Liquidity is a hard-to-define concept that often only comes to the fore during challenging market environments. This makes it understandable that market participants may view issues of liquidity with some trepidation.
As fundamental bottom-up stock pickers at Matthews Asia, we analyze businesses from across the liquidity spectrum. It is, therefore, important for us to consider and mitigate the associated risks where possible. While most readers will be aware of these risks during market downturns, we have found that what is often ignored is the potential for improved liquidity to augment stock returns while enhancing the opportunity set available to us as investors in the region.
A working paper by the International Monetary Fund broadly defines liquidity as having five overlapping characteristics against which it can be assessed: (i) tightness, (ii) immediacy, (iii) depth, (iv) breadth and (v) resiliency. A liquid market—at an index or security level—would thus exhibit low transaction costs, speed of execution, a large quantity of orders, a minimal impact on price from high volumes and a rapid correction to any market imbalances in order to satisfy each of these criteria.
Given the range of characteristics implied by the concept, there is no single metric we use that captures all the elements of market liquidity. However, using available data to measure transaction costs, bid-ask spreads and security turnover, we can quickly piece together the liquidity profile of markets, portfolios and even individual stocks.
If we are to use market turnover as a basic proxy, Asia-Pacific on the whole is the second-most liquid region globally, according to the World Federation of Exchanges.
However, what is most striking has been the increase in liquidity across the region, which has risen almost six-fold since 1996. This move has been more prominent in some countries than others, with average daily turnover for China’s Shanghai Stock Exchange Composite Index growing at a compound annual growth rate of 38%. Indonesia and Thailand also saw substantial compounded growth of 20% and 19% respectively. At the other end of the scale, South Korea saw the slowest growth in liquidity yet still achieved a compounded growth rate of 5%, showing that the benefit has been seen across the entire region.
Why is Liquidity Changing in Asia?
There are a multitude of reasons for the region’s improving liquidity, but the most prominent and recurring factors have included:
- Increased wealth
- Changes in shareholder structure
- Easing of regulations and improved accessibility for market participants
Private financial wealth has been growing by double digits in the Asia-Pacific region and, according to the Boston Consulting Group, will continue to do so until 2020, around which time it is expected to surpass North America. The main driver behind this has been rising household incomes. With an increasing proportion of this wealth expected to be allocated toward equities, this should continue to improve trading conditions in local stock markets.
In the past, we have often seen a constraint on trading volumes where large shareholders, such as local governments, have maintained a significant stake in the business, limiting the free float available to the broader market. In such scenarios, any decision to exit or sell-down holdings have generally been positive for security liquidity. However, contrary to such action, we have seen some exceptions where new large, long-term shareholders enter the fray. For example, Japan’s significant monetary stimulus in recent years has involved greater indirect government ownership, which ultimately reduces the frequency of the index’s free float being traded. According to Bloomberg, the Bank of Japan will be the largest shareholder in 55 of the Nikkei 225 Index’s constituents by the end of 2017, and it has already become a top five shareholder in 81 of these companies.
Looking beyond the restrictions imposed by government-related entities, a similar pattern has been evident in the private sector where business founders and their families often maintain significant shareholding positions. Generally, decisions to reduce the size of significant family stakes are well-received by the market in the long term.
Regulation and Accessibility
While changes in ownership structure are infrequent events, changing regulations have been far more evident in recent times across the Asia-Pacific region. For example, in Vietnam the government has removed the 49% foreign ownership limit across a number of market sectors which should be a positive development for liquidity over the long term. It will however take time before we can fully assess the impact of this measure as relatively few companies have invoked this change to date. We have seen similar sector-specific legislation in India as the government strives to open up the market to increased foreign direct investment while media reports in the Philippines suggest we could see a removal of the 40% foreign ownership restrictions on public utilities. Continued action on some of these regulations bode well for the continued growth in liquidity across these markets.