Liquidity, informational efficiency and default risk in Chinese stock markets

A market is termed efficient if prices reflect all available information, and any new information can be compounded into prices rapidly, so market efficiency mainly refers to informational efficiency (Fama, 1970). Financial markets produce and aggregate information on stock prices via speculative trading (Grossman and Stiglitz, 1980; Glosten and Milgrom, 1985; Kyle, 1985; Kim, 2015; Brown and Yang, 2017). Higher liquidity permits more private information incorporation into stock prices through more informed trading (Holden and Subrahmanyam, 1992), while exacerbated noise trading from increased liquidity damages informational efficiency (Goldstein and Guembel, 2008). Brogaard et al. (2017) show that enhanced liquidity decreases default risk in the United States, through the mechanisms of informational efficiency and corporate government. However, the informational efficiency channel for emerging markets is still in debate, and both agency problems matter for corporate governance in emerging economies like China. Using a dataset of Chinese listed firms, this thesis clarifies the impact of liquidity on informational efficiency, examines the channels between liquidity and default risk, and further explores the roles of state ownership and government subsidies. 

In Chapter 2, I systematically review the literature in the fields of liquidity, informational efficiency, and default risk, and finally outline the key research streams and provide possible pathways for future research. Using the bibliographic mapping to identify the most influential papers from 1984 to 2021, the study identifies four key research themes that include efficiency and transparency of markets; corporate yield spreads; market interactions: bonds, stocks, and cryptocurrencies; and corporate governance. By assessing publications published from 2018 to 2021, it also documents seven key emerging research trends: cross markets, managerial learning and corporate governance, state ownership and government subsidies, international evidence, machine learning (fintech approaches), environmental themes, and financial crisis. Drawing on these emerging trends, the study highlights the opportunities for future research. The four key research streams contribute to a comprehensive understanding of liquidity, informational efficiency, and default risk. The emerging trends integrate existing knowledge and leave the chance for innovative research to expand the research frontier. Chapter 2 fulfils the systematic literature review streams in the fields of liquidity, informational efficiency, and default risk, and provides fruitful opportunities for future research. 

Chapter 3 examines the relationship between liquidity and informational efficiency in China, based on the stock trading data from 1998 to 2017. Through a panel regression analysis using different liquidity metrics, the results show that enhanced stock liquidity contributes to informational efficiency improvement. Using exogenous shocks with the difference-in-differences method to examine the relation between liquidity and informational efficiency, the results show that informational efficiency is improved after the liquidity increase from stamp duty reductions, and vice versa. Furthermore, I investigate how institutional investments affect the relationship between liquidity and informational efficiency, it is verified that the positive relation between liquidity and efficiency is weakened by the volume of institutional trading and is enhanced by the change in the number of institutional investors. 

Chapter 4 investigates the relation between stock liquidity and default risk in Chinese markets, and further examines the main driver of this relationship. In particular, it first tests the effectiveness of informational efficiency and corporate governance channels individually, and then compares the explanatory power of these two mechanisms via standardized regressions. The learning channel is verified, but the significance depends on the metric selections of default risk. In contrast, the default risk is significantly reduced by corporate governance improvements regardless of the default risk metrics. The horse race between these two mechanisms shows that the corporate governance channel is more important than the informational efficiency channel in China. 

Chapter 5 explores the impact of stock liquidity on firm default risk in China and further explores how state ownership affects this relationship. Generally, state-owned enterprises (SOEs) have easier access to government subsidies vis-a-vis non-SOEs. The empirical results confirm that enhanced liquidity decreases default risk, however, the interaction of state ownership weakens the relation. Such a result is indicative of the inhibiting effect of state ownership on the relationship between liquidity and bankruptcy risk. A further test on the role of government subsidies in this relationship finds that the moderating effect of state ownership can be partly interpreted by subsidies. Taking different subsidy classes into consideration, tax deductions and subsidies from local government have stronger moderating effects. 

From the findings of these studies, this thesis concludes that increased stock liquidity improves informational efficiency in China; then the improved informational efficiency, companied with corporate governance enhancement, contributes to firm default risk reduction. Furthermore, the relation between liquidity and default risk is weakened in SOEs, and this moderating effect of state ownership can partly be explained by government subsidies, especially by the tax deductions and government subsidies from local governments.