The Effect of the China Connect

Abstract

We study an important capital account liberalization in China: the Shanghai (Shenzhen)- Hong Kong Stock Connect of the mid-2010’s. This program created a channel for cross-border equity investments into a selected set of stocks while the overall capital controls policy remained in place. Using a difference-in-difference approach, we find that firm-level investment is negatively affected by US monetary policy shocks, argued by Miranda-Agrippino and Rey (2019) to be the crucial driver of the Global Financial Cycle, and that firms in the Connect are relatively more adversely affected than those that remained outside of it. These effects are economically large, robust, and stronger for firms with a weaker financial condition, higher level of financial constraints, higher equity return volatility, operating in the non-tradable sector. These empirical findings point to the adverse consequences that capital liberalization policies can have, and suggest that capital controls can be a way for emerging market economies to curb the negative consequences of global financial cycles. Balancing these negative consequences concerning increased sensitivity to external shocks, however, are the positive effects on equity valuations and capital issuance for firms under market liberalizations such as those in the Connect.

Keywords: Capital Liberalization; Foreign Spillovers; FOMC Shocks; China Connect; Corporate Investment

JEL Classification: F38; E40; E52; G15