being reported for firms exposed to foreign competition and that enjoy little market power. Although the channel through which foreign competition affects stock liquidity is different from the channel through which relative market power affects stock liquidity, we show that the two concepts are interrelated in the context of stock liquidity.

The remainder of the paper proceeds as follows. We describe the data in Section 2. In Section 3, we present the baseline results for the relation between foreign competition and stock liquidity, including several additional tests dealing with endogeneity concerns. We discuss the validity of the information channel in Section 4 while in Section 5 we examine the interplay between foreign competition and market structure. We conclude in Section 6.

Section snippets

Data, measures of stock liquidity and foreign competition, and other variables

In this section, we present our data and sample selection. We further describe the main measures for stock liquidity, foreign competition, and other control variables. Finally, we provide the descriptive statistics of the variables used in our study.

Foreign competition and stock liquidity

In this section, we examine the relation between foreign competition, as measured by import penetration, and stock liquidity. We start our analysis by providing a visual representation of the relation between industry-level average import penetration and industry-level average stock liquidity. We then conduct a more formal analysis utilizing ordinary least squares (OLS) regression analysis in which we control for time-varying firm-level factors, as well as fixed effects. To address potential

Examining the information transparency channel

Our underlying hypothesis is that import penetration reduces profit margins (Xu, 2012), which in turn induces managers to distort the information signals released to the market as a way of concealing the deteriorating state of the firm's financials (Markarian and Santalo, 2014, Karuna et al., 2015, Lin et al., 2016). Bhattacharya et al. (2013) show that poor earnings quality is associated with higher information asymmetry in financial markets. The increased information asymmetry will

Interplay between foreign competition and market power

We finish our empirical analysis with an examination of the interaction between foreign competition and market power. Foreign competition has the potential to undercut domestic producers on both price and quality and can therefore radically change the market dynamics in an industry. At the same time, firms that are more established and have a greater market share are in a better position to handle the consequences of intensified competition, since they can use their higher margins to reinvest

Conclusion

Does trade liberalization affect stock market liquidity? Utilizing a large sample of U.S. firms during 1993–2012, we find that foreign competition indeed has an adverse effect on the liquidity of individual stocks. Our results are robust to a large set of control variables and fixed effects. More significantly, we conduct numerous tests to address endogeneity concerns and find consistent results. Specifically, we first use large reductions in import tariffs as exogenous shocks to foreign

Acknowledgements

We thank Paolo Pasquariello (the editor) and an anonymous referee for their insightful comments and suggestions. We also thank Jonathan Batten, Xin Chang, Yangyang Chen, Darren Henry, Elaine Hutson, Lily Nguyen, Alba Ruiz-Buforn, Avanidhar Subrahmanyam, Wenrui Zhang, John Zhang, Josef Zorn, and participants at the 2016 Conference on Financial Markets and Corporate Governance in Australia, 2017 European Financial Management Conference in Greece and 2017 World Finance Conference in Italy and

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