Stock Liquidity and Corporate Diversification PDF

Journal of Empirical Finance 49 (2018) 57–80
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Journal of Empirical Finance

journal homepage: www.elsevier.com/locate/jempfin
Stock liquidity and corporate diversification: Evidence from

China’s split share structure reform✩
Lifeng Gu a, *, Yixin Wang b , Wentao Yao a , Yilin Zhang b, *
a
University of Hong Kong, Hong Kong
b
Peking University, HSBC Business School, China
ARTICLE INFO ABSTRACT
JEL classification: We establish that stock liquidity is conducive to less corporate diversification. Two potential
G14 channels are identified: the financial constraint channel and the corporate governance channel.
L25 Specifically, the negative effect of liquidity on diversification is stronger among financially-
G30 constrained firms, since higher liquidity helps firms improve external capital markets and thus
Keywords: reduces the need to broaden the internal capital markets through diversification. Moreover,
Stock liquidity the effect of liquidity on diversification is strengthened among firms with severe information
Corporate diversification asymmetry, since enhanced price informativeness caused by increased liquidity promotes market
Financial constraint monitoring and deters managers’ opportunistic diversification decisions. Meanwhile, we rule out
Agency problem the alternative explanation that liquidity discourages diversification by facilitating blockholders’
Corporate governance monitoring on managers’ decisions. Our results suggest that stock liquidity plays a positive role
Split share structure reform
in corporate decision making.
China
1. Introduction
Corporate finance research in recent years has highlighted the role of stock liquidity in different aspects of corporate decisions and
outcomes. Researchers have shown that liquidity affects firms’ investment decisions (Becker-Blease and Paul, 2006), capital structure
and financing choices (Frieder and Martell; Lipson and Mortal, 2009), dividend policies (Banerjee et al., 2007; Jiang et al., 2017),
and firm performance and value (Holmström and Tirole, 1993; Fang et al., 2009, 2014).
As an important corporate decision that integrates both investment and financing considerations, diversification has also been a
major issue of interest for both academics and practitioners in finance and management. Studies show that diversification impacts
labor productivity (Tate and Yang, 2015), cash holdings (Duchin, 2010), the cost of capital (Hann et al., 2013), and firm value (Lang
and Stulz, 1994; Berger and Ofek, 1995; Denis et al., 1997; Hoechle et al., 2012). However, the benefits and costs of corporate
diversification cannot be thoroughly understood without discussing the motivations that drive diversification. The finance literature
suggests that firm managers often diversify for two important reasons: to broaden internal capital markets in order to overcome
frictions in external capital markets and thereby fulfill financing needs (Fluck and Lynch, 1999), and to seek private benefits (Denis
et al., 1997; Aggarwal and Samwick, 2003) or idiosyncratic risk reduction (May, 1995).1
✩ We thank Dirk Hackbarth, Alan Kwan, Nan Liu, Vinh Nguyen, Seungjoon Oh, Thomas Schmid, Chunyang Wang, and Joe Zhou for their helpful comments. All
errors are our own.

* Corresponding authors.
E-mail addresses: oliviagu@hku.hk (L. Gu), wangyixin@sz.pku.edu.cn (Y. Wang), yaowt029@connect.hku.hk (W. Yao), ylzhang@phbs.pku.edu.cn (Y. Zhang).
1 Firms may diversify for other reasons such as the ones related to product market strategy or synergy. Some of these reasons might affect the interpretation of
our results about the causal effect of stock liquidity on corporate diversification. We provide further discussion on this issue in later sections.
https://doi.org/10.1016/j.jempfin.2018.09.002
Received 28 June 2018; Received in revised form 2 September 2018; Accepted 10 September 2018
Available online 24 September 2018
0927-5398/© 2018 Elsevier B.V. All rights reserved.
L. Gu et al. Journal of Empirical Finance 49 (2018) 57–80
Theories have suggested that liquidity may influence corporate diversification. Higher stock liquidity not only lowers a firm’s
cost of equity and raises asset prices (Amihud and Mendelson, 1986; Amihud et al., 2006), but also stimulates informed traders to
trade on their private information so that more firm information is impounded into stock prices (Subrahmanyam and Titman, 2001;
Khanna and Sonti, 2004). These benefits help to improve firms’ external financing conditions and relax the financial constraints that
they face. In addition, liquidity helps to discipline managers by either enhancing market monitoring (Holmström and Tirole, 1993)
through improving stock price informativeness, or by facilitating blockholder control and non-controlling blockholders’ threats to
exit (Edmans et al., 2013). Considering the two motivations for diversification mentioned above, it is reasonable to conjecture that
improved stock liquidity is negatively related to diversification. However, no direct empirical investigation on this relation has been
undertaken so far. Our paper aims to fill this gap in the literature by examining whether and how liquidity affects diversification. Our
study should also be interesting to regulators, as stock liquidity can be changed by adjusting regulations and laws related to financial
markets.
In this paper, we use Chinese data to conduct our studies for several reasons. First, China provides a good environment for studies
related to diversification. The Chinese economy has been transitioning from a phase of rapid growth to a ‘‘new normal’’ stage marked
by slower GDP growth and economic rebalancing. Faced with fierce competition in traditional industries and challenges in fund raising
in an underdeveloped Chinese financial market, many firms choose to accelerate their industrial upgrading through diversification
strategies to achieve a sustainable growth. For example, from 2011 to 2014, the share of diversification mergers in all mergers and
acquisitions grew from 1.9% to 10.9%, according to WIND. In the process of industrial upgrading, the role of diversification in
building internal capital markets to alleviate funding difficulties is often highlighted, as many firms try to enter new industries with
higher profits to support their traditional businesses. Therefore, our use of Chinese data to study diversification is not only timely,
but also well-suited.
Second, the agency problem is more severe in China than in developed markets such as the United States, largely due to weaker
shareholder protection legislation and more opaque information environments. As a result, managers in Chinese firms are more likely
to make diversification decisions based on their own desire to pursue personal benefits such as risk sharing or better compensation
packages by managing a larger company. Thus, the effect that liquidity has in alleviating information asymmetry and in enhancing
corporate governance is likely to be more significant in China than in developed markets. In this sense, the Chinese market provides
an excellent setting to investigate the informational and governance role of stock liquidity.
Finally, one of the challenges in establishing a causal effect of liquidity on corporate decision is endogeneity. In addition to possible
omitted underlying variables that drive both the liquidity and corporate decisions, changing liquidity itself can also reflect a market’s
reaction to various firm decisions and strategies. The split share structure reform of China, initiated in 2005, allows previously
non-tradable shares to be freely traded on stock exchanges and significantly improves the liquidity of A-share listed stocks in general.
It provides a nice quasi-natural experimental environment for studying the effect of liquidity on diversification: First, the split share
reform is initiated for very different reasons than to affect firms’ diversification strategies. More important, the reform is carried out
mandatorily by the China Securities Regulatory Commission (CSRC) within a given time frame. So no firm can endogenously choose
whether or when to implement the reform. Therefore, the reform generates plausibly exogenous shocks on liquidity, which helps to
solve the reverse causality problem.
Using a panel of 1172 non-financial listed firms in China over the period from 2001 to 2015, we establish that an increase in stock
liquidity significantly reduces the level of corporate diversification. This finding is valid across various types of robustness tests. For
example, we employ two alternative liquidity measures in our baseline tests to address concerns with respect to measurement errors,
and we include firm-fixed effects to alleviate firm-level omitted variable bias. To address reverse causality concerns, we perform two
separate tests using the split share structure reform in China as a quasi-natural experiment. First, following Chen et al. (2012), as firms
successively complete the reform from 2005, we are able to conduct a panel difference-in-differences analysis to examine the effect
of liquidity on diversification. Consistent with our expectations, the results from this analysis show that firms significantly reduce
the level of diversification after the reform. Second, following Fang et al. (2014), to isolate the liquidity effect from other potential
effects caused by the reform, we construct a matched sample by using a propensity score matching (PSM) approach to conduct a
difference-in-differences analysis around the reform. Specifically, we match a firm from the group with the largest change in liquidity
after the reform (treatment group) to a firm from the group with the smallest liquidity change (control group) that has similar firm
characteristics. The regression results using this matched sample are consistent with our main findings.
While it is reasonable to assume that the reform affects diversification mainly through liquidity since changes in liquidity is one
of its most direct and first order outcomes, we perform a couple of additional tests to ensure that our results are really capturing
liquidity’s effect on diversification. For example, we repeated all the main regressions controlling for some additional factors that are
likely to affect diversification and experience changes during the reform; we also follow Jiang et al. (2017) to further examine the
changes in the fundamental firm characteristics (our control variables) in the PSM DID framework to make sure that they are uniformly
affected by the reform across the treatment and control groups. The results from both tests confirm that the documented deterring
effect of the reform on diversification is driven by changes in liquidity, not by changes in other factors or strategic considerations.
After establishing the negative effect of stock liquidity on corporate diversification, we further try to explore the potential
channels through which liquidity impacts diversification. Based on prior studies, we come up with two hypotheses: a financial
constraint hypothesis and a corporate governance hypothesis. The financial constraint hypothesis highlights the potential benefits
of diversification in overcoming the imperfections of external capital markets through the expansion of internal capital markets
(Subrahmanyam and Titman, 1999; Fluck and Lynch, 1999; Matsusaka and Nanda, 2002). Since increased liquidity helps to improve
external financing conditions, the needs for firms to pursue diversification strategies and broaden the internal capital markets are
reduced (Bhide, 1990; Markides, 1995; Berger and Ofek, 1995). For financially-constrained firms, the motivation to overcome the
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costs and frictions in external capital markets through diversification is stronger. Therefore, we expect that the negative effect of
liquidity on corporate diversification is more significant among financially-constrained firms.
The corporate governance hypothesis highlights liquidity’s effect on mitigating agency problems. Managers tend to derive private
benefits from diversification, as they are motivated to manage more diversified firms to diversify their own risks, to obtain bigger
compensation contracts, or to be more irreplaceable (Amihud and Lev, 1981; Jensen, 1986; Shleifer and Vishny, 1989; Jensen and
Murphy, 1990). However, liquidity may help firms improve corporate governance in a few ways. On the one hand, the enhanced price
informativeness of liquid stock contributes to more efficient managerial incentive contracts and performance monitoring (Holmström
and Tirole, 1993). On the other hand, liquidity also improves monitoring by facilitating blockholder control and non-controlling
blockholders’ threats to exit (Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011). Thus, managers have less
discretion to pursue private benefits through diversification after liquidity increases. Therefore, we expect the deterring effect of
liquidity to be more significant either for firms with more severe information asymmetry, or for firms with higher blockholder
ownership, or both.
With the split-share reform setting, we use a difference-in-difference-in-differences (DDD) approach to test both the financial
constraint and corporate governance hypotheses and to further verify the potential mechanism through which liquidity affects
corporate governance in China. Our findings are twofold: First, we find strong supportive evidence for both hypotheses. In addition,
our results support that liquidity improves corporate governance and reduces managers’ opportunistic diversification decisions
through the information mechanism, while we rule out the alternative explanation that our results are driven by the role of liquidity
in facilitating blockholder control and, in turn reducing diversification. The implication of our results on the underlying mechanism
through which liquidity influences corporate governance in China is consistent with that of Jiang et al. (2017).
Our paper mainly contributes to the rapidly growing research on the effect of stock liquidity on corporate decisions. Some existing
studies focus on firms’ investment considerations. For example, Becker-Blease and Paul (2006) show that higher stock liquidity raises
capital expenditure, indicating that liquidity influences investment decisions. Some studies, meanwhile, look into liquidity’s link
to financing decisions and find that firms with more liquid equity have lower leverage and prefer equity financing when raising
capital (Frieder and Martell; Lipson and Mortal, 2009). Other studies point to the effects of liquidity on dividend payouts (Banerjee
et al., 2007; Jiang et al., 2017) and on firm innovation (Fang et al., 2014). Our paper supplements this literature by investigating
how liquidity influences corporate diversification, which is a comprehensive decision that involves both investment and financing
considerations. To the best of our knowledge, our paper is the first to provide causal evidence that improved liquidity leads to less
corporate diversification. In doing so, we provide a new perspective on the role that market friction plays in corporate finance.
Our paper also builds on and contributes to the literature on the relation between liquidity and corporate governance. Thus far, the
literature has offered competing views on whether higher stock liquidity enhances or deters corporate governance. Researchers have
also provided different perspectives on how liquidity influences governance. According to Holmström and Tirole (1993), liquidity
improves the information content in stock prices and mitigates information asymmetry between insiders and outsiders. By doing
so, liquidity helps shareholders design better managerial incentive contracts and conduct more efficient performance monitoring.
Similarly, Faure-Grimaud and Gromb (2004) suggest that information generated in a liquid stock market on insider activities
incentivizes large shareholders (e.g., institutional investors) to monitor. In contrast, Coffee (1991) and Bhide (1993) argue that a
liquid stock market lowers the costs of exit and impedes intervention by potential monitors. Maug (1998) and Kyle and Vila (1991),
on the other hand, argue that a liquid stock market lowers the cost of acquiring shares and helps investors to accumulate the blocks
that generate sufficient incentives to voice or intervene. Admati and Pfleiderer (2009), Edmans (2009), Edmans et al. (2013), Norli
et al. (2014), and Chen et al. (2015) also show that liquidity provides governance mechanisms through facilitating blockholders’
forming, voice, and threats to exit. More recently, Back et al. (2018) find a bidirectional link between liquidity and activism using
a dynamic trading model and conclude that the relation between liquidity and economic efficiency may be positive or negative,
depending on the model parameters. We show that the deterring effect of liquidity on diversification is stronger in firms with more
severe information asymmetry, but not significant among firms with stronger blockholder control. Thus, in contrast to Edmans et al.’s
argument that liquidity helps to discipline managers’ behavior through strengthening blockholder control, our results support the
information mechanism proposed by Holmström and Tirole (1993). Our evidence is consistent with the findings in Jiang et al. (2017),
in which they use Chinese data to examine the effect of liquidity on dividend policy. Overall, our evidence supports the view that
stock liquidity plays a positive role in improving governance.
Finally, our paper contributes to the literature on diversification, as we empirically identify a new factor that affects the diversifying
decision. In particular, our paper is closely related to two strands of research on why firms diversify. One of these strands focuses
upon the internal capital market theory. Fazzari et al. (1988) and Lamont (1997) argue that since external markets are imperfect,
internal capital markets play a nontrivial role in allocating capital among a firm’s interdependent financial segments. More recently,
as held by Fluck and Lynch (1999) and Kim et al. (2004) among others, an important motivation for diversification stems from
the potential benefit of building internal capital markets to address both financing needs and frictions in external markets. Many
researchers also show that improved external environments (e.g., the advancing of capital markets, deregulation, less opaque
information environment) are the main factors that have driven the refocus trend in the United States during the 1980s (Bhide, 1990;
Markides, 1995; Berger and Ofek, 1995). A second strand of research focuses upon agency cost theory with respect to motivations
for diversification. According to this theory, managers may diversify to increase the size of their respective firms to obtain more
control rights (Jensen, 1986), as well as more bargaining power and higher compensation (Jensen and Murphy, 1990), despite the
inefficiencies associated with particularly large firms. Managers can also entrench themselves through diversification by investing in
sub-optimal projects that require manager-specific knowledge or resources. Managers may also use diversification to diversify their
own idiosyncratic risks (Amihud and Lev, 1981; May, 1995). In addition, Aggarwal and Samwick (2003) find empirical evidence that
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corporate diversification decisions are usually made by managers who seek personal benefits rather than risk reduction. Our paper
extends this line of research by exploring what factors influence firm’s diversification decisions. Our results that increased liquidity
reduces corporate diversification through relaxing financial constraints and mitigating agency problems confirm both theories on
why firms diversify.
The rest of the paper proceeds as follows. Section 2 briefly introduces the institutional background of China’s split share structure
reform. Section 3 describes data and variable construction. Section 4 presents our baseline results and panel difference-in-differences
analysis, examining the relation between stock liquidity and corporate diversification. Section 5 shows results from robustness tests.
After we use Section 6 to investigate potential mechanisms for our findings, we conclude this paper with Section 7.
2. Institutional background
Before 2005, almost all Chinese publicly listed firms had a split share structure during the IPO subscription process. This unique
share structure consisted of around one third of tradable shares and two thirds of non-tradable shares. The tradable shares were issued
to investors, mostly small shareholders on the secondary market, to be freely traded. The non-tradable shares, which could not be
freely traded, were issued to government agents, state-owned enterprises (SOEs), and founders of private companies (Li et al., 2011).
However, considering the different trading status in the market, tradable shares and non-tradable shares had the same cash flow
rights and voting rights with respect to a firm’s managerial decisions. Before the reform, a large number of non-tradable shares could
not be freely traded and could only be exchanged at a negotiated price under special circumstances, and this process usually required
government approval. Moreover, compliance costs associated with the government could be very high. Therefore, this split share
structure created significant market friction for Chinese publicly listed firms at that time. Cautious of the severe incentive conflicts
between tradable and non-tradable shareholders and the illiquid market this structure created, the Chinese government came to
realize that the dominant position of non-tradable shares in the stock market prevented the development and prosperity of the stock
market (Firth et al., 2010; Liao et al., 2014).
In 2005, after two pilot programs for over 60 listed companies, the China Securities Regulatory Commission (CSRC) launched a
formal reform program that eliminated the two-tier share structure and gradually converted all non-tradable shares to tradable shares
over the next several years. The reform allowed non-tradable shares to be traded in the public market at the end of the lock-up period
(usually one year). After the lock-up period, shareholders of non-tradable shares are able to trade no more than 5% (10%) of total
shares outstanding in the 1st (2nd) year. All non-tradable shares are then open for public trading in the stock market four years after
the lock-up period.
The CSRC intended to finish this split share structure reform by the end of 2006; by the end of 2007, firms representing 97% of the
Chinese A-share market capitalization had completed the reform (Li et al., 2011). However, because the shareholders of non-tradable
shares had to negotiate a compensation plan with shareholders of tradable shares of the same company and also because non-tradable
shares could only be traded on the market when the plan was implemented, those firms that could not complete the reform, largely
concentrated from 2005 to 2009, on time experienced huge problems and obstacles in the implementation (Liao et al., 2014). In our
sample, firms that completed the reform did so in the period lasting from 2005 to 2014. Specifically, our sample includes 209 firms
(2264 obs.) that completed the reform in 2005, 813 firms (9169 obs.) in 2006, 91 firms (957 obs.) in 2007, 25 firms (268 obs.) in
2008, 18 firms (154 obs.) in 2009, 2 firms (11 obs.) in 2010, 3 firms (26 obs.) in 2011, 1 firm (7 obs.) in 2012, 7 firms (48 obs.) in
2013, and 3 firms (21 obs.) in 2014. This distribution is consistent with that in prior studies.
As the reform itself does not change firms’ real assets of operations, it offers a good opportunity to apply a difference-in-differences
analysis to examine the clean effect on corporate characteristics. This setting has been used as an exogenous shock to study state
ownership (Firth et al., 2010; Liao et al., 2014), market risk sharing (Li et al., 2011), corporate cash holdings (Chen et al., 2012),
corporate innovation (Tan et al.), and payout policy (Jiang et al., 2017).
The reform generates plausibly exogenous shocks to stock liquidity and provides a good setting for examining how liquidity
affects diversification for a couple of reasons: First, the split share reform is initiated for very different reasons than to affect firms’
diversification strategies. The motivation of the reform is to promote the development of the Chinese financial market and to solve
the problems induced by the split share structure that is stemmed from the transition from a planned economy to a market-oriented
economy.
More important, the reform is carried out mandatorily by the China Securities Regulatory Commission (CSRC). Thus, no firm can
choose whether or when to implement the reform. As CSRC sets the starting time and the expected completion time of the reform to
be between August 2005 and the end of 2006, all firms are expected to finish the reform within this time window. The actual timing
of the reform for each firm depends mainly on the time needed for the negotiation between holders of the tradable and non-tradable
shares, as well as the time needed to obtain sufficient votes for completing the reform (Li et al., 2011). Therefore, the reform can
serve as a plausibly exogenous shock to stock liquidity.
In this paper, we take advantage of these features of the reform to study the effect of stock liquidity on corporate diversification.
3. Data and variable construction
To perform the empirical analysis, we construct a dataset from several data sources, based on data availability and reliability. We
build up a sample of Chinese A-share listed companies from 2001 to 2015. The data starts from 2001 because a series of new accounting
standards issued by the Ministry of Finance in China to standardize the disclosure of public firms’ financial statements became effective
in 2001. We obtain firms’ accounting information and stock prices from the China Stock Market & Accounting Research (CSMAR)
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and Peking University’s China Center for Economic Research (CCER) databases. The data we use to construct measures for our main
dependent variable, corporate diversification, are from the WIND database. Following standard sample selection procedures in the
literature, we exclude firms in the financial industry and retain firms that have revenues from the financial sector. We also exclude
firms that issued B shares and H shares in order to exclude the effects of liquidity from other stock markets on corporate diversification.
We then exclude both firms with significant asset infusions and restructurings during the split share structure reform and firms with
incomplete accounting information. Finally, our full sample consists of 12,925 firm–year observations with 1172 unique Chinese
public firms over the period from 2001 to 2015.
3.1. Measures for corporate diversification
Following the literature on corporate diversification (see, e.g., Comment and Jarrell, 1995; Denis et al., 1997; Jiang, 2006), we
use two standard proxies to measure corporate diversification in our analysis. The first one is 𝑁, the number of segments within a
firm, based on standard industry classifications. The second one is the Entropy Index (𝐸𝐼), which we compute as follows:
∑
𝑛
1
𝐸𝐼 = 𝑃𝑖 𝑙𝑛( ), (1)
𝑖=0
𝑃𝑖
where 𝑃𝑖 is calculated as the percentage of revenue from segment 𝑖 in total revenue and 𝑁 is the number of segments. The Entropy
Index not only contains information about the number of segments, but also reflects the relative importance of each segment, especially
when numbers of segments for two firms are the same. These two measures share the same implication: the higher the value, the
more diversified the firm is.
3.2. Measures for liquidity
We construct our main measure of liquidity from the Amihud (2002) illiquidity ratio. Goyenko et al. (2009) compare 12 different
types of popular liquidity measures in the literature and find that the Amihud (2002) illiquidity ratio more accurately reflects price
information. Hasbrouck (2009) also concludes that the Amihud (2002) illiquidity ratio is the most trustworthy measure for assessing
stock liquidity based on annual data. We compute this ratio as the average ratio of daily stock returns (absolute value) to daily trading
volume for each firm 𝑖 in fiscal year 𝑡 as follows:
𝐷
1 ∑
𝑖,𝑡
|𝑅𝑒𝑡𝑖,𝑑,𝑡 |
𝐴𝑚𝑖ℎ𝑢𝑑𝑖,𝑡 = × , (2)
𝐷𝑖,𝑡 𝑑=1 𝑉 𝑜𝑙𝑖,𝑑,𝑡
where 𝐷𝑖,𝑡 is the number of trading days for firm 𝑖 in year 𝑡. 𝑅𝑒𝑡𝑖,𝑑,𝑡 is the stock return enlarged by 100 on day 𝑑 for firm 𝑖 in year
𝑡. 𝑉 𝑜𝑙𝑖,𝑑,𝑡 is the trading volume of firm 𝑖 on day 𝑑 in year 𝑡 in million RMB. Following Edmans et al. (2013), we log-transform the
Amihud ratio and then multiply it by −1 for ease of interpretation. We calculate main liquidity ratio (𝐿𝐼𝑄) as follows:
𝐿𝐼𝑄 = −1 × 𝑙𝑛(1 + 𝐴𝑚𝑖ℎ𝑢𝑑𝑖,𝑡 ). (3)
For robustness checks, we conduct analysis with two alternative measures for stock liquidity. The first one is turnover rate
(𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟), which is used frequently in the liquidity literature (see, e.g., Lesmond et al., 1999; Goyenko et al., 2009; Su and Xiong,
2013). 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟 equals the value of the trading volume divided by the total number of tradable shares. We construct this measure as
follows:
𝐷
1 ∑
𝑖,𝑡
𝑉 𝑜𝑙𝑖,𝑑,𝑡
𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = × , (4)
𝐷𝑖,𝑡 𝑑=1 𝐿𝑁𝑆𝑖,𝑑,𝑡
where 𝐷𝑖,𝑡 is the number of trading days for firm 𝑖 in year 𝑡. 𝑉 𝑜𝑙𝑖,𝑑,𝑡 is the number of trading volume for firm 𝑖 on day 𝑑 in year 𝑡.
𝐿𝑁𝑆𝑖,𝑑,𝑡 is the number of tradable volume for firm 𝑖 on day 𝑑 in year 𝑡. The higher the value of 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟, the higher the liquidity is.
The second alternative measure for stock liquidity is the high minus low impact spread estimator (𝐻𝐿), proposed by Corwin and
Schultz (2012). First, we calculate the spread estimator, 𝑆, using the reduced form equation provided by Corwin and Schultz (2012)
as follows:
2(𝑒𝛼𝑖,𝑡 − 1)
𝑆= , (5)
1 + 𝑒𝛼𝑖,𝑡
√ √ √ { [ ]2 } [ ]2
2𝛽𝑖,𝑡 − 𝛽𝑖,𝑡 𝛾𝑖,𝑡 ∑1 𝑜
𝐻𝑖𝑡,𝑑+𝑗 𝐻𝑜
where 𝛼𝑖,𝑡 = √ − √ , 𝛽𝑖,𝑡 =𝐸 𝑗=0 𝑙𝑛( 𝐿𝑜
) , 𝛾𝑖,𝑡 = 𝑙𝑛( 𝐿𝑜𝑖𝑡,𝑑,𝑑+1 ) , 𝐻𝑖𝑡,𝑑 (𝐿𝑖𝑡,𝑑 ) is the highest (lowest) price of
3−2 2 2−2 2 𝑖𝑡,𝑑+𝑗 𝑖𝑡,𝑑,𝑑+1
day 𝑑 in year 𝑡 for firm 𝑖. The higher the 𝑆𝑖,𝑡 , the lower the liquidity. We then multiply 𝑆 by −1 to obtain 𝐻𝐿 in order to ease the
interpretation. The higher the value of 𝐻𝐿, the higher the liquidity is.
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Table 1
Summary statistics. This table reports summary statistics of main variables we used in our empirical analysis. 𝑁 and 𝐸𝐼 are proxies for corporate diversification. 𝐿𝐼𝑄
is the measure for stock liquidity. 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟 and 𝐻𝐿 are two alternative measures for stock liquidity. 𝑆𝑖𝑧𝑒, 𝐹 𝐶𝐹 , 𝑄, 𝑅𝑂𝐴, and 𝐿𝑒𝑣 are firm-level control variables in our
regression analysis. 𝑀𝑘𝑡𝑐𝑎𝑝, 𝑃 𝑎𝑦𝑜𝑢𝑡, and 𝐼𝑛𝑡𝑐𝑜𝑣 are three measures for financial constraint. 𝐵𝑖𝑔4, 𝐴𝑛𝑎𝑙𝑦𝑠𝑡, and 𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ are three measures for information asymmetry.
𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, and 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 are three measures for blockholder intervention. Variable definitions are provided in Table A.1. All
variables are at the firm–year level and continuous variables are winsorized at 1% and 99%. The sample consists of 12,925 observations with 1172 unique Chinese public
firms over the period from 2001 to 2015. The statistics include the mean value (Mean), standard deviation (SD), the 10th percentile value (P10), the 25th percentile
value (P25), the median value (Median), the 75th percentile value (P75), the 90th percentile value (P90), and the number of observations (N).
Variables Mean SD P10 P25 Median P75 P90 N
N 2.8781 1.8333 1.0000 1.0000 2.0000 4.0000 5.0000 12,925
EI 0.4798 0.4670 0.0000 0.0000 0.4076 0.7968 1.1461 12,925
LIQ −0.1711 0.2109 −0.4659 −0.2320 −0.0800 −0.0361 −0.0185 12,925
Turnover 2.1805 1.6987 0.6052 0.9623 1.6871 2.9122 4.5175 12,925
HL −1.7804 1.0695 −3.3081 −2.2083 −1.4799 −1.0276 −0.7496 12,925
Size 7.9172 1.2222 6.4787 7.0431 7.8093 8.6592 9.5435 12,925
FCF −0.0043 0.1194 −0.1362 −0.0405 0.0125 0.0562 0.1097 12,925
Q 2.1812 1.5144 1.0711 1.2777 1.7043 2.5104 3.7753 12,925
ROA 0.0311 0.0611 −0.0081 0.0100 0.0291 0.0550 0.0910 12,925
Lev 0.5081 0.1933 0.2433 0.3723 0.5182 0.6500 0.7522 12,925
Mktcap 8.1111 1.1262 6.8400 7.3751 8.0173 8.7555 9.5290 12,925
Payout 0.2777 0.2091 0.0482 0.1273 0.2454 0.3876 0.5411 12,925
IntCov 0.3200 0.4511 0.0102 0.0551 0.1763 0.3948 0.7376 12,278
Big4 0.0607 0.2390 0.0000 0.0000 0.0000 0.0000 1.0000 12,925
Analyst 1.0360 1.1190 0.0000 0.0000 0.6930 1.9460 4.1900 12,925
Research 1.2580 1.3490 0.0000 0.0000 0.6930 2.3030 5.3940 12,925
NcBlockholder 0.3070 0.4610 0.0000 0.0000 0.0000 1.0000 1.0000 12,924
N_NcBlockholder 0.3640 0.6010 0.0000 0.0000 0.0000 1.0000 4.0000 12,924
Share_NcBlockholder 0.6228 0.1048 0.0000 0.0000 0.0000 0.1245 0.5384 12,924
3.3. Control variables
Following the corporate diversification literature in both developed and emerging markets, we control for several factors that are
the most closely associated with diversification in our analysis. First, we control for firm size (𝑆𝑖𝑧𝑒), as the literature has documented
that firm size is positively associated with corporate diversification (Pomfret and Shapiro, 1980; Denis et al., 1997), and large firms
have more resource advantages and more likely to diversify. Second, we control for free cash flow (𝐹 𝐶𝐹 ). Jensen (1986) argues
that free cash flow is a prerequisite for the expansion of new business, and excessive free cash flow facilitates managers’ over-
investment incentives. Some researchers find that sufficient free cash flow, when coupled with over-confident managers who are
more likely to overestimate such managers’ personal capacities, will exacerbate their over-investment behaviors, thereby increasing
the level of business diversification (Malmendier and Tate, 2008). Third, we control for growth opportunity (𝑄), as Lin and Su (2008)
show that firms with better growth opportunities are more capable of diversifying in China. Fourth, we control for profitability
(𝑅𝑂𝐴). Jammine and Thomas (1988) study manufacturing companies in the UK and find that high profitability in domestic markets
encourages companies to develop their overseas business. Finally, we control for leverage ratio (𝐿𝑒𝑣) as literature has suggested
that diversification is correlated with corporate leverage and the use of debt (see, e.g. Fluck and Lynch, 1999; Singh et al., 2003).
Table A.1 provides more details about variable definitions.
3.4. Summary statistics
Table 1 presents summary statistics of all the variables we used in our analysis. During our sample period, the median of 𝑁 is
2.000, meaning that more than half of the sample firms adopt diversification strategies. The means (standard deviations) of 𝑁 and
𝐸𝐼 are 2.8781 (1.8333) and 0.4798 (0.4670), respectively, for the period from 2001 to 2015. The values of these statistics are similar
to those found by Jiang (2006) and Lin and Su (2008): Jiang (2006) reports 2.164 and 0.4 for the means of 𝑁 and 𝐸𝐼, respectively,
over the period from 2001 to 2004, and Lin and Su (2008) report a mean (standard deviation) of 2.3905 (1.5518) for 𝑁 between
2000 and 2002.
Table 2 presents Pearson correlations among variables that we use in our analysis. Unsurprisingly, our two measures of corporate
diversification, 𝑁 and 𝐸𝐼, are highly correlated with a positive correlation coefficient of 0.8331 at the 1% level. Also, our main
measure of stock liquidity, 𝐿𝐼𝑄, is significantly positively correlated with its two alternative measures, 𝐻𝐿 and 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟. From this
matrix, we find a significantly negative correlation coefficient of −0.0500 between the liquidity measure (𝐿𝐼𝑄) and the diversification
measure (𝐸𝐼) at the 1% level. The two alternative measures of stock liquidity, 𝐻𝐿 and 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟, also have significantly negative
correlation (−0.0333 and −0.0200, respectively) with the diversification measure (𝑁). At the same time, the level of diversification
is positively correlated with firm size (𝑆𝑖𝑧𝑒), leverage ratio (𝐿𝑒𝑣), and free cash flow (𝐹 𝐶𝐹 ), but negatively correlated with growth
opportunity (𝑄) and profitability (𝑅𝑂𝐴). The level of stock liquidity is positively correlated with firm size (𝑆𝑖𝑧𝑒), growth opportunity
(𝑄), and profitability (𝑅𝑂𝐴); however, there is an uncertain correlation with leverage ratio (𝐿𝑒𝑣) and free cash flow (𝐹 𝐶𝐹 ).
62
Table 2
Pearson correlation matrix. This table reports the Pearson correlations for the main variables we used in the empirical analysis. Variable definitions are provided in
Table A.1. The full sample consists of 12,925 observations with 1172 unique Chinese public firms over the period from 2001 to 2015. *** , ** , and * indicate significance
at the 1%, 5%, and 10% levels, respectively.
N EI LIQ Turnover HL Size ROA Q Lev FCF
N 1.0000
EI 0.8331*** 1.0000
LIQ −0.0144 −0.0500*** 1.0000
Turnover −0.0333*** −0.0122 0.2911*** 1.0000
HL −0.0200** −0.0091 0.1633*** 0.6181*** 1.0000
Size 0.0944*** −0.0030 0.4580*** −0.1911*** −0.1144*** 1.0000
ROA −0.0367*** −0.0499*** 0.2212*** −0.0133 −0.0451*** 0.1444*** 1.0000
Q −0.0921*** −0.0522*** 0.1282*** 0.1973*** 0.1535*** −0.3977*** 0.1783*** 1.0000
Lev 0.0863*** 0.0224** −0.0091 0.0035 0.0636*** 0.3137*** −0.3392*** −0.2591*** 1.0000
FCF 0.0182** 0.0082 −0.0122 −0.1222*** −0.0355*** 0.0700*** 0.0644*** −0.0281*** 0.0363*** 1.0000
Table 3
Univariate analysis. This table reports our univariate test results of the difference in corporate diversification between firms with high stock liquidity and firms with
low stock liquidity. Each year, firms are classified into high stock liquidity and low stock liquidity groups according to the median value of our main liquidity measure,
𝐿𝐼𝑄. Observations with stock liquidity above the median are included in the high stock liquidity group, and those below form the low stock liquidity group. 𝑁 and
𝐸𝐼 are two measures of corporate diversification. Variable definitions are provided in Table A.1. The sample consists of 12,925 observations with 1172 unique public
firms over the period from 2001 to 2015. t -statistics and z-statistics are for the tests of difference in the mean and median value of diversification between two different
liquidity groups. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables High liquidity stock Low liquidity stock Test of difference
Median Mean Median Mean z-stat t -stat
N 2.0000 2.7372 3.0000 2.9791 32.42*** 7.44***
EI 0.3714 0.4560 0.4299 0.4956 10.48*** 4.76***
4. Empirical results
4.1. Univariate analysis
To begin with, we conduct a univariate analysis of stock liquidity and corporate diversification based on our sample. Specifically,
every year we divide firms into high stock liquidity and low stock liquidity groups according to the median value of the stock liquidity
measure (𝐿𝐼𝑄). Observations with stock liquidity above the median value are classified into the high liquidity group, and those below
form the low liquidity group. We then compare the mean and median value of our diversification measures (𝑁 and 𝐸𝐼) between the
two liquidity groups.
Table 3 reports the results. As shown, the median and mean value of firms’ number of segments (𝑁) and firms’ Entropy index (𝐸𝐼)
for the high liquidity group are significantly lower than those values for the low liquidity group, and the cross-group differences of
both values are statistically significant at the 1% level in terms of both the Wilcoxon 𝑧-stat and 𝑡-stat.2
4.2. Multivariate regression analysis
The preliminary results obtained from the univariate analysis indicate a negative correlation between stock liquidity and corporate
diversification. However, to better disentangle the relation between the two from other factors, we perform a multivariate regression
of diversification on liquidity, where we control for a series of factors that have been documented in prior literature to affect
diversification, as well as including multiple fixed effects. Our baseline regression model is as follows:
𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛼 + 𝛽𝐿𝐼𝑄𝑖,𝑡 + 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖𝑛𝑑 + 𝛿𝑡 + 𝜖𝑖,𝑡 , (6)

where 𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 is the diversification level measured by 𝑁 or 𝐸𝐼 for firm 𝑖 in year 𝑡 + 1. 𝐿𝐼𝑄𝑖,𝑡 is our main explanatory
variable, which measures stock liquidity for firm 𝑖 in year 𝑡. 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 are the control variables that include 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and
𝐹 𝐶𝐹 . 𝜃𝑖𝑛𝑑 and 𝛿𝑡 indicate industry- (or firm-) and year-fixed effects. Table A.1 provides more details on variable definitions.
Table 4 reports the estimation results. In columns (1) and (2), we estimate the regression model without any control variables.
Consistent with the results from our earlier univariate analysis, the liquidity measure, 𝐿𝐼𝑄, is significantly negatively associated
with 𝑁 (−0.3661, 𝑡 = 2.04) and 𝐸𝐼 (−0.0785, 𝑡 = 2.59). In columns (3) and (4), we still observe a significantly negative correlation
between stock liquidity and corporate diversification after including all the control variables and fixed effects. As liquidity increases
by one standard deviation, we find that the number of segments in a diversified firm decreases by about 2.8% and firms’ Entropy index
by 4.29% of their respective mean values. In addition, our results show that corporate diversification levels are positively associated
with firm size and leverage ratio, which confirms prior findings in Denis et al. (1997) and Fluck and Lynch (1999).
These results could still be biased by omitted variables. To address this concern, we include firm-fixed effects to control for all
time-invariant, firm-specific characteristics that might be correlated with diversification and liquidity. Columns (5) and (6) in Table 4
2 Wilcoxon 𝑧-stat is used for median difference test, and 𝑡-stat is used for mean difference test.
63
Table 4
Panel regression analysis. This table reports our baseline results about regressions of stock liquidity on corporate diversification. The dependent variables are two
measures of corporate diversification, 𝐸𝐼 and 𝑁. The independent variable is stock liquidity, 𝐿𝐼𝑄. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions
of variables are provided in Table A.1. Columns (1) and (2) report univariate regression results. Columns (3) and (4) report results when we include firm-level control
variables. Columns (5) and (6) report results when we include firm-fixed effects in the analysis. The sample consists of 12,925 observations with 1172 unique public
firms over the period from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%,
5%, and 10% level, respectively.
Variables (1) (2) (3) (4) (5) (6)
N EI N EI N EI
Intercept 3.2446*** 0.4656*** 1.2032*** 0.3399*** 0.5959** 0.1963***
(32.78) (40.26) (7.26) (8.02) (2.58) (3.51)
LIQ −0.3661** −0.0785*** −0.3833*** −0.0975*** −0.3029*** −0.0817***
(2.04) (2.59) (4.19) (4.17) (2.92) (3.26)
Size 0.1991*** 0.0197*** 0.2678*** 0.0368***
(10.59) (4.09) (9.20) (5.24)
ROA −0.6677** −0.2579*** −0.8776*** −0.1738***
(2.29) (3.47) (3.46) (2.84)
Q −0.0470*** −0.0147*** 0.0007 −0.0003
(3.73) (4.57) (0.05) (0.08)
Lev 0.3069*** 0.0132 0.6780*** 0.1526***
(3.16) (0.53) (5.87) (5.47)
FCF 0.1399 0.0267 −0.0184 −0.0093
(1.07) (0.79) (0.18) (0.38)
Year FE Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes No No
Firm FE No No No No Yes Yes
Observations 12,925 12,925 12,925 12,925 12,925 12,925
Adjusted R-squared 0.0690 0.0727 0.0874 0.0801 0.5439 0.5899
Table 5
Liquidity changes before and after the reform. This table reports the difference of firms’ stock liquidity between one year before the reform (pre-reform liquidity) and
one year after the reform (post-reform liquidity). Variable definitions are provided in Table A.1. The sample consists of 12,925 observations with 1172 unique public
firms over the period from 2001 to 2015. t -statistics and z-statistics are for the tests of difference in the mean and median value of stock liquidity between one year
before the reform and one year after the reform. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables Pre-reform liquidity Post-reform liquidity Test of difference
Median Mean Median Mean z-stat t -stat
𝐿𝐼𝑄 −0.3933 −0.4471 −0.1691 −0.2093 298.99*** 21.63***
report the estimation results with firm-fixed effects and they corroborate columns (3) and (4) results in that 𝐿𝐼𝑄 is negatively
associated with both corporate diversification measures at the 1% significance level.3
4.3. Panel difference-in-differences analysis
The documented negative relation between stock liquidity and diversification may be subject to reverse causality as investors
often make investment decisions and trade accordingly based on expectations about a firm’s future plan. Therefore, firms’ succeeding
diversification strategies may influence current stock liquidity, even though these strategies have yet to be implemented. To mitigate
this concern, we conduct a panel difference-in-differences analysis under a quasi-natural experiment, China’s split share structure
reform. As discussed in Section 2, this reform serves as a plausible exogenous shock to stock liquidity and has a staggered feature,
which we exploits in this panel difference-in-differences regression.
The reform has been used frequently in the literature as an exogenous shock representing the removal of market friction (Li et al.,
2011; Liao et al., 2014) and a sudden increase of stock liquidity (Jiang et al., 2017). However, for the purpose of our study, we first
show whether the reform indeed provides a liquidity shock. Specifically, we calculate the median and mean value of our liquidity
measure, 𝐿𝐼𝑄, for firms one year before the reform and for firms one year after the reform. Then, we test the differences between
those values.
As reported in Table 5, both the median and mean values of our liquidity measure, 𝐿𝐼𝑄, experience a substantial increase after
the reform. Moreover, these values are significant at the 1% level with respect to both Wilcoxon 𝑧-stat and 𝑡-stat. Hence the reform
generates a significantly positive exogenous shock on firms’ stock liquidity levels on average, and provides an appropriate setting for
a difference-in-differences analysis.
Following Chen et al. (2012), we estimate the effect of stock liquidity on corporate diversification using the staggered completion
feature of the reform with the following model:
𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛼 + 𝛽𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 + 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖𝑛𝑑 + 𝛿𝑡 + 𝜖𝑖,𝑡 , (7)
3 To control for industry cycles, we also include industry-by-year- and firm-fixed effects in all our main regression models including this baseline regression, the
panel difference-in-differences regression, and the difference-in-differences regression with a matched sample. The results are presented in Tables A.2–A.4 in the
Appendix, respectively. As shown, our findings still hold.
64
Table 6
Panel difference-in-differences regression analysis. This table reports the difference-in-differences regression results. Following Chen et al. (2012), we use the staggered
feature of China’s split share structure reform to perform a difference-in-differences regression analysis. In our sample, firms completed the reform in different years.
To capture the treatment effect of the reform on corporate diversification, we define a dummy variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, which equals one if it is at least one year after
the firm completes the reform because the reform requires that the shares have to be locked up for one year after the completion of the reform, and zero otherwise.
The dependent variables are two measures of corporate diversification, 𝐸𝐼 and 𝑁. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are
provided in Table A.1. Columns (1) and (2) report univariate regression results. Columns (3) and (4) report results when we include firm-level control variables in our
tests. Columns (5) and (6) report results when we include firm-fixed effects in the analysis. The sample consists of 12,925 observations with 1172 unique public firms
over the period from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and
10% level, respectively.
Variables (1) (2) (3) (4) (5) (6)
N EI N EI N EI
Intercept 3.1721*** 0.6146*** 1.9978*** 0.5822*** 0.7549*** 0.2385***
(35.85) (24.71) (6.09) (6.68) (3.35) (4.38)
AfterReform −0.5573*** −0.1299*** −0.6102*** −0.1346*** −0.2592*** −0.0467**
(4.09) (3.51) (4.74) (3.71) (3.01) (2.24)
Size 0.1641*** 0.0094 0.2570*** 0.0340***
(4.05) (0.87) (8.90) (4.87)
ROA −0.6471 −0.2152* −0.8981*** −0.1827***
(1.51) (1.88) (3.55) (2.99)
Q −0.0693*** −0.0214*** −0.0049 −0.0017
(3.51) (3.76) (0.37) (0.53)
Lev 0.4917*** 0.0760 0.7088*** 0.1609***
(2.69) (1.53) (6.16) (5.79)
FCF 0.1611 0.0312 0.0024 −0.0043
(1.16) (0.90) (0.02) (0.17)
Observations 12,925 12,925 12,925 12,925 12,925 12,925
where 𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 is the diversification level measured by 𝑁 and 𝐸𝐼 for firm 𝑖 in year 𝑡 + 1. 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 is the key variable
that equals one if it is at least one year after firm 𝑖 completes the reform in year 𝑡, and zero otherwise, capturing the average treatment
effect. The remaining variables are the same as those in Eq. (6). 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 are the control variables that include 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣,
and 𝐹 𝐶𝐹 . 𝜃𝑖𝑛𝑑 and 𝛿𝑡 indicate industry- (or firm-) and year-fixed effects, respectively.
Table 6 reports our estimation results. As shown in columns (1) and (2), the coefficients on our key variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚,
are −0.5573 (𝑡 = 4.09) and −0.1299 (𝑡 = 3.51), respectively, for two different measures of corporate diversification. Economically,
these results indicate an almost 20% drop in the number of segments and a nearly 30% drop in EI value, on average, after the
reform. In addition, both estimates are statistically significant at the 1% level. After we include control variables in columns (3)
and (4), our results become even stronger. Columns (5) and (6) of Table 6 report the regression results with firm-fixed effects.
They are qualitatively similar to the results in other columns and further confirm the significantly negative effect of liquidity on
diversification. Taken together, the difference-in-differences analysis in Table 6 suggests that firms that have completed the reform
adopted less diversified strategies after the reform, which provides supportive evidence for our predictions on the link between stock
liquidity and corporate diversification.4
Furthermore, we examine the dynamics of changes in diversification surrounding the reform to further address potential reverse
causality concern. If reverse causality drives our results, we should observe some pre-existing trends in diversification between
treated and control firms. These pre-existing trends could drive our results even in the absence of the reform. Specifically, we include
𝑅𝑒𝑓 𝑜𝑟𝑚−2 , 𝑅𝑒𝑓 𝑜𝑟𝑚−1 , 𝑅𝑒𝑓 𝑜𝑟𝑚𝑌 𝑒𝑎𝑟, 𝑅𝑒𝑓 𝑜𝑟𝑚+1 , 𝑅𝑒𝑓 𝑜𝑟𝑚+2 , and 𝑅𝑒𝑓 𝑜𝑟𝑚+3+ in our regression model. 𝑅𝑒𝑓 𝑜𝑟𝑚−2 , 𝑅𝑒𝑓 𝑜𝑟𝑚−1 , 𝑅𝑒𝑓 𝑜𝑟𝑚+1 ,
and 𝑅𝑒𝑓 𝑜𝑟𝑚+2 are dummy variables that equal one if it is two years before, one year before, one year after, and two years after a firm
completes the reform, respectively, and zero otherwise; 𝑅𝑒𝑓 𝑜𝑟𝑚𝑌 𝑒𝑎𝑟 refers to the year when a firm completes the reform; 𝑅𝑒𝑓 𝑜𝑟𝑚+3+
is a dummy variable that equals one for all years starting from the third year after the reform, and zero otherwise.
Table 7 reports our estimation results. As shown in our full model in columns (3) and (4), the significantly negative effect of
the reform on corporate diversification starts to occur one year after the reform, and persists in the following years. When we
include firm-fixed effects in columns (5) and (6), the negative effects become significant two years after the reform and remain strong
thereafter. Since the reform allows non-tradable shares to be traded in the open market at the end of the lock-up period, which usually
lasts for one year, it makes sense that the negative impact only appears significantly at least one year after the reform. Overall, the
results from Table 7 provide supportive evidence that the split share structure reform is a proper setting for us to study the link
between stock liquidity and corporate diversification.
4 To explore whether the decrease in diversification is achieved through less diversification mergers or through other ways (for example, more divestiture), we also
examine the effect of the reform on firm’s capital expenditure and the number of diversification merger and acquisitions (where acquirer and target are not in the same
industry). The test results are presented in Tables A.5 and A.6 in the Appendix. As shown, the effects on firm’s capital expenditure and the number of diversification
merger and acquisitions are negative and statistically significant.
65
Table 7
The validation test. This table reports the results for the dynamics of changes in diversification surrounding the reform with a difference-in-differences regression
model. 𝑅𝑒𝑓 𝑜𝑟𝑚−2 , 𝑅𝑒𝑓 𝑜𝑟𝑚−1 , 𝑅𝑒𝑓 𝑜𝑟𝑚+1 , and 𝑅𝑒𝑓 𝑜𝑟𝑚+2 are dummy variables that equal one if it is two years before, one year before, one year after, and two years after
the reform, respectively, and zero otherwise. 𝑅𝑒𝑓 𝑜𝑟𝑚𝑌 𝑒𝑎𝑟 is a dummy variable that equals one for the year when the firm completes the reform, and zero otherwise.
𝑅𝑒𝑓 𝑜𝑟𝑚+3+ is a dummy variable that equals one for all years starting from the third year after the reform, and zero otherwise. The dependent variables are two measures
of corporate diversification, 𝐸𝐼 and 𝑁. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are provided in Table A.1. Columns (1) and (2)
report the placebo difference-in-differences regression results. Columns (3) and (4) report results when we include firm-level control variables in our tests. Columns
(5) and (6) report results when we include firm-fixed effects in the analysis. The sample consists of 12,925 observations with 1172 unique public firms over the period
from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% level,
respectively.
Variables (1) (2) (3) (4) (5) (6)
N EI N EI N EI
Intercept 3.1538*** 0.6099*** 1.6776*** 0.4915*** 1.0226*** 0.2410***
(34.84) (24.19) (4.90) (5.37) (5.25) (4.42)
Reform−2 −0.1729 −0.0280 −0.1725 −0.0257 −0.0558 −0.0307
(1.28) (0.81) (1.29) (0.75) (0.88) (1.22)
Reform−1 −0.1117 −0.0263 −0.1177 −0.0207 −0.1223 −0.0277
(0.59) (0.53) (0.64) (0.42) (1.09) (0.90)
ReformYear −0.2533 −0.0756 −0.2373 −0.0607 0.0395 −0.0207
(1.03) (1.18) (1.01) (0.96) (0.65) (0.57)
Reform+1 −0.6550** −0.1657** −0.6907** −0.1578** −0.0844 −0.0673
(2.21) (2.13) (2.50) (2.08) (1.40) (1.60)
Reform+2 −0.2557*** −0.0658*** −0.3523*** −0.0858*** −0.1483** −0.0380*
(2.64) (2.73) (3.91) (3.68) (2.43) (1.86)
Reform+3+ −0.2743 −0.1015** −0.4778*** −0.1394*** −0.2074*** −0.0478*
(1.57) (2.29) (3.06) (3.28) (4.22) (1.76)
Size 0.2140*** 0.0241** 0.2152*** 0.0340***
(5.03) (2.11) (8.35) (4.86)
ROA −0.5809 −0.2247** −0.9017*** −0.1873***
(1.35) (1.97) (3.58) (3.03)
Q −0.0661*** −0.0203*** −0.0040 −0.0020
(3.26) (3.55) (0.35) (0.62)
Lev 0.3396* 0.0253 0.7595*** 0.1588***
(1.90) (0.50) (6.66) (5.71)
FCF 0.1631 0.0325 −0.0035 −0.0032
(1.17) (0.94) (0.03) (0.13)
Observations 12,925 12,925 12,925 12,925 12,925 12,925
5. Robustness tests
In the previous section, we used various analytic methods to show that when stock liquidity increases, firms tend to become less
diversified. In this section, we perform additional tests to ensure that our results are not driven by measurement errors and model
misspecification.
5.1. Alternative measures of liquidity
First, to mitigate the concern on measurement errors of our independent variable, stock liquidity, we use two alternative measures
of stock liquidity, turnover rate (𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟) and the high-minus-low impact spread estimator (𝐻𝐿), to verify our baseline results.5
These two measures have been widely used to proxy for stock liquidity, and we use the same methodology as in the literature to
construct these variables (see, e.g., Lesmond et al., 1999; Goyenko et al., 2009; Corwin and Schultz, 2012; Su and Xiong, 2013).
These two measures share the same implication as our main measure, 𝐿𝐼𝑄: the higher the value of the measure, the higher the stock
liquidity is.
Table 8 reports the estimation results when we use alternative liquidity measures in our baseline model. Columns (1) and (2) show
the results when we use turnover rate (𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟), and columns (3) and (4) show the results when we use the high-minus-low impact
spread estimator (𝐻𝐿). Specifically, we find that the coefficients on 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟 for our two diversification measures, 𝑁 and 𝐸𝐼, are
negative (−0.3258, −0.0111) and statistically significant at the 5% (𝑡 = 1.98) and 1% level (𝑡 = 2.65), respectively. Moreover, when
we use 𝐻𝐿 to measure liquidity, both coefficients are negative (−0.1130, 𝑡 = 4.00; −0.0314, 𝑡 = 4.35) and statistically significant
at the 1% level. These results indicate that increased liquidity is associated with decreased diversification. Overall, the results from
Table 8 confirm our baseline findings.
5 Here we follow Jiang et al. (2017) and only include industry- and year-fixed effects in the regression for these two alternative measures. The reason is that the
within-firm variations of these two measures over time are quite small. Hence including firm-fixed effects not only absorbs most of the explanatory power but also
creates potential multicollinearity concerns. While we have considered other alternative measures of liquidity, the choices of our alternative measures here are based
on both theoretical literature foundation and data availability.
66
Table 8
Baseline regression results with alternative measures for liquidity. This table reports the baseline regression results when we employ alternative liquidity measures.
One alternative liquidity measure is the Turnover rate (𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟), which is a standard measure of liquidity in the literature (Lesmond et al., 1999; Goyenko et al., 2009;
Su and Xiong, 2013). The other one is the high minus low impact spread estimator (𝐻𝐿), proposed by Corwin and Schultz (2012). The dependent variables are two
measures of corporate diversification, 𝐸𝐼 and 𝑁. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are provided in Table A.1. Columns
(1) and (2) report the results when we use 𝑇 𝑢𝑟𝑛𝑜𝑣𝑒𝑟 to measure liquidity. Columns (3) and (4) report results when we use 𝐻𝐿 to measure liquidity. Firm-level control
variables are included in all tests. The sample consists of 12,925 observations with 1172 unique public firms over the period from 2001 to 2015. All regressions are
specified with year- and industry-fixed effects. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the
1%, 5%, and 10% level, respectively.
Variables (1) (2) (3) (4)
N EI N EI
Intercept 1.8701*** 0.5402*** 1.8492*** 0.5416***
(10.75) (12.16) (11.04) (12.67)
Turnover −0.3258** −0.0111***
(1.98) (2.65)
HL −0.1130*** −0.0314***
(4.00) (4.35)
Size 0.1757*** 0.0133*** 0.1744*** 0.0122***
(9.57) (2.84) (9.91) (2.72)
ROA −0.7800*** −0.2447*** −0.6818** −0.2174***
(2.66) (3.27) (2.32) (2.90)
Q −0.0622*** −0.0195*** −0.0696*** −0.0217***
(4.62) (5.67) (5.18) (6.33)
Lev 0.4817*** 0.0722*** 0.4552*** 0.0657***
(4.95) (2.91) (4.67) (2.64)
FCF 0.1684 0.0352 0.1648 0.0329
(1.27) (1.04) (1.25) (0.98)
Year FE Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes
Observations 12,925 12,925 12,925 12,925
Adjusted R-squared 0.0808 0.0772 0.0817 0.0780
5.2. Difference-in-differences test using a matched sample
In prior sections, we used a panel difference-in-differences analysis to show that the split share structure reform in China has a
significantly negative impact on firms’ diversification strategies. However, this reform could lead to changes in factors in addition
to stock liquidity, and these changes could potentially affect corporate diversification through various mechanisms.6 For example,
Chen et al. (2012) find that, after the reform, the tunneling incentive of controlling shareholders decreases, thereby encouraging firms
to reduce cash holdings. To better isolate the effects of increased liquidity from those of other channels, we use a propensity score
matching (PSM) approach to construct a matched sample and perform the difference-in-differences analysis again with this sample.
Following Jiang et al. (2017), we select the PSM sample by requiring that all firms in this sample are listed before December
31, 2004. This requirement is to ensure that all of these firms are affected by the shock. According to Li et al. (2011), 1254 firms,
representing over 97% of the A-share market capitalization at the time, had completed the reform by the end of 2007. Liao et al.
(2014) suggests that the firms that had yet to complete the reform by the end of 2009, when a majority (76.8%) of listed firms had
completed the reform, might have experienced significant problems and obstacles in the implementation. Thus, we require that all
firms in our sample complete the split share structure reform by the end of 2009 and exclude those firms that completed the reform
after 2009.
Next, following Fang et al. (2009, 2014), we calculate the liquidity difference with our new sample as the difference between
the liquidity one year before the reform and the liquidity one year after the reform, which is the end of the lock-up period when
non-tradable shares are gradually open to the market. Next, we sort the sample based on the difference of liquidity and divide the
sample into three groups with equal size. The top group, which includes firms with the largest liquidity difference, is the treatment
group, while the bottom group, which includes firms with the smallest liquidity difference, is the control group.
We then conduct our difference-in-differences analysis using a six-year window (i.e., from three years before the reform (year −3)
to three years after the reform (year +3)). We select this six-year window to strike a balance between the relevance and accuracy
of our estimated results.7 If the time window is too long, it may contain too much noise besides the effects of the reform, which
would diminish our model’s credibility. If the window is too short, the changes of stock liquidity would not have yet exerted sufficient
influence on corporate diversification. We then conduct the PSM by using the probit model to estimate the propensity score for each
6 To ensure that the decrease in diversification is capturing the effect of reform on liquidity rather than on changes in other factors, we also directly control
for a number of such factors that have been identified in the literature in all our main regressions. These additional controls include measures of risk sharing, cash
holding and innovation (patent and patent quality), which may alter firms’ diversification decision from risk sharing perspective, financial consideration and product
market strategy, respectively. The results are shown in Tables A.2, A.3, A.4 in the Appendix. They all confirm that liquidity has a significantly negative impact on
diversification even after controlling for these factors. In addition, we also try to include measures of risk sharing, cash holding, and innovation in the controlling list
for the propensity score matching and the effect of liquidity on diversification is not affected, suggesting that our results are not driven by the effects of the reform on
these factors.
7 Our results are robust if we use a four-year or an eight-year window.
67
Table 9
Matching diagnostic and post-matching differences. This table reports the matching
diagnostic and post-matching differences. We use the one-to-one nearest-neighbor
propensity score matching, without replacement, on a host of observable firm char-
acteristics to match a control firm for a treatment firm. Following Fang et al. (2014)
and Jiang et al. (2017), we use a six-year window (from year −3 to year +3) around
the reform to perform the matching. Panel A reports the parameter estimates that
we generate from a probit model for treatment group firms and control group firms
before and after the matching. Column (1) reports the pre-matching results, and col-
umn (2) reports the post-matching results. Panel B reports the univariate compar-
isons of firm characteristics between the treatment and control groups after match-
ing. The control variables for matching are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Defi-
nitions of variables are provided in Table A.1. All regressions are specified with
year- and Industry-fixed effects. Standard errors are clustered by firm. t -statistics
are reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and
10% level, respectively.
Panel A: Matching diagnostic
(1) (2)
Pre-match Post-match
Intercept 7.9800*** −1.0133
(1.04) (1.04)
Size (−3 to −1) −1.0221*** 0.1112
(0.13) (0.22)
ROA (−3 to −1) 0.1333 −0.6762
(1.60) (2.23)
Q (−3 to −1) −0.4281*** −0.0830
(0.11) (0.17)
FCF (−3 to −1) 4.3800*** −1.3751
(1.020) (1.42)
Lev (−3 to −1) 0.3321 0.1301
(0.41) (0.54)
Industry FE Yes Yes
Year FE Yes Yes
N 420 396
Pseudo R2 0.3233 0.0230
Panel B: Post-matching differences

Treatment Control Difference t -statistics
Size (−3 to −1) 7.2652 7.1603 −0.1049 0.95
ROA (−3 to −1) 0.0129 0.0186 0.0058 0.58
Q (−3 to −1) 1.7208 1.8598 0.1390 1.01
FCF (−3 to −1) 0.0050 0.0105 0.0055 0.42
Lev (−3 to −1) 0.5225 0.5142 −0.0082 0.23
observation in the treatment and control groups. The dependent variable in the probit model is a dummy variable that equals one
if the observation comes from the treatment group, and zero otherwise. The independent variables are the arithmetic mean of all
control variables (𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 ) in our baseline model over the three-year window before the reform. We also include
firm- and year-fixed effects in the probit model.
Table 9 reports matching diagnostics and post-matching differences. Panel A shows the pre-matching probit regression results in
column (1) and post-matching results in column (2). Pseudo-𝑅2 in column (1) indicates that the independent variables in the model
interpret 32.3% of the dependent variable. The results also suggest that 𝑆𝑖𝑧𝑒, 𝑄, and 𝐹 𝐶𝐹 have significant effects on the dependent
variable. Thus, there is a significant difference between the treatment and the control group, which does not meet the parallel
trend assumption for our difference-in-differences analysis. To eliminate this difference, we match each firm–year observation in the
treatment group with a firm–year observation in the control group using propensity scores estimated from the nearest-neighborhood
matching algorithm. In so doing, we obtain 79 pairs of firms.
We then conduct a series of tests to ensure that firms in the treatment group and the control group share similar matching
characteristics before the reform. First, after matching, we re-run the probit model using the new matched sample, and we report
our estimation results in column (2) of panel A. The coefficients on all the explanatory variables, 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 , are
statistically insignificant, suggesting that there is no significant difference between the treatment group and the control group after
we complete the matching procedure. Moreover, the magnitudes of the coefficients on all the explanatory variables in column (2) are
much smaller than those in column (1). In addition, the Pseudo-𝑅2 slumps from 32.3% in pre-matching to 2.3% in post-matching,
suggesting that those explanatory variables lost a great amount of explanatory power. Second, we conduct the mean-difference
comparison test for all the explanatory variables, 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 , between the treatment group and the control group
after we complete the matching procedure. As we show in panel B of Table 9, after matching, there is no significant difference in
various firm’s characteristics between the treatment group and the control group.
68
Table 10
Difference-in-differences regression analysis with a matched sample. This table reports the results of the difference-in-differences analysis with a matched sample.
Following Fang et al. (2014) and Jiang et al. (2017), we use a six-year window (from year −3 to year +3) around the reform to perform our analysis. The key explanatory
variable is 𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟, a dummy variable that equals one for the treatment group in the post-reform period, and zero otherwise. 𝑇 𝑟𝑒𝑎𝑡 equals one if the firm belongs
to the treatment group and zero for firms in the control group. 𝐴𝑓 𝑡𝑒𝑟 equals one if it is at least one year after the firm has completed the reform, and zero otherwise.
provided in Table A.1. Columns (1) and (2) report univariate regression results. Columns (3) and (4) report results when we include firm-level control variables in our
tests. All regressions are specified with year- and firm-fixed effects. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate
significance at the 1%, 5%, and 10% level, respectively.
Variables (1) (2) (3) (4)
N EI N EI
Intercept 2.6149*** 0.4774*** 0.7378 0.2436
(16.54) (10.96) (1.12) (1.49)
TreatAfter −0.4371*** −0.0828** −0.4906*** −0.0965***
(3.15) (2.45) (3.72) (2.94)
Size 0.2645*** 0.0362*
(3.05) (1.68)
ROA 0.1722 0.1716
(0.35) (1.41)
Q −0.0055 −0.0005
(0.18) (0.07)
Lev 0.1504 −0.0381
(0.64) (0.65)
FCF 0.3029 0.1080*
(1.25) (1.79)
Year FE Yes Yes Yes Yes
Firm FE Yes Yes Yes Yes
Observations 1243 1243 1243 1243
Next, we estimate the effect of the reform on diversification using the new PSM sample with the following model:
𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛼 + 𝛽𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟𝑖,𝑡 + 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖 + 𝛿𝑡 + 𝜖𝑖,𝑡 , (8)
where 𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 is the diversification level measured by 𝑁 and 𝐸𝐼 for firm 𝑖 in year 𝑡 + 1. 𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟𝑖,𝑡 is our key variable
of interest, an interaction term that is multiplied by 𝑇 𝑟𝑒𝑎𝑡𝑖,𝑡 and 𝐴𝑓 𝑡𝑒𝑟𝑖,𝑡 . It captures the treatment effect by liquidity on corporate
diversification. 𝑇 𝑟𝑒𝑎𝑡𝑖,𝑡 equals one if firm 𝑖 belongs to the treatment group and zero for firms in the control group. 𝐴𝑓 𝑡𝑒𝑟𝑖,𝑡 equals
one if it is at least one year after firm 𝑖 has completed the reform in year 𝑡, and zero otherwise. 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 are control variables that
include 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . 𝜃𝑖 and 𝛿𝑡 indicate firm- and year-fixed effects, respectively.
Table 10 reports our estimation results. As shown in columns (1) and (2), for univariate regressions, the coefficients on our variable
of interest, 𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟, are −0.4371 (𝑡 = 3.15) and −0.0828 (𝑡 = 2.45), and they are statistically significant at the 1% and 5% level,
respectively. The negative signs indicate that the adverse effects of liquidity on diversification is more prominent in the treatment
group after the reform. The results regarding 𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟 become even stronger, in terms of both the magnitude of the coefficients
and statistical significance, after we include control variables in columns (3) and (4). Overall, our difference-in-differences analysis
with a matched sample suggest that firms in the treatment group tend to adopt significantly less diversified strategies after the reform
when compared to comparable firms in the control group.
It is still likely that other strategic motivations (for example, product market strategy) of diversification than the ones related to
liquidity have also changed during the reform and drive part of our results. To ensure that the DID regression with a matched sample
really captures the isolated effect of liquidity on diversification, we follow Jiang et al. (2017) to further examine the changes in firms’
fundamental characteristics such as firm size, profitability, growth opportunity, leverage and cash holdings in our DID framework.
These characteristics are the foundations based on which many firm strategic decisions are made. The results are reported in Table A.9
and confirm that the treated and the control firms do not differ significantly in changes in these control variables, suggesting that the
documented changes in diversification are not driven by the effects of the reform on other strategic considerations based on these
firm characteristics.
Overall, these findings are consistent with the panel difference-in-differences analysis that we conducted with the original sample,
and provides us with more solid evidence on the causal effect of stock liquidity on corporate diversification.
6. Mechanism tests
Our results thus far confirm a negative relation between stock liquidity and corporate diversification; to confirm this relation,
we provide consistent, strong results from baseline regressions, from a difference-in-differences analysis that employs a quasi-natural
experiment (i.e., China’s split share structure reform), and from a series of robustness tests, including a PSM difference-in-differences
analysis. However, we have not provided any evidence on how liquidity changes could affect firms’ diversification strategies.
Therefore, in this section, we use a difference-in-difference-in-differences (DDD) model to investigate potential mechanisms for the
effects we identified. Specifically, we focus on two channels: the financial constraints channel and the corporate governance channel.
69
Table 11
Mechanism tests: the financial constraint channel. This table investigates the impact of financial constraint on the effect of stock liquidity on corporate diversification.
We use three variables to measure financial constraint in the pre-reform period: market capitalization (𝑀𝑘𝑡𝐶𝑎𝑝), the payout ratio (𝑃 𝑎𝑦𝑜𝑢𝑡), and the interest coverage
ratio (𝐼𝑛𝑡𝐶𝑜𝑣). We define a dummy variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, that equals one if it is at least one year after the firm completes the reform, and zero otherwise. The
variables of interest are the interaction terms of 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 and financial constraint proxies: 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝑀𝑘𝑡𝑐𝑎𝑝, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝑃 𝑎𝑦𝑜𝑢𝑡, and 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝐼𝑛𝑡𝑐𝑜𝑣.
provided in Table A.1. Columns (1) and (2) report results when we use 𝑀𝑘𝑡𝐶𝑎𝑝 to measure financial constraint. Columns (3) and (4) report results when we use 𝑃 𝑎𝑦𝑜𝑢𝑡
to measure financial constraint. Columns (5) and (6) report results when we use 𝐼𝑛𝑡𝐶𝑜𝑣 to measure financial constraint. Firm-level control variables are included in
all tests. All regressions are specified with year- and firm-fixed effects. The sample period is from 2001 to 2015. Standard errors are clustered by firm. t -statistics are
reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables MktCap Payout IntCov
(1) (2) (3) (4) (5) (6)
N EI N EI N EI
Intercept 0.8119*** 0.2506*** 0.8725*** 0.2620*** 0.7105*** 0.2252***
(3.43) (4.38) (3.64) (4.52) (2.95) (3.85)
AfterReform −1.2780*** −0.3258*** −0.3976*** −0.0759*** −0.2275** −0.0409*
(4.87) (5.14) (4.03) (3.18) (2.49) (1.84)
AfterReform_Mktcap 0.1348*** 0.0377***
(4.07) (4.71)
Mktcap 0.0155 0.0020
(0.45) (0.24)
AfterReform_Payout 0.3929*** 0.0973***
(3.00) (3.08)
Payout −0.0244 −0.0034
(0.18) (0.10)
AfterReform_Intcov 0.0030*** 0.0009***
(2.83) (3.43)
Intcov 0.0000 0.0000
(0.45) (0.47)
Size 0.2363*** 0.0309*** 0.2454*** 0.0316*** 0.2656*** 0.0368***
(5.66) (3.06) (8.22) (4.37) (8.60) (4.91)
ROA −0.8735*** −0.1743*** −0.9629*** −0.1996*** −0.8425*** −0.1939***
(3.33) (2.75) (3.66) (3.14) (3.10) (2.94)
Q −0.0094 −0.0017 −0.0088 −0.0022 −0.0043 −0.0005
(0.55) (0.41) (0.64) (0.66) (0.31) (0.16)
Lev 0.7078*** 0.1557*** 0.6577*** 0.1462*** 0.7615*** 0.1616***
(5.67) (5.16) (5.49) (5.05) (6.20) (5.42)
FCF 0.0664 0.0090 0.0358 0.0008 0.0809 0.0091
(0.62) (0.35) (0.34) (0.03) (0.74) (0.34)
Firm FE Yes Yes Yes Yes Yes Yes
Observations 11,958 11,958 11,958 11,958 11,211 11,211
6.1. Financial constraint channel
According to the internal capital market theory, one of the motivations for firms to diversify is to leverage the advantages of
the internal capital market. If external financing channels such as stock markets and financial intermediaries are flawed, firms may
attempt to build their own internal capital markets through diversification strategies to fulfill funding needs (Fluck and Lynch, 1999).
However, once external capital market conditions improve, the motivations for a firm to build an internal capital market will
fade away (Subrahmanyam and Titman, 1999). Increased stock liquidity not only lowers a firm’s cost of equity and raises asset prices
(Amihud and Mendelson, 1986; Amihud et al., 2006), but also attracts more informed investors to trade on their private information so
that more firm information is revealed by stock prices (Subrahmanyam and Titman, 2001; Khanna and Sonti, 2004). These benefits
contribute to improved external financing conditions that mitigate firms’ financial constraints and, as a result, firms will refocus
instead of becoming more diversified (Bhide, 1990; Berger and Ofek, 1995). Therefore, we predict that the negative effect of stock
liquidity on corporate diversification will be more pronounced among financially-constrained firms.
We use three different variables to gauge the level of a firm’s financial constraint in the pre-reform period: firm size in terms of
market capitalization (𝑀𝑘𝑡𝐶𝑎𝑝), payout ratio (𝑃 𝑎𝑦𝑜𝑢𝑡), and interest coverage ratio (𝐼𝑛𝑡𝐶𝑜𝑣). Although these variables are standard
measures for financial constraints in the literature (Fazzari et al., 1988; Gertler and Gilchrist, 1994; Guariglia, 1999; Almeida et al.,
2004), they measure financial constraints from different perspectives. Specifically, it has long been documented that, small firms are
less likely to get external financing compared to large firms (Fazzari et al., 1988; Almeida et al., 2004). Also, the more financially
constrained, the less likely firms are going to pay cash dividends (Almeida et al., 2004). Finally, the interest coverage ratio, defined
as the EBIT over interest expenses of the year, reflects a firm’s ability to pay debt and obtain debt financing (Gertler and Gilchrist,
1994; Guariglia, 1999). The higher the ratio, the less financially constrained a firm is.
70
Table 12
Mechanism tests: information asymmetry. This table investigates the impact of information asymmetry on the effect of stock liquidity on corporate diversification.
We use three variables to measure information asymmetry in the pre-reform period: 𝐵𝑖𝑔4 (whether a firm is audited by a Big 4 auditor firm), 𝐴𝑛𝑎𝑙𝑦𝑠𝑡 (the number of
analysts following the firm), and 𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ (the number of research reports covering the firm). We define a dummy variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, that equals one if it is at
least one year after the firm completes the reform, and zero otherwise. The variables of interest are the interaction terms of 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 and information asymmetry
proxies: 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝐵𝑖𝑔4, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝐴𝑛𝑎𝑙𝑦𝑠𝑡, and 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ. The dependent variables are two measures of corporate diversification, 𝐸𝐼 and 𝑁. The
control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are provided in Table A.1. Columns (1) and (2) report results when we use 𝐵𝑖𝑔4 to measure
information asymmetry. Columns (3) and (4) report results when we use 𝐴𝑛𝑎𝑙𝑦𝑠𝑡 to measure information asymmetry. Columns (5) and (6) report results when we use
𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ to measure information asymmetry. Firm-level control variables are included in all tests. All regressions are specified with year- and firm-fixed effects. The
sample period is from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%,
and 10% level, respectively.
Variables Big4 Analyst Research
(1) (2) (3) (4) (5) (6)
N EI N EI N EI
Intercept 0.7903*** 0.2469*** 0.9071*** 0.2858*** 0.9307*** 0.2928***
(3.50) (4.52) (3.67) (4.79) (3.76) (4.89)
AfterReform −0.3111*** −0.0568*** −0.3190*** −0.0658*** −0.3236*** −0.0667***
(3.57) (2.71) (3.57) (3.05) (3.62) (3.09)
AfterReform_Big4 0.4204*** 0.0674**
(3.44) (2.29)
Big4 −0.1573 −0.0032
(1.33) (0.11)
AfterReform_Analyst 0.1028** 0.0330***
(2.44) (3.25)
Analyst −0.0774* −0.0253**
(1.79) (2.41)
AfterReform_Research 0.0984*** 0.0307***
(2.61) (3.37)
Research −0.0738* −0.0231**
(1.89) (2.46)
Size 0.2523*** 0.0327*** 0.2363*** 0.0275*** 0.2331*** 0.0266***
(8.70) (4.67) (7.38) (3.56) (7.26) (3.43)
ROA −0.8736*** −0.1770*** −0.8654*** −0.1717*** −0.8676*** −0.1730***
(3.45) (2.89) (3.39) (2.78) (3.40) (2.81)
Q −0.0048 −0.0018 −0.0083 −0.0028 −0.0089 −0.0029
(0.36) (0.57) (0.62) (0.84) (0.66) (0.90)
Lev 0.7092*** 0.1626*** 0.7223*** 0.1650*** 0.7246*** 0.1658***
(6.16) (5.84) (6.25) (5.91) (6.27) (5.94)
FCF 0.0015 −0.0049 −0.0127 −0.0092 −0.0121 −0.0089
(0.01) (0.20) (0.12) (0.37) (0.12) (0.36)
Observations 12,925 12,925 12,925 12,925 12,925 12,925
We modify our difference-in-differences model into a DDD model by including an interaction term of the financial constraint
measure and the 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 dummy. The specification of the model is as follows:
𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 =𝛼 + 𝛽𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 + 𝜁 𝑍𝑖,𝑡 + 𝜆𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 ∗ 𝑍𝑖,𝑡
(9)
+ 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖 + 𝛿𝑡 + 𝜖𝑖,𝑡 ,
where 𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 is the diversification level measured by 𝑁 and 𝐸𝐼 for firm 𝑖 in year 𝑡 + 1. 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 equals one if it
is at least one year after firm 𝑖 has completed the reform in year 𝑡. 𝑍𝑖,𝑡 refers to the series of financial constraint measures, 𝑀𝑘𝑡𝐶𝑎𝑝,
𝑃 𝑎𝑦𝑜𝑢𝑡, and 𝐼𝑛𝑡𝐶𝑜𝑣, for firm 𝑖 before the reform. The interaction term, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 ∗ 𝑍𝑖,𝑡 , is the key variable that shows whether
the effect of the reform on corporate diversification is through the financial constraints channel. The remaining variables are the
same as those in our prior tests. 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 are control variables that include 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . 𝜃𝑖 and 𝛿𝑡 indicate firm-
and year-fixed effects, respectively.
Columns (1) and (2) in Table 11 show the results when we use market capitalization (𝑀𝑘𝑡𝐶𝑎𝑝) to measure financial constraints.
Columns (3) and (4) report the results when we use the payout ratio (𝑃 𝑎𝑦𝑜𝑢𝑡), and the results when we use interest coverage ratio
(𝐼𝑛𝑡𝐶𝑜𝑣) are included in columns (5) and (6). As higher values of these measures indicate lower financial constraints status, the
significantly positive coefficients on the interaction terms in all columns are consistent with our expectation that the liquidity effects
on diversification are more pronounced among financially-constrained firms. Specifically, in columns (1)and (2), the coefficients on
𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝑀𝑘𝑡𝐶𝑎𝑝 are 0.1348 (𝑡 = 4.07) and 0.0377 (𝑡 = 4.71), respectively, and both of them are statistically significant at the
1% level, suggesting that the negative effect of the reform on corporate diversification is stronger in smaller firms, which are usually
more financially constrained. In columns (3) and (4), the coefficients on 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝑃 𝑎𝑦𝑜𝑢𝑡 are 0.3929 (𝑡 = 3.00) and 0.0973 (𝑡
= 3.08), respectively, and both of them are significant at the 1% level, implying that the negative effect of the reform on corporate
diversification is stronger among firms that pay less cash dividends. In columns (5) and (6), the coefficients on 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝐼𝑛𝑡𝐶𝑜𝑣
71
Table 13
Mechanism tests: blockholder intervention. This table investigates the impact of blockholder intervention on the effect of stock liquidity on corporate diversification.
We use three variables to measure non-controlling blockholders’ ownership (the largest shareholder is excluded) in the pre-reform period: 𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 (whether a
firm has a secondary blockholder who hold more than 10% of total shares), 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 (the number of non-controlling blockholders who own more than 10%
of total shares), and 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 (the total shares of non-controlling blockholders who own more than 10% of total shares). We define a dummy variable,
𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, that equals one if it is at least one year after the firm completes the reform, and zero otherwise. The variables of interest are the interaction terms of
𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 and blockholders’ ownership proxies: 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠, and 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚_𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠. The
dependent variables are two measures of corporate diversification, 𝐸𝐼 and 𝑁. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are
provided in Table A.1. Columns (1) and (2) report results when we use 𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 to measure blockholders’ ownership. Columns (3) and (4) report results when
we use 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 to measure blockholders’ ownership. Columns (5) and (6) report results when we use 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 to measure blockholders’
ownership. Firm-level control variables are included in all tests. All regressions are specified with year- and firm-fixed effects. The sample period is from 2001 to 2015.
Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables NcBlockholder N_NcBlockholder Share_NcBlockholder
(1) (2) (3) (4) (5) (6)
N EI N EI N EI
Intercept 0.7426** 0.2378*** 0.6747** 0.2135*** 0.7687*** 0.2419***
(2.57) (3.40) (2.31) (2.99) (2.66) (3.46)
AfterReform −0.2521** −0.0487** −0.2582** −0.0536* −0.2757*** −0.0505**
(2.41) (2.03) (2.04) (1.81) (2.64) (2.12)
AfterReform_NcBlockholder 0.0064 0.0136
(0.09) (0.78)
NcBlockholder 0.0787 0.0234
(1.20) (1.45)
AfterReform_N_NcBlockholder 0.0098 0.0085
(0.19) (0.68)
N_NcBlockholder 0.0765* 0.0258**
(1.69) (2.30)
AfterReform_Share_NcBlockholder 0.0039 0.0012
(1.25) (1.60)
Share_NcBlockholder 0.0030 0.0012*
(1.11) (1.87)
Size 0.2546*** 0.0327*** 0.2525*** 0.0321*** 0.2512*** 0.0320***
(6.95) (3.73) (6.88) (3.66) (6.85) (3.64)
ROA −0.8956*** −0.1822*** −0.9059*** −0.1859*** −0.9074*** −0.1862***
(2.99) (2.46) (3.03) (2.51) (3.03) (2.52)
Q −0.0044 −0.0016 −0.0043 −0.0015 −0.0046 −0.0019
(0.28) (0.40) (0.28) (0.38) (0.30) (0.41)
Lev 0.7102*** 0.1624*** 0.7093*** 0.1617*** 0.7133*** 0.1622***
(5.32) (4.86) (5.31) (4.83) (5.34) (4.85)
FCF 0.0015 −0.0049 −0.0127 −0.0092 −0.0121 −0.0089
(0.01) (0.20) (0.12) (0.37) (0.12) (0.36)
Observations 12,924 12,924 12,924 12,924 12,924 12,924
are 0.0030 (𝑡 = 2.83) and 0.0009 (𝑡 = 3.43), respectively, and both of them are significant at the 1% level, indicating that the negative
effect of the reform on corporate diversification is stronger among firms that are less able to pay their debt. Taken together, our results
are consistent with our hypothesis that increased liquidity helps financially-constrained firms obtain more external financing; as a
result, these firms tend to refocus by reducing their levels of diversification.8
6.2. Corporate governance channel
According to the agency theory, seeking private benefits is another essential motivation for managers to pursue diversification
strategy. For example, diversification may help reduce the risk of managers’ undiversified investment portfolios (Amihud and Lev,
1981; May, 1995), or bring managers more bargaining power when negotiating a compensation contract since they can manage a
larger and more spread-out firm (Jensen, 1986); further, once a firm becomes more diversified, such firms are challenged to find a
new manager with similar expertise to replace the current one, leading to a more severe agency problem (Shleifer and Vishny, 1989).
Meanwhile, a large body of research has argued that liquidity can enhance corporate governance and mitigate agency problems.
Higher stock liquidity improves the information quality in stock prices, thereby enabling better market monitoring and more efficient
compensation contract design for managers. Apart from that, higher stock liquidity facilitates blockholder control and non-controlling
8 We also compare firm’s external financing activities before and after the reform by looking at firm’s engagement in seasoned equity offerings (SEOs). Specifically,
we create two variables: 𝑆𝐸𝑂, which is a dummy variable that equals one if a firm engages in SEOs at year t, and zero otherwise; 𝑆𝐸𝑂𝑠ℎ𝑎𝑟𝑒, which is defined as the
number of total SEO shares issued by a firm scaled by the number of outstanding shares at year t. Then we compute the difference of the mean of these two variables
before and after the reform. The t -test results reported in A.7 in the Appendix show that the mean values of these two variables are statistically significantly higher
after the reform.
72
Table A.1
Variable definition.
Variables Definition
∑𝑛
EI The entropy index. 𝐸𝐼 = 𝑖=0
𝑃𝑖 𝑙𝑛( 𝑃1 ), where 𝑃𝑖 is calculated as the
𝑖
percentage of revenue from segment 𝑖 in total revenue.
N Number of segments that generate revenue at the end of a fiscal year.
LIQ Liquidity ratio. 𝐿𝐼𝑄 = −1 × 𝑙𝑛(1 + 𝐴𝑚𝑖ℎ𝑢𝑑𝑖,𝑡 ), where
1 ∑𝐷𝑖,𝑡 |𝑅𝑒𝑡𝑖,𝑑,𝑡 |
𝐴𝑚𝑖ℎ𝑢𝑑𝑖,𝑡 = 𝐷
× 𝑑=1 𝑉 𝑜𝑙
(Amihud, 2002), 𝐷𝑖,𝑡 is the number of trading
𝑖,𝑡 𝑖,𝑑,𝑡
days for firm 𝑖 in year 𝑡. 𝑅𝑒𝑡𝑖,𝑑,𝑡 is the stock return enlarged by 100 on day 𝑑
for firm 𝑖 in year 𝑡. 𝑉 𝑜𝑙𝑖,𝑑,𝑡 is the trading volume in million RMB on day 𝑑 for
firm 𝑖 in year 𝑡.
∑𝐷𝑖,𝑡 𝑉 𝑜𝑙𝑖,𝑑,𝑡
Turnover Turnover rate. 𝑇 𝑜𝑢𝑟𝑜𝑣𝑒𝑟 = 𝐷1 × 𝑑=1 𝐿𝑁𝑆
, where 𝐷𝑖,𝑡 is the number of
𝑖,𝑡 𝑖,𝑑,𝑡
trading days for firm 𝑖 in year 𝑡. 𝑉 𝑜𝑙𝑖,𝑑,𝑡 is the number of trading volume for
firm 𝑖 on day 𝑑 in year 𝑡. 𝐿𝑁𝑆𝑖,𝑑,𝑡 is the number of tradable volume for firm
𝑖 on day 𝑑 in year 𝑡.
HL High-Low impact spread estimator (Corwin and Schultz, 2012).
𝛼𝑖,𝑡
𝐻𝐿 = −𝑆 = 2(𝑒1+𝑒𝛼−1) , where
𝑖,𝑡
{ [ ]2 } [ ]2
√ √
2𝛽𝑖,𝑡 − 𝛽𝑖,𝑡
√ 𝛾 ∑1 𝐻𝑜 𝐻𝑜
𝛼𝑖,𝑡 = √ − 𝑖,𝑡
√ , 𝛽𝑖,𝑡 = 𝐸
𝑗=0
𝑙𝑛( 𝐿𝑜𝑖𝑡,𝑑+𝑗 ) , 𝛾𝑖,𝑡 = 𝑙𝑛( 𝐿𝑜𝑖𝑡,𝑑,𝑑+1 ) .
3−2 2 2−2 2 𝑖𝑡,𝑑+𝑗 𝑖𝑡,𝑑,𝑑+1
𝐻𝑖𝑡,𝑑 (𝐿𝑖𝑡,𝑑 ) is the highest (lowest) price of day 𝑑 in year 𝑡 for firm 𝑖.
Size Firm size. The natural logarithm of the book value of total assets at the end
of a fiscal year.
FCF Free cash flow ratio. The ratio of free cash flow to the book value of total
assets at the end of a fiscal year. Free cash flow is calculated as the earnings
before interest and tax (EBIT) after taxes, plus amortization and
depreciation, minus changes in net working capital, and minus the capital
expenditure.
Q Growth opportunity. It is defined as Tobin’s 𝑄 scaled by the book value of
total assets at the end of a fiscal year.
ROA Profitability. It is defined as the ratio of net income to the book value of
Lev Leverage ratio. It is defined as the ratio of total debt to the book value of
MktCap Market capitalization. It equals the logarithm of market shares multiplied by
the closing stock price on the final trading day of a year.
Payout Payout ratio. It equals firms’ dividend payout amounts scaled by total
revenue of a year.
IntCov Interest coverage ratio. It equals the EBIT scaled by interest expenses of a
year.
Big4 A dummy variable that equals 1 if a firm is audited by one of the Big 4
auditor firms, and zero otherwise.
Analyst Number of analysts following a firm. It equals a natural logarithm of 1 plus
the number of analysts following the firm at the end of a fiscal year.
Research Number of research reports covering the firm. It equals a natural logarithm
of 1 plus the number of research reports issued from security companies
covering the firm at the end of a fiscal year.
NcBlockholder A dummy variable that equals 1 if a firm has a secondary largest
blockholder who owns more than 10% of total shares at the end of a fiscal
year, and zero otherwise.
N_NcBlockholder The number of non-controlling blockholders (shareholders except the largest
shareholder) who own more than 10% of total shares at the end of a fiscal
year.
Share_NcBlockholder The total number of shares of non-controlling blockholders (shareholders
except the largest shareholder) who own more than 10% of total shares at
the end of a fiscal year.
blockholders’ threats to exit, both of which have been shown to be effective corporate governance mechanisms. Therefore, in addition
to the financial constraint channel that we discussed in the previous section, higher liquidity may also deter managers’ opportunistic
diversification decisions through the corporate governance channel. In this section, we perform two separate tests to examine whether
this conjecture is true, and to explore the exact mechanism through which the proposed corporate governance channel works.
73
Table A.2
Panel regression analysis with additional controls and industry-by-year-fixed effects. This table reports baseline results of regressions of stock liquidity on corporate
diversification. The dependent variables are two measures of corporate diversification, 𝐸𝐼 and 𝑁. The independent variable is stock liquidity, 𝐿𝐼𝑄. The control
variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Additional control variables are 𝑃 𝑎𝑡𝑒𝑛𝑡, 𝑃 𝑎𝑡𝑒𝑛𝑡_𝑞𝑢𝑎𝑙𝑖𝑡𝑦, 𝐶𝑎𝑠ℎ_ℎ𝑜𝑙𝑑𝑖𝑛𝑔, and 𝑅𝑖𝑠𝑘_𝑠ℎ𝑎𝑟𝑖𝑛𝑔. 𝑃 𝑎𝑡𝑒𝑛𝑡 is measured as the natural
logarithm of one plus the total number of patents applied in year t, including invention patents, design patents, and utility patents. 𝑃 𝑎𝑡𝑒𝑛𝑡_𝑞𝑢𝑎𝑙𝑖𝑡𝑦 is measured as the
ratio of the number of invention patents over the total number of patents. 𝐶𝑎𝑠ℎ_ℎ𝑜𝑙𝑑𝑖𝑛𝑔 refers to firm’s cash holding scaled by total assets. 𝑅𝑖𝑠𝑘_𝑠ℎ𝑎𝑟𝑖𝑛𝑔, our proxy for
risk sharing, is defined as firm’s idiosyncratic volatility which is computed as the standard deviation of the residual from the market model regression of firm’s daily
stock returns on market returns. Following Li et al. (2011), we use daily stock returns over the period from 260 to 60 trading days prior to the first announcement of the
reform. For firms with less than one year of the trading data, we use the return data from the first trading day after the IPO to 60 trading days prior to the announcement
of the reform. Definitions of variables are provided in Table A.1. Columns (1) and (2) report univariate regression results. Columns (3) and (4) report results when we
include additional control variables in our tests. All regressions are specified with industry-by-year- and firm-fixed effects. The sample consists of 12,925 observations
with 1172 unique public firms over the period from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate
significance at the 1%, 5%, and 10% level, respectively.
Variables (1) (2) (3) (4)
N EI N EI
Intercept −0.0283 0.0104 −0.1153 0.0032
(0.09) (0.13) (0.32) (0.04)
LIQ −0.3417** −0.0811*** −0.3372** −0.0832***
(2.55) (2.58) (2.51) (2.64)
Size 0.2989*** 0.0439*** 0.3003*** 0.0439***
(7.85) (4.82) (7.82) (4.80)
ROA −0.9090*** −0.1493** −0.8920*** −0.1602**
(2.93) (1.96) (2.87) (2.10)
Q 0.0109 0.0015 0.0115 0.0013
(0.67) (0.36) (0.70) (0.31)
Lev 0.6909*** 0.1665*** 0.6762*** 0.1718***
(5.00) (4.90) (4.84) (5.00)
FCF 0.0053 −0.0034 −0.0068 0.0045
(0.05) (0.12) (0.06) (0.16)
Patent −0.0052 0.0017
(0.22) (0.32)
Patent_quality 0.0036 −0.0026
(0.12) (0.36)
Cash_holding −0.0857 0.0466
(0.50) (1.09)
Risk_sharing 4.3004 −0.0796
(0.79) (0.06)
Industry-by-Year FE Yes Yes Yes Yes
Observations 12,925 12,925 12,925 12,925
6.2.1. Information asymmetry

The literature has established that, in addition to financing provision, stock markets also play an important role in monitoring
managerial performance (Holmström and Tirole, 1993). More precisely, high liquidity increases stock price informativeness and
hence facilities market monitoring on managers’ performance. Moreover, highly informative stock prices help shareholders design
more efficient incentive compensation to alleviate agency problems. Firms with higher levels of information asymmetry are usually
associated with more agency problems; thus, the positive effect of liquidity on corporate governance should be more significant among
this type of firms. Enhanced corporate governance, in turn, leads to less opportunistic diversification decisions by firms’ managers.
Therefore, we expect that the negative effect of stock liquidity on corporate diversification is more pronounced among firms with
more severe information asymmetry.
To test this hypothesis, we follow the literature and use three widely adopted measures to proxy for information asymmetry. First,
we use a dummy variable, 𝐵𝑖𝑔4, which equals one if a firm is audited by a Big 4 auditor firm in the pre-reform period, as prior
research has established that such firms tend to have lower information asymmetry between insiders and outsiders (see, e.g., Francis
and Wang, 2008; Francis and Yu, 2009). Second, since higher analyst coverage makes the information of a firm more transparent to
outsiders, we use the number of analysts following a firm (𝐴𝑛𝑎𝑙𝑦𝑠𝑡) and the number of research reports covering a firm (𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ) to
proxy for analyst coverage (Yu, 2008; Derrien and Kecskés, 2013). 𝐴𝑛𝑎𝑙𝑦𝑠𝑡 (𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ) is calculated as the pre-reform-period average
of the logarithm of one plus the number of analysts (research reports) following a firm at the end of a fiscal year. The higher the
value of these three measures, the less information asymmetry the firm has.
To test this information improvement mechanism of liquidity on diversification, we include an interaction term of the information
asymmetry measure (𝐵𝑖𝑔4, 𝐴𝑛𝑎𝑙𝑦𝑠𝑡, and 𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ) and the 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 dummy in our DDD model as we show in Eq. (9).
Columns (1) and (2) in Table 12 report our estimation results when we use 𝐵𝑖𝑔4 to measure information asymmetry. Columns (3)
and (4) show the results when we use 𝐴𝑛𝑎𝑙𝑦𝑠𝑡, and the results when we use 𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ are shown in columns (5) and (6). Specifically, in
columns (1) and (2), the coefficients on 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝐵𝑖𝑔4 are 0.4204 (𝑡 = 3.44) and 0.0674 (𝑡 = 2.29), respectively, and both results
are statistically significant. The positive sign on the interaction term implies that for firms with higher information transparency, the
74
Table A.3
Panel DID regression analysis with additional controls and industry-by-year-fixed effects. This table reports the difference-in-differences regression results. Following
Chen et al. (2012), we use the staggered feature of China’s split share structure reform to perform a difference-in-differences regression analysis. In our sample, firms
completed the reform in different years. To capture the treatment effect of the reform on corporate diversification, we define a dummy variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, which
equals one if it is at least one year after the firm completes the reform because the reform requires that the shares have to be locked up for one year after the completion
of the reform, and zero otherwise. The dependent variables are two measures of corporate diversification, 𝐸𝐼 and 𝑁. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣,
and 𝐹 𝐶𝐹 . Additional control variables are 𝑃 𝑎𝑡𝑒𝑛𝑡, 𝑃 𝑎𝑡𝑒𝑛𝑡_𝑞𝑢𝑎𝑙𝑖𝑡𝑦, 𝐶𝑎𝑠ℎ_ℎ𝑜𝑙𝑑𝑖𝑛𝑔, and 𝑅𝑖𝑠𝑘_𝑠ℎ𝑎𝑟𝑖𝑛𝑔. 𝑃 𝑎𝑡𝑒𝑛𝑡 is measured as the natural logarithm of one plus the total
number of patents applied in year t, including invention patents, design patents, and utility patents. 𝑃 𝑎𝑡𝑒𝑛𝑡_𝑞𝑢𝑎𝑙𝑖𝑡𝑦 is measured as the ratio of the number of invention
patents over the total number of patents. 𝐶𝑎𝑠ℎ_ℎ𝑜𝑙𝑑𝑖𝑛𝑔 refers to firm’s cash holding scaled by total assets. 𝑅𝑖𝑠𝑘_𝑠ℎ𝑎𝑟𝑖𝑛𝑔, our proxy for risk sharing, is defined as firm’s
idiosyncratic volatility which is computed as the standard deviation of the residual from the market model regression of firm’s daily stock returns on market returns.
Following Li et al. (2011), we use daily stock returns over the period from 260 to 60 trading days prior to the first announcement of the reform. For firms with less than
one year of the trading data, we use the return data from the first trading day after the IPO to 60 trading days prior to the announcement of the reform. Definitions of
variables are provided in Table A.1. Columns (1) and (2) report univariate regression results. Columns (3) and (4) report results when we include additional control
variables in our tests. All regressions are specified with industry-by-year- and firm-fixed effects. The sample consists of 12,925 observations with 1172 unique public
firms over the period from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%,
Variables (1) (2) (3) (4)
N EI N EI
Intercept 0.3429 0.0842 0.2481 0.0751
(1.22) (1.23) (0.85) (1.07)
AfterReform −0.2517*** −0.0457** −0.2666*** −0.0467**
(2.84) (2.14) (2.99) (2.17)
Size 0.2860*** 0.0409*** 0.2872*** 0.0408***
(9.47) (5.61) (9.44) (5.55)
ROA −0.9230*** −0.1544** −0.9000*** −0.1644**
(3.50) (2.43) (3.38) (2.56)
Q 0.0048 0.0001 0.0056 −0.0001
(0.34) (0.02) (0.40) (−0.04)
Lev 0.7220*** 0.1738*** 0.7035*** 0.1785***
(6.05) (6.03) (5.83) (6.12)
FCF 0.0255 0.0012 0.0114 0.0085
(0.24) (0.05) (0.11) (0.32)
Patent −0.0050 0.0017
(0.21) (0.30)
(0.22) (0.25)
Cash_holding −0.1004 0.0422
(0.64) (1.12)
Risk_sharing 5.4491* 0.1286
(1.69) (0.16)
Observations 12,925 12,925 12,925 12,925
negative liquidity effect on diversification is diminished. As shown in columns (3) through (6), the regression results with two other
measures of information asymmetry are similar and consolidate this conclusion. Overall, our results in Table 12 confirm that the
negative effect of liquidity on corporate diversification is more prominent among firms with higher information asymmetry, which
is consistent with our prediction.
6.2.2. Blockholder intervention

Another strand of literature argues that higher liquidity helps firms improve corporate governance by facilitating both blockholder
control and non-controlling blockholders’ threats to exit (Admati and Pfleiderer, 2009; Edmans, 2009; Edmans and Manso, 2011;
Edmans et al., 2013). If these arguments are true, we should observe stronger negative effect of liquidity on corporate diversification
among firms with higher blockholders’ ownership before the reform.
Following the literature, we construct three measures to gauge blockholders’ ownership. First, we follow Jiang et al. (2017) to
create a dummy variable, 𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, which equals one if a firm has a secondary blockholder holding more than 10% of total
shares in the pre-reform years, and zero otherwise.9 Second, we follow Bharath et al. (2013) to construct the number of blockholders
who own more than 10% of total shares, 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠, and the total shares of blockholders who own more than 10% of total
shares, 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠. We calculate 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 and 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 as the average in pre-reform years, and
we exclude controlling shareholders’ ownership in this calculation. We define these two measures to explore whether liquidity reduces
diversification by reinforcing non-controlling blockholders’ threats to exit. Our three measures are similar in that the higher the value
of the measure, the stronger blockholder monitoring a firm is subject to.
9 Our results are similar if we use 5% or 20% as the blockholders’ ownership benchmark.
75
Table A.4
DID regression analysis with a matched sample with additional controls and industry-by-year-fixed effects. This table reports the results of the difference-in-differences
analysis with a matched sample. Following Fang et al. (2014) and Jiang et al. (2017), we use a six-year window (from year −3 to year +3) around the reform to perform
our analysis. The key explanatory variable is 𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟, a dummy variable that equals one for the treatment group in the post-reform period, and zero otherwise. 𝑇 𝑟𝑒𝑎𝑡
equals one if the firm belongs to the treatment group and zero for firms in the control group. 𝐴𝑓 𝑡𝑒𝑟 equals one if it is at least one year after the firm has completed the
reform, and zero otherwise. The dependent variables are two measures of corporate diversification, 𝐸𝐼 and 𝑁. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 .
Additional control variables are 𝑃 𝑎𝑡𝑒𝑛𝑡, 𝑃 𝑎𝑡𝑒𝑛𝑡_𝑞𝑢𝑎𝑙𝑖𝑡𝑦, 𝐶𝑎𝑠ℎ_ℎ𝑜𝑙𝑑𝑖𝑛𝑔, and 𝑅𝑖𝑠𝑘_𝑠ℎ𝑎𝑟𝑖𝑛𝑔. 𝑃 𝑎𝑡𝑒𝑛𝑡 is measured as the natural logarithm of one plus the total number of
patents applied in year t, including invention patents, design patents, and utility patents. 𝑃 𝑎𝑡𝑒𝑛𝑡_𝑞𝑢𝑎𝑙𝑖𝑡𝑦 is measured as the ratio of the number of invention patents over
the total number of patents. 𝐶𝑎𝑠ℎ_ℎ𝑜𝑙𝑑𝑖𝑛𝑔 refers to firm’s cash holding scaled by total assets. 𝑅𝑖𝑠𝑘_𝑠ℎ𝑎𝑟𝑖𝑛𝑔, our proxy for risk sharing, is defined as firm’s idiosyncratic
volatility which is computed as the standard deviation of the residual from the market model regression of firm’s daily stock returns on market returns. Following Li
et al. (2011), we use daily stock returns over the period from 260 to 60 trading days prior to the first announcement of the reform. For firms with less than one year
of the trading data, we use the return data from the first trading day after the IPO to 60 trading days prior to the announcement of the reform. Definitions of variables
are provided in Table A.1. Columns (1) and (2) report univariate regression results. Columns (3) and (4) report results when we include additional control variables in
our tests. All regressions are specified with industry-by-year- and firm-fixed effects. Standard errors are clustered by firm. t -statistics are reported in parentheses. *** ,
**
, and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables (1) (2) (3) (4)
N EI N EI
Intercept 0.4567 −0.0043 1.1771 0.2529
(0.55) (0.02) (1.18) (1.03)
TreatAfter −0.4275*** −0.0911** −0.3670** −0.0845**
(2.95) (2.54) (2.47) (2.31)
Size 0.3223*** 0.0639*** 0.2974** 0.0388
(3.25) (2.60) (2.37) (1.26)
ROA 0.2888 0.2234* −0.1117 0.1716
(0.54) (1.68) (0.15) (0.94)
Q 0.0155 0.0043 0.0517 0.0146
(0.43) (0.48) (1.22) (1.40)
Lev 0.1484 −0.0177 0.0688 0.1600
(0.56) (0.27) (0.14) (1.33)
FCF 0.4733* 0.1199* 0.1537 0.0029
(1.76) (1.80) (0.49) (0.04)
Patent −0.0567 −0.0155
(0.74) (0.82)
(0.82) (0.06)
Cash_holding −0.8542* −0.1110
(1.71) (0.90)
Risk_sharing −18.3990 −6.4849**
(1.49) (2.13)
Observations 1243 1243 1190 1190
To test whether liquidity reduces diversification by facilitating blockholder control and non-controlling blockholders’ treats
to exit, we include an interaction term of the blockholders’ ownership measure (𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, and 𝑆ℎ𝑎𝑟𝑒_
𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟) and the 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 dummy in our DDD model as we show in Eq. (9).
Columns (1) and (2) in Table 13 report our estimation results when we use 𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 to measure blockholders’ ownership,
columns (3) and (4) show our results when we use 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠, and the estimation results using 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 are
included in columns (5) and (6). Across columns (1) to (6), the coefficients on the interaction terms, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟,
𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝑁_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟, and 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚 ∗ 𝑆ℎ𝑎𝑟𝑒_𝑁𝑐𝐵𝑙𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟 are all statistically insignificant. Our results suggest
that the negative effect of liquidity on corporate diversification is not driven by the blockholder intervention channel. This conclusion
is similar to that of Jiang et al. (2017) who also use Chinese data and find that liquidity does not affect firms’ dividend policy
by facilitating blockholder control. To summarize, our tests in this subsection imply that reducing information asymmetry, rather
than reinforcing blockholder control, serves as the channel through which liquidity disciplines managers’ behavior and discourages
diversification.10
7. Conclusion
In this paper, we examine the effect of stock liquidity on corporate diversification. Using a sample of firms listed in the A-share
market from 2001 to 2015, we address two important research questions. First, we investigate whether stock liquidity has an influence
10 We also examine the effect of the reform on firm’s executive compensation and the results are reported in Table A.8 in the Appendix. Specifically, we define
the dependent variable, 𝐶𝑂𝑀𝑃 , as the natural logarithm of the mean of total top three executives’ compensation for a firm. As shown, the effect is positive and
statistically significant.
76
Table A.5
The effect of the reform on capital expenditure. This table reports the difference-in-differences regression results for the effect of the reform on capital expenditure. Fol-
lowing Chen et al. (2012), we use the staggered feature of China’s split share structure reform to perform a difference-in-differences regression analysis. In our sample,
firms completed the reform in different years. To capture the treatment effect of the reform on corporate diversification, we define a dummy variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚,
which equals one if it is at least one year after the firm completes the reform because the reform requires that the shares have to be locked up for one year after the
completion of the reform, and zero otherwise. The dependent variables is 𝐶𝐴𝑃 𝐸𝑋, which is defined as the natural logarithm of fixed assets. The control variables
are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are provided in Table A.1. Columns (1) and (3) report univariate regression results. Columns (2) and (4)
report results when we include control variables in our tests. The sample period is from 2001 to 2015. Standard errors are clustered by firm. t -statistics are reported
in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables (1) (2) (3) (4)
CAPEX CAPEX CAPEX CAPEX
Intercept −8.0437*** −14.1619*** −7.0494*** −14.9920***
(162.18) (48.98) (88.23) (49.76)
AfterReform −0.1928*** −0.1867*** −0.1638** −0.1461**
(2.62) (3.10) (2.12) (2.42)
Size 0.8805*** 0.9424***
(21.88) (27.38)
ROA −1.7595*** −1.4834***
(7.60) (6.96)
Q −0.0227 −0.0239
(1.59) (1.64)
Lev −0.1478 −0.1705
(1.05) (1.36)
FCF 0.8779*** 0.8015***
(11.95) (11.77)
Year FE Yes Yes No No
Industry-by-Year FE No No Yes Yes
Observations 12,920 12,920 12,920 12,920
on managers’ diversification decisions. Second, we identify potential channels through which liquidity affects diversification. To
address endogeneity problems from omitted variables and reverse causality, we include firm-fixed effects in our regressions and
perform difference-in-differences tests, using the split share structure reform in China as a plausible exogenous shock on liquidity.
We establish three main findings. First, we find that stock liquidity is conducive to less corporate diversification. Second, we
find that as firms become more financially constrained, the negative effect of liquidity on diversification is stronger. This finding is
consistent with the implication from theoretical studies that higher liquidity improves external capital markets and reduces the need
to broaden internal capital markets through diversification. Third, we show that for firms with more severe information asymmetry,
the negative effect of liquidity on diversification is more pronounced, since improved price informativeness from increased liquidity
generates more efficient monitoring and more forcefully prevents managers from pursuing private benefits through diversification.
Meanwhile, we rule out the potential alternative theory that liquidity disciplines managers and deters diversification by promoting
blockholder control and non-controlling blockholders’ threats to exit. In sum, our results support both the financial constraints channel
and the corporate governance channel.
Our results have implications for the public policy debate on whether liquidity is desirable for corporate governance. Specifically,
our results are consistent with a growing literature that supports the facilitating role that liquidity plays with respect to governance,
as diversification is often viewed as driven by managers’ pursuit of private benefits and individual risk-sharing needs. Our study
should be of interest to practitioners in management and finance as well as regulators, for our study highlights another beneficial
effect of stock liquidity on corporate decisions and provides ground for policies that can potentially improve liquidity.
Appendix. Additional empirical results
This appendix provides variable definitions and additional empirical results. Table A.1 provides variable definitions. Tables A.2,
A.3, and A.4 report our baseline results, panel DID regression analysis, and PSM analysis with industry-by-year-fixed effects and
additional control variables, respectively. Table A.5 reports the panel DID regression results for the effect of the reform on firm’s
capital expenditure. Table A.6 reports the panel DID regression results for the effect of the reform on firm’s number of diversification
merger and acquisitions. Table A.7 compares firm’s external financing activities before and after the reform by looking at firm’s
engagement in seasoned equity offerings (SEOs). Table A.8 reports the panel DID regression results for the effect of the reform on
firm’s top executive compensation. Table A.9 reports changes of matching variables around the reform for the treatment and control
groups.
77
Table A.6
The effect of the reform on the number of diversification merger and acquisitions.
This table reports the difference-in-differences regression results for the effect of the
reform on the number of diversification merger and acquisitions. Following Chen
et al. (2012), we use the staggered feature of China’s split share structure reform
to perform a difference-in-differences regression analysis. In our sample, firms com-
pleted the reform in different years. To capture the treatment effect of the reform on
corporate diversification, we define a dummy variable, 𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, which equals
one if it is at least one year after the firm completes the reform because the reform
requires that the shares have to be locked up for one year after the completion of
the reform, and zero otherwise. The dependent variables is 𝐷𝑀𝐴_𝑛, which is de-
fined as the number of diversification merger and acquisition cases conducted by
a firm in a particular year. Diversification merger and acquisitions are defined as
merger and acquisition cases where acquirer and target are not in the same industry.
The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables
are provided in Table A.1. Columns (1) and (3) report univariate regression results.
Columns (2) and (4) report results when we include control variables in our tests.
To isolate the effect of the reform, we only include firm–year observations that are
within 4 years around the reform year. Standard errors are clustered by firm. t -
statistics are reported in parentheses. *** , ** , and * indicate significance at the 1%,
Variables (1) (2) (3) (4)
DMA_n DMA_n DMA_n DMA_n
Constant 0.7778 −0.6493 3.8103*** 4.8801**
(0.42) (0.28) (4.78) (2.02)
AfterReform −0.7069* −0.7309* −0.8445* −0.9836**
(1.74) (1.79) (1.73) (2.01)
Size 0.1388 −0.1872
(0.63) (0.69)
ROA −0.8613 0.8782
(0.68) (0.56)
Q 0.2021*** 0.1657*
(2.85) (1.94)
Lev −0.0603 0.5276
(0.07) (0.54)
FCF −0.0023 −0.2859
(0.00) (0.43)
Observations 1853 1853 1853 1853
Table A.7
Changes in the occurrence of SEOs before and after the reform. This table reports
the difference in firms’ engagement in seasoned equity offerings (SEOs) before and
after the reform. 𝑆𝐸𝑂 is a dummy variable that equals one if a firm engages in SEOs
at year t, and zero otherwise. 𝑆𝐸𝑂𝑠ℎ𝑎𝑟𝑒 is defined as the number of total SEO shares
issued by a firm scaled by the number of outstanding shares at year t. Then we
compute the mean value of 𝑆𝐸𝑂 and 𝑆𝐸𝑂𝑠ℎ𝑎𝑟𝑒 before and after the reform. Panel
A uses our full sample over the period from 2001 to 2015. Panel B uses firm–year
observations that are within 4 years around the reform. t -statistics are for the tests
of difference in the mean value of 𝑆𝐸𝑂 and 𝑆𝐸𝑂𝑠ℎ𝑎𝑟𝑒 before and after the reform.
*** **
, , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Pre-reform SEOs Post-reform SEOs Test of difference
Variables Mean Mean t -stat
Panel A: Full sample
𝑆𝐸𝑂 0.0098 0.1004 17.79***
𝑆𝐸𝑂𝑠ℎ𝑎𝑟𝑒 0.0016 0.0239 14.64***
Panel B: Four years around the reform
𝑆𝐸𝑂 0.0072 0.0900 14.11***
𝑆𝐸𝑂𝑠ℎ𝑎𝑟𝑒 0.0012 0.0222 11.46***
78
Table A.8
The effect of the reform on executive compensation. This table reports the difference-in-differences regression results for the effect of the reform on executive com-
pensation. Following Chen et al. (2012), we use the staggered feature of China’s split share structure reform to perform a difference-in-differences regression analysis.
In our sample, firms completed the reform in different years. To capture the treatment effect of the reform on corporate diversification, we define a dummy variable,
𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚, which equals one if it is at least one year after the firm completes the reform because the reform requires that the shares have to be locked up for one
year after the completion of the reform, and zero otherwise. The dependent variables is 𝐶𝑂𝑀𝑃 , which is defined as the natural logarithm of the mean of total top
three executives’ compensation. The control variables are 𝑆𝑖𝑧𝑒, 𝑅𝑂𝐴, 𝑄, 𝐿𝑒𝑣, and 𝐹 𝐶𝐹 . Definitions of variables are provided in Table A.1. Columns (1) and (3) report
univariate regression results. Columns (2) and (4) report results when we include control variables in our tests. Standard errors are clustered by firm. t -statistics are
reported in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Variables (1) (2) (3) (4)
COMP COMP COMP COMP
Constant −1.6615*** −3.7143*** 0.3092*** −2.0565***
(11.05) (15.18) (6.83) (8.95)
AfterReform 0.1275*** 0.1182*** 0.0978** 0.1042***
(2.84) (2.97) (2.19) (2.64)
Size 0.2961*** 0.2870***
(12.03) (11.64)
ROA 0.9874*** 0.9618***
(6.52) (6.27)
Q 0.0217*** 0.0215***
(2.80) (2.66)
Lev −0.3851*** −0.3604***
(4.66) (4.22)
FCF 0.0420 0.0066
(0.91) (0.14)
Observations 10,093 10,093 10,093 10,093
Table A.9
Changes of matching variables. This table reports changes of matching variables around the reform for the treatment group and the control group. The change of each
matching variable is calculated as the difference between the mean value of this variable over the time window [t − 2,t − 1] and the mean value of this variable over
the time window [t + 1,t + 2]. Then we test the difference of these change variables between the treatment and control groups. Panel A reports results when we use
our regression control variables as matching variables. Panel B reports results when we include additional variables in the matching list. t -statistics are reported in
parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% level, respectively.
Treatment Control Difference t -statistics
Panel A: five matching variables
Change_Size 0.7820 0.8276 −0.4559 1.60
Change_ROA 0.0230 0.0251 −0.0021 1.44
Change_Q 0.4160 0.4239 −0.0079 0.29
Change_FCF 0.0130 0.0118 0.0012 0.75
Change_Lev −0.0155 −0.0216 0.0061 0.93
Panel B: nine matching variables
Change_Size 0.7480 0.7694 −0.0214 1.66
Change_ROA 0.0235 0.0255 −0.0020 1.21
Change_Q 0.5335 0.5701 −0.0367 0.98
Change_FCF 0.0093 0.0062 0.0031 1.32
Change_Lev −0.0130 −0.0171 0.0042 0.66
Change_Cash −0.0107 −0.0083 −0.0024 1.28
Change_Patent 0.1119 0.1147 −0.0028 0.16
Change_Patent_quality 0.1175 0.1149 0.0025 0.17
Change_Irisk 0.0105 0.0126 −0.0020 0.58
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Journal of Empirical Finance 49 (2018) 57–80

Contents lists available at ScienceDirect

Journal of Empirical Finance

Stock liquidity and corporate diversification: Evidence from

ARTICLE INFO ABSTRACT

errors are our own.

3. Data and variable construction

3.1. Measures for corporate diversification

3.2. Measures for liquidity

𝐿𝐼𝑄 = −1 × 𝑙𝑛(1 + 𝐴𝑚𝑖ℎ𝑢𝑑𝑖,𝑡 ). (3)

3.3. Control variables

3.4. Summary statistics

4.1. Univariate analysis

4.2. Multivariate regression analysis

𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛼 + 𝛽𝐿𝐼𝑄𝑖,𝑡 + 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖𝑛𝑑 + 𝛿𝑡 + 𝜖𝑖,𝑡 , (6)

4.3. Panel difference-in-differences analysis

𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛼 + 𝛽𝐴𝑓 𝑡𝑒𝑟𝑅𝑒𝑓 𝑜𝑟𝑚𝑖,𝑡 + 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖𝑛𝑑 + 𝛿𝑡 + 𝜖𝑖,𝑡 , (7)

5.1. Alternative measures of liquidity

5.2. Difference-in-differences test using a matched sample

Panel B: Post-matching differences

𝐷𝑖𝑣𝑒𝑟𝑠𝑖𝑓 𝑖𝑐𝑎𝑡𝑖𝑜𝑛𝑖,𝑡+1 = 𝛼 + 𝛽𝑇 𝑟𝑒𝑎𝑡𝐴𝑓 𝑡𝑒𝑟𝑖,𝑡 + 𝛾𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡 + 𝜃𝑖 + 𝛿𝑡 + 𝜖𝑖,𝑡 , (8)

6.1. Financial constraint channel

6.2. Corporate governance channel

6.2.1. Information asymmetry

6.2.2. Blockholder intervention

Appendix. Additional empirical results

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