How Catfish Effects Drive Stock Market Reform

The collapse of the Bretton Woods system in 1971 set off a domino effect. Starting in the 1980s, country after country removed or relaxed restrictions on foreign ownership in local public companies — a key way for countries to integrate their economy within global capital markets.

Stock market liberalization has led to mostly positive results. It has been shown to reduce the cost of equity, stabilize stock volatility, increase stock market liquidity and foster greater transparency. The jury is still out on the impact of stock market liberalization on long-term investment.

Late to the game is China. It was only in 2015 when the country’s leaders truly committed to opening their capital markets to foreign investors. Two stock market liberalization programs — the Shanghai-Hong Kong Stock Connect program and the Shenzhen-Hong Kong Stock Connect program – allowed foreign investors to access shares of a select number of public companies on the Shanghai Stock Exchange and Shenzhen Stock Exchange via Hong Kong brokers. Mainland Chinese investors were also allowed to acquire shares listed on these exchanges through domestic brokers.

The secret sauce for any efficient stock market is the free flow of market-relevant information. It is, therefore, expected that an enhanced information environment would be one major benefit of liberalization. This improvement is usually credited to foreign analysts advocating for better corporate public disclosure. But in the case of the Chinese initiatives, is this really so? According to one study, the liberalization of the two stock markets has not been associated with a significant increase in public disclosures by Chinese-listed firms.

The researchers behind this study believe foreign analysts did indeed have a hand in improving the stock market information environment in post-reform China. But they do not believe it’s due to foreign analysts influencing the disclosure policy of Chinese public companies. After all, these analysts are handicapped by physical distance and linguistic and cultural barriers.

Instead, they argue that the influx of foreign analysts ratcheted up competition with domestic analysts in China, thereby incentivizing domestic analysts to improve their work and reduce their biases, a phenomenon they dub “catfish effects.” Are they right? 

How was the study designed?

The study focused on financial analysts’ forecast errors and biases before and after the date that stock of Chinese public firms became tradable to global investors. The main sample looked at trading data, financial statement items and earnings forecast information of domestic and foreign brokers for Chinese A-Share listed firms from 2012 to 2019. The control group was made up of firms not selected into the stock market liberalization program.

The study controlled for an extensive set of analyst and firm characteristics that could affect forecast errors and biases. Analyst characteristics included forecasting horizon, number of covered firms, the size of the analyst’s brokerage, star status of the analyst and analyst’s experience. Firm variables included firm size, return on equity, sales growth, board independence, institutional ownership and returns volatility, among others.

What did the study find?

• After China’s stock market liberalization went into effect, the forecast quality of domestic analysts improved. Specifically, there was a statistically and economically significant decrease in both their forecast biases and forecast errors.
• The improvement among domestic analysts was particularly evident in environments with lower analyst competition before liberalization and greater pre-liberalization information uncertainty, as well as among stocks followed by foreign analysts with higher forecast accuracy. 
• The Chinese firms that were open to foreign investing appeared to benefit from the improved forecast quality. Stock prices appeared to accurately reflect available information on these firms, as indicated by the smaller bid-ask price (showing that buyers and sellers agreed more closely on the stock’s value) and how closely the stock price tracked firm-specific information rather than overall market trends.

What do I need to know? 

It is not always easy to identify cause and effect when domestic capital markets are opened to the world. Studies have generally looked at four means by which liberalization impacts emerging stock markets: risk diversification, market competition, information sharing and reduction of market barriers. It may be time to add another one: competition between foreign and domestic stock analysts.

In an underdeveloped stock market environment — China being one example — foreign analysts bring in new expertise, global perspectives and higher standards of forecasting that spur domestic analysts to adapt new technology and invest in training. The researchers point out that the presence of foreign analysts may also encourage domestic investors to demand the type of analysis and reporting standards provided by foreign analysts.

These knock-on effects are amplified in markets with weak enforcement, where public disclosure is not deemed credible.

The researchers refer to the impact of foreign analysts on their domestic counterparts as catfish effects, encompassing both competition and learning. “This concept is similar to the effect Apple had on Chinese phone manufacturers and Tesla on Chinese electric car manufacturers,” says Yu Hou of Smith School of Business, one of the researchers.

Competitive dynamics bubbling away beneath the surface of the analyst community is not only beneficial for stock market efficiency in China. There is plenty of research tying analyst competition to lower optimism bias and improved ratings quality within well-developed U.S. and European capital markets.

If the findings of this study hold up, they show market regulators there are subtle ways to liberalize stock markets that may have been overlooked.

“The introduction of foreign market intermediaries,” the researchers conclude, “could serve as an alternative method to enhance market efficiency, as opposed to relying solely on top-down regulatory reforms.”

Study title: The Role of Analyst Competition in the Process of Stock Market Liberalization
Authors: Yu Hou (Smith School of Business), Chongluan Lu (Renmin University of China), Yutao Wang (Renmin University of China)
Published: Unpublished working paper