Living with the "enemy": An analysis of foreign investment in the Japanese equity market

This paper studies the impact of foreign investment on domestic financial markets. It examines the empirical validity of some protectionist claims used by regulators to restrict foreign investment. These people argue that 1) trading by foreign investors tends to increase market volatility more than trading by domestic investors, 2) foreign investors have sophisticated investment technology to which domestic investors do not have access so that domestic investors tend to "lose" to foreign investors, and 3) foreign investors tend to be short term investors whose investments are mostly driven by expectation of short-term gains rather than long-term fundamentals such as corporate dividend growth. We find there is no evidence supporting these claims from the Japanese experience. To the contrary, we find that foreign investors tend to be long-term contrarian players in the market and their presence helps to improve liquidity in the Japanese market. Thus, our results support the hypothesis that international free flow of equity capital is beneficial to domestic markets.