We examine the influence of foreign equity flows on China's unique retail-dominated stock market, identifying a novel channel through which investors’ herding creates significant market externalities. We find that the daily disclosure of foreign investors' positions induces local investors to imitate these trades, resulting in observable short-term price distortions followed by reversals. Our analyses, which include inflow predictability tied to disclosure timing and path analysis decomposition, confirm that the herding effect, largely driven by retail participants, is more impactful than the direct effect based on the informational content of foreign capital. Furthermore, inflated stock prices resulting from the herding behavior cause public firms to overvalue and overinvest, leading to reduced investment efficiencies. These findings highlight potential adverse consequences stemming from specific stock market liberalization designs.

Based on 5-minute high-frequency trading data, we examine the time-varying causal relationship between herding behavior and multiscale spillovers (return, volatility, skewness, and kurtosis) in the Chinese stock market. We employ the novel time-varying Granger causality test proposed by Shi et al. (2018), which is based on the recursive evolving algorithm developed by Phillips et al. (2015a, 2015b), to identify real-time causal relationships and capture possible changes in the causal direction. Our findings reveal a strong relationship between herding and spillover effects, particularly with odd-moment (return and skewness) spillovers. For most of the study period, a bidirectional causal relationship was found between herding and odd-moment spillovers. These results imply that herding behavior is a key driver of spillover effects, especially return and skewness spillovers, which are primarily transmitted through the information channel. By contrast, volatility and kurtosis spillovers are more strongly driven by real and financial linkages. Furthermore, spillover effects also affect herding behavior, highlighting the intricate feedback loop between investor behavior and risk transmission.