Foreign Institutional Investors and Corporate Governance in Emerging Markets: Evidence from Split Share Reform in China

Abstract

We study the benefits of opening up local equity markets to foreign institutional investors using data on Qualified Foreign Institutional Investors (QFIIs) in China around the reform floating non-tradable shares. We find evidence supporting the view (Stulz (1999)) that as “outsiders,” foreign institutional investors are less prone to political pressure and are more likely to perform arm’s length monitoring than local mutual funds. In particular, the presence of QFII ownership shortens the duration of reform, enhances the terms in negotiation, and increases the compensation to tradable shareholders. We confirm that while state-controlled companies on average offer higher compensation ratio for a quicker approval, the state entities may exert political power and offer lower compensation ratio for companies with domestic mutual fund ownership (Firth et al (2008)). In contrast, we further find that the positive relation between state ownership and the final compensation ratio increases with the level of QFII ownership. QFIIs increase the likelihood of change in the compensation proposal among state-controlled companies, while local mutual funds show opposite effect. These results are unlikely due to endogeneity problem as local mutual funds and QFII have closely akin portfolio holdings and similarly positive effect on firm value. Our study suggests that the influx of large foreign institutional investors help promote market principle in corporate governance in emerging markets and alleviate the “twin agency” problem from state ruler discretion. (Stulz (2005))