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Hiding bad news puts stock liquidity at risk

Companies that hide bad news about the financial impact of foreign competition are putting their stock liquidity at risk.

Companies that hide bad news about the financial impact of foreign competition are putting their stock liquidity at risk, a Deakin University study has found.

Deakin Business School finance researcher Dr Edward Podolski, in partnership with colleagues from Monash and La Trobe universities, has revealed this ‘dark side’ of trade liberalisation in a study published in the Journal of Financial Markets.

“Trade liberalisation, whereby barriers to trade between different countries are removed and free trade is encouraged, is considered beneficial for the economy, as it reduces prices of goods and services for consumers and forces local businesses to operate in a more efficient manner,” Dr Podolski said.

"However our study found that firms operating in industries that face more stringent foreign competition tend to be less willing to be transparent with their shareholders which in turn has a negative effect on the liquidity of these firms.

“This is particularly true for companies competing with imports from low-wage countries, where improvements in efficiency to be more competitive are not possible.

“Given the important role liquidity plays in a firm’s ability to raise capital as well as the efficient and effective operation of modern capital markets, the study highlights a ‘dark side’ of globalisation and trade liberalisation.”

The study involved an analysis of data from 3,450 US firms from 1993—2012 across all industries, including manufacturing, mining and retails. It analysed the impact the level of foreign competition had on stock liquidity and then looked into the underlying causes of any impact.

“The intensity of foreign competition in a firm’s industry was found to cause a drop in stock liquidity,” Dr Podolski said.

“For example, an increase in import penetration (from the 25th to 75th percentile) was associated with a 14 per cent reduction in liquidity.

“This drop in liquidity was driven by firms overstating their earnings in reports to the market in response to intensified competition from foreign companies.

“This was more so the case among firms whose managers had a greater ability to send distorted signals to the market due to weaker corporate governance controls.”

Dr Podolski said that the study showed the importance of strong corporate governance in an age when foreign competition is more intense, as these are the only mechanisms that can prevent corporate managers reducing their information transparency.

“The bottom line is, that if greater trade liberalisation is to occur, shareholders or policy-makers must take steps to strengthen corporate governance mechanisms. Without doing so stock liquidity, so essential to economic growth, will be a casualty of intensified international trade,” Dr Podolski said.

The study, ‘Does exposure to foreign competition affect stock liquidity? Evidence from industry-level import data’, is published in the Journal of Financial Markets.

Originally published on Deakin Media.

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