Equity Flows, Banks, and Asia
Ren M. Stulz*
* Ren M. Stulz is a Research Associate in the NBER's Programs on Corporate Finance and
Asset Pricing and the Everett D. Reese Chair of Banking and Monetary Economics at Ohio State
After World War II, capital markets in different countries were almost completely
segmented from each other. Individual investors generally could not buy securities in other
countries because they could not acquire the correct currency. Since then, dramatic changes have
occurred. Currencies typically are convertible and most major obstacles to capital flows among
developed countries have been removed. This evolution has allowed equity investors to invest in
most countries in the world.
Unfortunately, throughout history, periods with limited barriers to international investment were
followed by periods with stronger restrictions. Since the devaluation of the Thai baht last year,
many countries have faced economic difficulties; many economists and policymakers have
argued that the so-called "Asian flu" has spread too far and too decisively. Led by fears of
contagion and encouraged by some prominent economists, some countries, for example
Malaysia, have taken measures recently to restrict capital flows. Though fixed exchange rates can
breed speculative attacks and contagion, we should not forget that countries benefit from open
equity markets. There is little evidence that the presence of foreign equity investors will lead to
irrational movements in equity markets.
In a recent paper,(1) I discuss the costs and benefits of opening equity markets to foreign investors.
With closed equity markets, investors within a country have to bear all the risks of that country.
Therefore, they charge a higher risk premium to bear risk, which translates into a higher cost of
capital. The cost of capital determines which investments are worthwhile. An increase in the risk
premium means that riskier investments with a greater expected return are replaced by safer
investments with a lower expected return. Consequently, a country whose investors cannot
diversify risks internationally has an economy that invests in safer projects with lower risk. This
practice hampers economic growth. When the investors in a country become able to share risks
with foreign investors, the cost of capital falls, and the economy invests in riskier projects that
contribute more to growth because the cost of bearing risk is lower.
As countries have progressively liberalized, we have seen the emergence of a world capital
market, which for a number of years included most developed countries. Eventually, it was
joined by emerging markets. The theory predicts that, as the world capital market grows with the
addition of new countries, the risk premium for bearing risk falls. As a country joins this world
capital market, its cost of capital also falls. However, the evidence shows that the decrease in a
country's cost of capital when it opens its capital market has been smaller than predicted. Recent
papers by Geert Bekaert and Campbell R. Harvey(2)2 and P. B. Henry(3) indicate that the fall in the
cost of capital when an emerging market opens its capital market might be on the order of two
hundred basis points when theory predicts a much larger drop.
The Home Bias and Portfolios of Foreign Investors
Part of the reason that the cost of capital does not fall as much as predicted is that when markets
open up, foreign investors do not acquire as much equity as expected. In general, investors have a
strong preference for their own country's equity. This phenomenon is called the home bias in
equity holdings. Though the home bias has been studied for more than 20 years, it has recently
become more of a puzzle, because some of the reasons for its existence seem to have
disappeared. For instance, earlier research emphasized differences in transaction costs and taxes
as an explanation for the home bias,(4) but these differences have diminished over time. As Linda
L. Tesar and Ingrid M. Werner point out,(5) in some cases foreign investors trade more than
domestic investors; thus higher transaction costs cannot explain why their holdings of foreign
equity are so limited.
Because of the home bias, investors do not take as much advantage of international
diversification as would be expected. Jun-Koo Kang and I(6) examine the apparent home bias in
holdings of equity by foreign investors in Japan. For that study, we had data on holdings of
equity by foreign investors for each firm on the Tokyo Stock Exchange from 1975 to 1991.
Strikingly, despite all the liberalization of capital flows, foreign holdings of Japanese securities
were quite small over the entire sample period. In 1975, foreign investors held 4.64 percent of the
market capitalization of the Tokyo Stock Exchange. In 1991, they held 5.59 percent. Their
holdings reached a peak of 11.31 percent in 1984. Expressed as a fraction of the world equity
market capitalization, the holdings of Japanese stocks by foreign investors were always small
relative to the importance of the Japanese equity market. Even in 1991, the Japanese equity
market was more than 30 percent of the capitalization of the Morgan Stanley Capital
International World Index.
Why have investors been so slow to take advantage of the benefits of international
diversification? Our paper on the behavior of foreign investors in Japan offers some clues. We
find that foreign investors have an extremely strong preference for holding shares of large firms.
On average during our sample period, foreign investors held 7.12 percent of a firm in the top
quintile of Japanese firms in equity capitalization, but only 1.4 percent of a firm in the bottom
quintile. Hyuk Choe, Bong-Chan Kho, and I(7) demonstrate that this large firm bias is not
restricted to Japan. We show a similar bias for foreign investors in Korea in 1997. Kang and I(8)
also show that, for a given firm size, foreign investors invest more in the more liquid stocks. This
evidence is consistent with a model where foreign investors are better informed, or less at an
informational disadvantage relative to domestic investors, for large firms. Choe, Kho, and I(9)
show that institutional investors account for almost all of the holdings of equity by foreign
investors in Korea. Institutional investors generally exhibit a bias toward large stocks, and
institutional investors who invest abroad are no different.
Globalization and the Relationships Among Equity Markets
As barriers to international investment fall, equity markets everywhere are affected by changes in
the risk premium on equity. Stock prices can fall because investors expect future economic
activity to become less favorable, because of an increase in real interest rates, or because
investors require a higher compensation for risk. With free markets, the fact that an increase in
the risk premium that investors require on equity causes stock prices throughout the world to fall
is a sign of efficiency rather than a reason for concern. In simple models, the risk premium on the
world market portfolio depends on the volatility of the return on that portfolio. An unexpected
increase in volatility increases the risk premium and causes stock prices to decrease. Everything
else being equal, an increase in the volatility of a foreign market increases the volatility of the
world market portfolio. Consequently, an increase in volatility abroad causes stock prices to drop
in the United States.
K. C. Chan, G. Andrew Karolyi, and I(10) examine this relationship between the volatility of a
foreign market and the risk premium on U.S. stocks. We find that the risk premium on U.S.
stocks, for example, depends on the volatility of the Japanese market. An increase in the
volatility of Japanese stock returns leads to an increase in the risk premium on U.S. stocks and a
fall in the price of these stocks. Opening an equity market to foreign investors increases the
dependence of that market on events outside it. If this were not the case, there would be no
benefit from opening the market. However, factors that affect the risk premium on stocks now
affect the stocks in the newly opened market. As a result, the return on equity in that market is
likely to be more correlated than before with the return on equity in the rest of the world. I have
found some evidence of such an increase.(11) Further, when Karolyi and I(12) examine the
determinants of the correlation between U.S. stocks and Japanese stocks, we show that the U.S.
market and the Japanese market move more closely together when volatility in either market is
Though the evidence just described relates to the rational links between markets that result from
the removal of barriers to international investment, there has also been much concern about the
existence of links that are attributable to panic and confusion of foreign investors. When I
examine the evidence available before the most recent events, though, it does not seem that there
is irrational contagion among equity markets.(13)
Do Countries Still Matter?
Globalization makes markets move together more than they did before. This has led some to
believe that the focus of equity analysis should be on industries across frontiers rather than on
countries. Some investment management firms are now reorganizing, so that instead of having
analysts whose work stops at the border of a country, they have analysts who look at an industry
across countries. This raises the question of whether globalization has gone so far that we can
ignore countries. Both Karolyi and I(14) and John M. Griffin and I(15) find that we cannot. Industry
effects are of surprisingly little importance in explaining the correlation of stock returns across
countries, we find. Griffin and I(16) also show that exchange rates explain very little of the
difference in performance across industries. Even though there have been many analyses of how
yen depreciation makes American car producers more competitive at the expense of Japanese car
producers, in fact the impact of an unexpected change in the yen-dollar exchange rate on the
equity of American car producers is economically trivial.
Are Foreign Equity Investors Dangerous?
Chan, Karolyi, and I(17) demonstrate the existence of a completely rational relationship between
the volatility of foreign markets and the equity premium on U.S. stocks. But recently, many
observers and policymakers have been concerned about the ability of foreign investors to
destabilize markets. Choe, Kho, and I(18) investigate the role of foreign equity investors in Korea
using a database that includes all trades made on the Korea Stock Exchange in 1997. This
database makes it possible to identify trades made by foreign investors. We first explore the
dynamics of foreign holdings of shares in Korea, because policymakers are concerned that
foreign equity investors buy when markets are going up and sell when markets are going down.
Such investment strategies are called positive feedback strategies. They can be destabilizing
because investors can lead prices away from fundamentals. This is especially the case if different
investors pursue similar strategies, so that they end up forming a herd. We find strong evidence
that foreign investors engaged in positive feedback strategies in Korea. In particular, foreign
investors were more likely to buy when Korea's market was up the previous day and to sell when
it was down. We also find that foreign investors tended to act as a group, in that they were likely
to buy together and sell together. Our evidence, therefore, supports those who are concerned that
foreign investors engage in positive feedback trading and herding.
Next we ask whether the practices of foreign investors are destabilizing. We look in great detail
at the last three months of 1997 and show that the practices of foreign investors that have caused
concern diminished during that time, when Korea's economic crisis developed. In particular, we
find that positive feedback trading dropped dramatically and perhaps disappeared during the last
three months of 1997. Further, herding fell significantly during that period. Based on our
evidence, it seems implausible that short-term destabilizing positive feedback trading on the part
of foreign equity investors played a role in the Korean crisis. Perhaps the most telling evidence
that positive feedback trading cannot have been important is that the fraction of the total
capitalization of Korea's stock market held by foreign investors was higher at the end of 1997
than at the beginning.
Further investigating the impact of trading by foreign investors, we consider whether foreign
investors might have started runs on stocks. In other words, we ask if stock prices start to
increase following purchases by foreign investors and start to fall following sales by foreign
investors. We first look at five-minute intervals: as one would expect, if foreign investors make a
large purchase of a stock during a five-minute interval, the stock price increases. This is true both
before and during the crisis period. Once the purchase is made, however, the market adjusts
within five minutes. Therefore, there is no evidence that purchases by foreign investors have a
destabilizing effect. The market also adjusts quickly to sales and the small negative impact of a
large sale (on the order of 1 percent) gets reversed in part. When we examine daily returns, we
again find that the actions of foreign investors do not lead to runs. Thus, no case can be made that
foreign equity investors were disruptive.
What About Banks?
If the actions of foreign investors seem unlikely to explain dramatic falls in stock markets, we
must look elsewhere to understand such episodes. The drop in the Japanese stock market in the
early 1990s offers fertile ground for researchers. Kang and I(19) try to understand the contribution
of the difficulties in the banking sector to the collapse of equity prices. We show that those
Japanese firms that relied more heavily on banks for their financing at the end of the 1980s
experienced a sharper loss of equity value during the early 1990s.
We then explore possible explanations for this result. We find that the impact of bank reliance on
equity performance cannot be explained by other firm characteristics. Rather, the explanation for
the poor performance of firms that relied more on banks seems to be that these firms had to cut
back their investment relative to firms that did not rely on banks as much. Everything else being
equal, the firms that relied more on bank financing at the end of the 1980s invested less at the
beginning of the 1990s. Shocks to banks' ability to finance investment thus have a significant
economic impact on those firms that depend on them. We further confirm the importance of bank
health on bank-dependent firms by examining the performance of Japanese firms on days when
important announcements about the Basle Accord on capital requirements for banks were made.
On days when Japanese bank stocks fell because of announcements about the Basle Accord, the
firms that relied more on bank debt performed poorly, we find.
Our evidence does not imply that firms should not rely on banks. Rather, it shows that finance
provided by banks is fundamentally different from finance provided by equity investors. If
foreign investors want to reallocate their holdings away from a country, they have to worry about
the price impact of their trades. If a bank has to reduce the exposure of its loan portfolio to firms
in one country, it benefits from being the first to do so. This is because the borrower is likely to
run out of liquid assets to pay back loans and the firm that had obtained bank finance no longer
has it once the bank has called the loan. As a result, when too many firms in a country rely
excessively on bank debt, it does not take much of an economic shock to force them to shrink
investment and to put some of them into default.
1. R. M. Stulz, "International Portfolio Flows and Security Markets," Dice Center Working Paper,
Ohio State University, 1997, pp. 97-112.
2. G. Bekaert and C. R. Harvey, "Foreign Speculators and Emerging Equity Markets,"
unpublished working paper, Duke University, 1998.
3. P. B. Henry, "Stock Market Liberalization, Economic Reform, and Emerging Market Equity
Prices," unpublished working paper, Graduate School of Business, Stanford University, 1998.
4. R. M. Stulz, "On the Effects of Barriers to International Investment," Journal of Finance, 36,
(1981), pp. 459-68.
5. L. L. Tesar and I. M. Werner, "Home Bias and High Turnover," Journal of International Money
and Finance, 14, (1995), pp. 467-93.
6. J. Kang and R. M. Stulz, "Why Is There a Home Bias? An Analysis of Foreign Portfolio Equity
Ownership in Japan," Journal of Financial Economics, 46, (1997), pp. 3-28.
7. H. Choe, B. Kho, and R. M. Stulz, "Do Foreign Investors Destabilize Stock Markets? The
Korean Experience in 1997," NBER Working Paper No. 6661, July 1998.
8. J. Kang and R. M. Stulz, "Why Is There a Home Bias? An Analysis of Foreign Portfolio Equity
Ownership in Japan."
9. H. Choe, B. Kho, and R. M. Stulz, "Do Foreign Investors Destabilize Stock Markets? The
Korean Experience in 1997."
10. K. C. Chan, G. A. Karolyi, and R. M. Stulz, "Global Financial Markets and the Risk Premium
on U.S. Equity," Journal of Financial Economics, 32, (1992), pp. 137-68.
11. R. M. Stulz, "International Portfolio Flows and Security Markets."
12. G. A. Karolyi and R. M. Stulz, "Why Do Markets Move Together? An Investigation of
U.S.-Japan Stock Return Comovements," Journal of Finance, 51, (1996), pp. 951-86.
13. R. M. Stulz, "International Portfolio Flows and Security Markets."
14. A. Karolyi and R. M. Stulz, "Why Do Markets Move Together? An Investigation of
U.S.-Japan Stock Return Comovements."
15. J. M. Griffin and R. M. Stulz, "International Competition and Exchange Rate Shocks: A
Cross-Country Industry Analysis of Stock Returns," NBER Working Paper No. 6243, October
17. K. C. Chan, A. Karolyi, and R. M. Stulz, "Global Financial Markets and the Risk Premium on
18. H. Choe, B. Kho, and R. M. Stulz, "Do Foreign Investors Destabilize Stock Markets? The
Korean Experience in 1997."
19. J. Kang and R. M. Stulz, "Is Bank-Centered Corporate Governance Worth It? A
Cross-Sectional Analysis of the Performance of Japanese Firms During the Asset Price
Deflation," NBER Working Paper No. 6328, October 1997.