Policy uncertainty, irreversibility, and cross-border flows of capital

TLDR: This article examined the effects of political uncertainty on cross-border capital flows using election timing as a source of fluctuations in political uncertainty and found that FDI flows from US companies to foreign affiliates drop significantly during the period just before an election and increase after the uncertainty is resolved, consistent with the view that political uncertainty deters foreign investment.

About: This article is published in Journal of International Economics.The article was published on 2013-08-01 and is currently open access. It has received 279 citations till now. The article focuses on the topics: Foreign direct investment.

Figures

Table 5 FDI Regressions: Including U.S. Elections

Table 1 Capital Flows Summary Statistics

Table 4 FDI Regressions: Country Controls

Table 3 FDI Flows around Elections

Table 8 Interactions with Measures of Government Stability

Table 7 FDI Flows around Close Elections

Frequently asked questions

Q1. What are the contributions in "Policy uncertainty, irreversibility, and cross-border flows of capital" ?

The authors examine the effects of government policy uncertainty on cross-border capital flows. The views expressed in this article are those of the authors and not necessarily of the Federal Reserve System. The electoral cycles are present in relatively irreversible FDI flows but not in foreign portfolio investment flows, suggesting a likely causal link from political uncertainty to and capital flows. The authors thank Ling Cen, Pasquale Della Corte, Joshua Gallin, Pedro Magalhães, Anamaria Piloiu, Vincenzo Quadrini, and seminar participants at American University, Federal Reserve Board of Governors, Korea University Economics Department, Seoul National University, Sungkyunkwan University, University of Maryland, University of Sydney, University of Technology, Sydney, 2012 China International Conference in Finance, the Chinese Finance Association Best Paper Symposium 2012, Global Finance Conference, Lisbon Meeting on Institutions and Political Economy, Western Finance Association Annual Meeting, European Finance Association Meeting, and the Conference on Policy Uncertainty and its Economic Implications at the University of Chicago for helpful comments. 

Q2. Why are direct investors forced to sell at a lower price?

Because direct investors who act effectively as managers of firms are more informed than portfolio investors, they would be forced to sell at a lower price that reflects the discount for information asymmetry. 

Q3. What is the primary source of the macroeconomic variables in the sample?

The World Bank database is their primary source for the macroeconomic variables including real per capita GDP, government spending, exports, and imports. 

Q4. What is the effect of an increase in government expenditures on FDI flows?

An increase in government expenditures is expected to act as a deterrent for FDI inflows as increased government spending funded by higher taxation is likely to discourage private investment. 

Q5. What is the main obstacle to identifying a link between policy uncertainty and changes in capital flows?

As noted by Rodrik (1991), a major obstacle to identifying a link between policy uncertainty and changes in capital flows is the availability of an adequate proxy for variation in uncertainty due to difficulties in measurement and possible endogeneity. 

Q6. Why is irreversibility an important feature in models of investment under uncertainty?

Because investment is costly to reverse, irreversibility increases the information value of waiting to invest (Caballero (1991)), causing investment to vary negatively with fluctuations in policy uncertainty over time. 

Q7. How does Rodrik demonstrate that policy uncertainty is driving investment decisions?

Rodrik demonstrates that under reasonable assumptions even a 10 percent probability of policy reversal requires an investment subsidy of 7.5 percentage points to offset its adverse effects on investment. 

Q8. Why are FDI flows considered to be easier to reverse?

While FDI flows are typically considered relatively irreversible due to specificity, foreign portfolio investment (FPI) flows are considered to be easier to reverse (Razin, Sadka and Yuen (1998)). 

Q9. What is the effect of political uncertainty on FDI flows?

Election cycles in FDI flows are present, though less severe, in high income countries as well, suggesting that the depressing effects of policy uncertainty on FDI flows are not just an emerging markets phenomenon. 

Q10. Why are FPI flows considered easier to reverse?

While FDI flows are typically considered relatively irreversible due to specificity, FPI flows are considered to be easier to reverse (Razin, Sadka and Yuen (1998)). 

Q11. What do Caballero and Hammour (1998) argue about FDI flows?

Caballero and Hammour (1998) classify FDI as relationship-specific and argue that the specificity reduces the flexibility of decisions. 

Q12. What is the effect of election uncertainty on policy?

To the extent that different candidates have different policy preferences, election uncertainty translates into policy uncertainty when the outcome is uncertain. 

Q13. How do the authors address the concern that incumbents may opportunistically time elections?

To address the concern that incumbents may opportunistically time elections to maximize their chance of re-election and thereby induce a correlation between election timing and economic activity, the authors repeat the tests with the subsample of countries for which elections are fixed in time by electoral law. 

Q14. What is the effect of a political uncertainty on FDI flows?

Electoral uncertainty, therefore, appears to have larger effects on FDI flows when election outcomes may lead to relatively unchecked policy changes by the national leader.