It has been well documented that in the U.S. and other countries with developed stock markets, sound public disclosure practices strengthen the reputation and credibility of firms. However, it’s unclear whether good disclosure practices are also beneficial in emerging markets that have weak systems of financial controls. Does disclosure build investor confidence? If so, are public disclosures the most effective way to disseminate information?
In my paper, “Catering through Disclosure: Evidence from Shanghai-Hong Kong Connect,” I use China to explore these questions and find that, although firms operating in developing markets use disclosure to boost investor confidence, it is private rather than public.
I focus on a recent regulation change in China, the Shanghai-Hong Kong Connect (SHK Connect), which was announced personally by Chinese Premier Li Keqiang in April 2014. It allowed foreign investors to own up to an aggregate of $48 billion worth of stock in 568 eligible Shanghai firms and did not affect shares of the 382 ineligible Shanghai firms. The new $48 billion quota was much larger at the time than the $11 billion of then-existing foreign investment spread across all Shanghai firms, and foreigners held less than 1 percent of shares in the Shanghai market before the new regime.
SHK Connect was implemented seven months after it was announced in November 2014, and affected only a limited number of eligible firms. These features allowed me to examine how and why the eligible firms changed their disclosure in anticipation of the new regime and what the consequences of those changes were.
I found that eligible firms on average increased private disclosures ahead of SHK Connect’s implementation. Specifically, they significantly increased the number of events at which they offered information about themselves through foreign brokers such as Goldman Sachs and Morgan Stanley and also the frequency of private English language conference calls. These findings were based on the analysis of information about broker events hand collected from analyst reports and data from institutional investors that participated substantially in the SHK Connect. In contrast to the private disclosure results, I found that the eligible firms did not make significant changes to their public disclosures through, for example, English-language press releases or earnings forecasts.
I looked at firm characteristics before the regulation’s announcement to understand the factors that led to increases in disclosure and found that the firms that needed capital because of, for example, strong sales growth were the ones that increased private disclosures the most. After SHK Connect’s implementation, these eligible firms attracted more foreign institutional investors and also issued more stock to foreign institutional investors.
China is particularly interesting because, despite having the world’s second largest stock market, it has a substantial amount of insider trading and other problems linked to a lack of information. The magnitude of such problems can be much more severe in China than in developed markets, because retail investors that aren’t equipped to invest on company fundamentals account for 85 to 90 percent of all trades. From June 2015 to February 2016, the Chinese stock market suffered extreme volatility and a 40 percent decline in total market capitalization. The government mostly blamed insider trading, but the problems were no doubt exacerbated by retail investor panic over disappointing macroeconomic results and forecasts.
I used this market crash to identify whether disclosure strengthened investor confidence. This crash is useful because it occurred only seven months after SHK Connect’s implementation, but it is highly unlikely that firms predicted this event when choosing to improve their disclosures in the prior period. I confirmed that disclosure boosted investor confidence, finding that foreign institutional investors continued to own stock in eligible firms that gave them extensive access to information and held frequent English-language conference calls. Shares in those firms were also significantly less volatile during the market crash.
In my paper, I show that a significant increase in the opportunity of sophisticated investors to own companies can affect how those companies communicate with stockholders, how institutional investors make trading decisions and, subsequently, who makes up the investor base. Overall, the findings of my paper suggest that disclosure, specifically through private communication, is a valuable option for firms and is particularly useful in strengthening their credibility and reputation with sophisticated investors.
This post comes to us from Aaron S. Yoon, a PhD candidate at Harvard Business School. It is based on his recent paper, “Catering Through Disclosure: Evidence from Shanghai-Hong Kong Connect,” available here.