Informed trading by foreign institutional investors as a constraint on tunneling: Evidence from China

Abstract

Manuscript Type: EmpiricalResearch Question/Issue: This paper investigates how the trading activities of foreign institutional investors (FIIs) affect the tunneling activities of controlling shareholders in an emerging economy (China).Research Findings/Insights: We use an unbalanced panel dataset of 167 FIIs with investments in Chinese real estate firms during the period 2003 to 2011, which gives us 1006 firm-year observations in total. We find strong support for our hypothesis of an inverted U-shaped relationship between FII trading turnover and the extent of tunneling by controlling shareholders.Theoretical/Academic Implications: In many emerging economies, the institutional environment for investor protection is weak. Powerful controlling shareholders may take the opportunity to extract private benefits via tunneling activities to the detriment of minority shareholders, and informed minority investors may also take advantage of less well-informed investors.There are thus multiple principal-principal agency conflicts. FIIs are a particularly important group of informed investors. On the one hand, large-scale aggressive trading by FIIs should drive stock prices to fundamentals, provide market discipline to management, and thus limit tunneling. On the other hand, FIIs may opt to exploit their private knowledge to gain trading profits at the expense of uninformed investors, and implicitly support tunneling. We highlight these potential effects, and demonstrate empirically an inverted U-shaped relationship between FII trading turnover and the extent of tunneling.Practitioner/Policy Implications: Tunneling is a serious issue, particularly in emerging economies where the institutional arrangements for minority investor protection are often weak.FII involvement may enhance market discipline, but may also exacerbate the problem, so policymakers need to guard against potential adverse effects. An ownership cap on FII shareholdings is unlikely to be effective, but policymakers might strengthen QFII license revocation policies and issue more licenses to promote competition among FIIs.

Related‐party transactions and corporate performance following the adoption of International Financial Reporting Standards in Taiwan

“…An issue that was not addressed in this study was whether the related‐party transactions occurred in the forms of tunneling or propping. More research like Zhang, Yang, Strange, and Zhang () is needed to determine the efficacy of related‐party transactions on corporate performance following the adoption of IFRS. Moreover, it would be interesting to assess the similar effects using more industries or even across countries that have adopted IFRS.…”

Family firm and analyst forecasts in an emerging economy

“…Different from advanced economies with strong institutional environments, emerging markets are featured with concentrated ownership, poor disclosure quality, and overall weak institutional environments (Claessens and Fan, 2002). Powerful large shareholders, by using their ownership pyramids and cross-holdings, effectively entrench themselves and weaken market discipline (Claessens and Fan, 2002; Zhang et al , 2013, 2017). A weakened market discipline over large family shareholders makes meeting or beating analyst forecasts less beneficial, bearing in mind the complex pyramid and cross-holding ownership structures in place which facilitate their extraction of private benefits through opaque environments (Johnson et al , 2000; Baek et al , 2006).…”

“…We build on previous literature which suggests largest shareholders can abuse their pyramid and cross-holding ownership structures to entrench themselves and extract private benefits via related-party transactions or tunneling at the cost of minority shareholders (Johnson et al , 2000). Large shareholders by entrenching themselves mitigate market discipline imposed on them, but increase career-related risk for professionally hired managers whose entrenchment is constrained and whose careers are still subject to market discipline (Zhang et al , 2013, 2017). Subject to a higher level of market discipline than large shareholders but constrained by more limited channels to extract private benefits, professionally hired managers, with their private information, have a higher priority to meet or beat analyst forecasts.…”

Ownership concentration, foreign ownership and tunneling in Indonesia

“…Foreign ownership in several studies can be an effective mechanism to monitor the management from activities that can reduce the company value (David, 1996;M.W. Peng, 2003;Tihanyi et al, 2003;Zhang et al, 2017). Foreign investors can have the Tunneling in Indonesia ability to reduce the company's dependence on concentrated ownership (Sari et al, 2016).…”

“…The results of research related to the effect of foreign ownership on tunneling activities are still varied. Several studies stated that foreign ownership can reduce the opportunistic behavior of the majority shareholders (David, 1996;Peng, 2003;Tihanyi et al, 2003;Zhang et al, 2017). Meanwhile, other studies state that when investors have great control, they will tend to carry out activities that benefit them, one of which is tunneling (Dyreng and Lindsey, 2011;Graham et al, 2011).…”