Abstract
This paper analyzes the effect of economic freedom on the liquidity of financial markets using a non-traditional approach. Using a sample of 393 American Depositary Receipts (ADRs), we examine the liquidity of these securities while conditioning on the level of economic freedom in the ADR home country. We find robust evidence that ADRs from countries with the most economic freedom have the most liquidity (i.e. the lowest bid-ask spreads and the least price impact). These findings are driven by certain characteristics of economic freedom, such as the lower levels of regulation, more free trade, stronger property-right protection, and sound money. In other tests, we examine liquidity surrounding the beginning of several broad-based regulatory changes in the Chinese financial system, which allowed for more open foreign investment and lending services. Using this (arguably) exogenous event as a natural experiment, we find meaningful improvements in the liquidity of Chinese ADRs vis-a-vis non-Chinese ADRs. These results suggest that causation flows from economic freedom to market liquidity instead of the other way around.
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