Using the split-share structure reform in China as a quasi-natural experiment, we examine the effect of stock liquidity on investment efficiency. Feedback theories argue that managers learn from stock trading when making real decisions and this mechanism thrives when the stock is liquid. Incentive theories suggest that the effectiveness of both institutional monitoring and incentive compensation increase with stock liquidity. Consistent with these views, we find that the investment efficiency of Chinese firms improves after the split-share structure reform but only for under-investing firms. When stock liquidity increases, compared to under-investing firms, over-investing firms face a reduction in institutional shareholding and witness no increase in takeover risk; thus, the over-investing firms face lower pressure to make optimal investments. Our findings further substantiate the real effects of financial markets and add evidence to the consequences of the Chinese structural reform initiatives. 

JEL Classifications: G12, G14, G15, G31
Keywords: Stock liquidity, Investment efficiency, Under-investment, Financial constraints, Institutional ownership.​