Stock Liquidity and the Under-investment Problem: A Quasi-natural Experiment in China

Using the split-share structure reform in China as a quasi-natural experiment, we examine the effect of stock liquidity on investment efficiency. Consistent with feedback and incentive theories, investment efficiency increases after the reform but only for under-investing firms. Higher stock liquidity increases institutional ownership, board independence, and price efficiency, especially for under-investing firms; thereby increasing investment efficiency of firms including those owned by the state. Our analysis is robust to a battery of considerations, including multiple specifications and several natural experiments. Our findings highlight externalities linked to the Chinese reform and further substantiate the real effects of financial markets.