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

• Author: Xiaoxiang Zhang,Roger Strange,Xiaotong Yang,Qiyu Zhang
• Date: 01 July 2017
• DOI: http://doi.org/10.1111/corg.12206
• Published date: 01 July 2017

ORIGINAL ARTICLE

Informed trading by foreign institutional investors as a

constraint on tunneling: Evidence from China

Xiaoxiang Zhang

1

|Xiaotong Yang

2

|Roger Strange

1

|Qiyu Zhang

3

1

School of Business, Management and

Economics, University of Sussex, Brighton, UK

2

Department of Architecture and Built

Environment, Northumbria University, UK

3

The Management School, Lancaster

University, Lancaster, UK

Correspondence

Xiaoxiang Zhang, School of Business,

Management and Economics, University of

Sussex, 316 Jubilee Building, Falmer, Brighton

BN1 9SL, UK.

Email: xiaoxiang.zhang@sussex.ac.uk

Abstract

Manuscript Type: Empirical

Research 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 invest-

ments in Chinese real estate firms during the period 2003 to 2011, which gives us 1006 firm‐year

observations in total. We find strong support forour hypothesis of an inverted U‐shaped relation-

ship 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 ofminority share-

holders, 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.

KEYWORDS

Corporate governance, emerging economy,foreign institutional investors,informed trading,

tunneling

1|INTRODUCTION

Tunneling refers to the extraction of value from a firm by its control-

ling shareholders (Johnson, La Porta, Lopez‐de‐Silanes, & Shleifer,

2000). It involves the controlling shareholders using their dominant

position to extract private benefits of control at the expense of the

minority shareholders, and thus constitutes a principal–principal

agency problem. Tunneling is facilitated by opaque and complex infor-

mation environments, such as exist in many emerging economies, in

which large and/or inside shareholders are often much better

informed about the firm's performance and prospects than smaller

minority investors (Claessens & Fan, 2002; Makhija & Patton, 2004).

These information asymmetries provide fertile grounds for tunneling

activities.

Received: 27 August 2015 Revised: 3 January 2017 Accepted: 24 February 2017

DOI: 10.1111/corg.12206

222 © 2017 John Wiley & Sons Ltd Corp Govern Int Rev. 2017;25:222–235.wileyonlinelibrary.com/journal/corg