Nicolas E. Magud and Sebastián Sosa
In our working paper on investment in emerging markets (2015) we document that (i) although private investment growth in emerging markets has decelerated in recent years, it came down from cyclical highs and remains close to precrisis trends; and (ii) investment-to-output ratios generally remain close to or above historical averages. Investment is positively related to expected future profitability, cash flows and debt flows, and negatively associated with leverage. Critically, it is also positively related to (country-specific) commodity export prices and capital inflows. The latter help to relax firms’ financial constraints, which tend to be stronger for smaller firms and those less integrated with international financial markets. Lower commodity export prices and expected profitability, a moderation in capital inflows, and an increased leverage account for the bulk of the recent investment deceleration. Looking forward, prospects for a recovery of business investment are not promising.
Emerging market economies (EMEs) exhibited strong investment growth in 2003–11, interrupted only temporarily in 2009 by the global financial crisis. After peaking in 2011, however, investment growth has waned in most of these economies. Furthermore, real output growth forecasts have been revised down significantly, to a large extent because of the lower-than-projected actual investment. But what explains this weakness in investment? What is the role of external factors? Is the slowdown a generalized phenomenon across EMEs? Moreover, can recent investment trends be explained by the standard determinants? How concerned should policymakers be about the recent investment disappointment?
We address these questions by first identifying and documenting key trends in private investment across emerging market economies, putting the recent slowdown in historical perspective. Then, we study the determinants of investment using an expanded Q-theory of investment model in panel regressions that combine firm level data for about 16,000 listed firms with country-specific macroeconomic variables—particularly commodity export prices and capital inflows—for 38 emerging market economies over the period 1990–2013. After identifying the key factors driving firms’ investment decisions in EMEs, we shed light on which of these factors have been the main drivers of the recent investment weakness.
The stylized facts show that although investment in EMEs has weakened in the last few years, it came down from cyclical highs and remains broadly at precrisis levels. And although investment-to-output ratios have flattened or declined moderately, they remain close to or above historical averages for most EMEs.
Figure 1.Real Private Investment1
Source: IMF, World Economic Outlook, and IMF staff calculations
Note: LAC=Latin America and the Caribbean; EUR=Europe; CIS=Commonwealth of Independent States
1 PPP-weighted average.
The main results from the panel regressions can be summarized as follows:
The usual suspects: Emerging market firms’ capital expenditure is positively associated with expected profitability (proxied by Tobin’s Q), cash flows (suggesting the existence of borrowing constraints), and debt flows. It is negatively associated with leverage.
Commodities matter: Investment is positively associated with changes in (country-specific) commodity export prices.
Foreign financing and relaxation of financial constraints: Investment by firms in emerging markets is positively influenced by the availability of foreign (international) financing. Moreover, capital inflows help relax firms’ financial constraints, with the sensitivity of investment to cash flow weakening as capital inflows increase. This effect is particularly strong for nontradable sector firms.
After the boom: Firms’ investment has not been abnormally weak in the past three years, at least not above and beyond what can be explained by the evolution of its main determinants mentioned above.
Who is to blame? The sharp decline in commodity export prices (especially in Latin America and the Caribbean (LAC)) and the lower expected profitability of firms (which partly reflects the downward revisions to potential growth in many EMEs) have been important factors behind the recent deceleration of investment. A moderation in capital inflows to EMEs and increased leverage (particularly in Asia) have also played a significant role.
Figure 2:Contributions to the Recent Investment Slowdown1
Why does this matter? Examining the determinants of private investment is important to understand business cycle fluctuations in EMEs. But the topic is also relevant because capital accumulation is a key driver of potential output growth. The latter is of particular interest at the current juncture given that most emerging markets have been experiencing significant downward revisions to potential growth. Moreover, identifying the main drivers of the recent slowdown in investment is relevant for policymakers in emerging market economies to the extent that it helps with assessing the likely effectiveness of alternative policy measures to foster private investment and boost potential growth.
Our work is related to the extensive empirical literature on the determinants of corporate investment in emerging markets. In particular, it relates to a strand that studies financing constraints, typically relying on Tobin’s Q investment models or Euler investment equations. Most of these studies have documented the importance of internal financing for firms’ investment owing to capital markets imperfections. Based on this framework, for example, Fazzari and others 1988 examine the case of U.S. manufacturing firms, while Love and Zicchino 2006 study emerging market companies. The sensitivity of investment to cash flows is particularly strong for smaller firms (Fazzari and others 2000, and Carpenter and Guariglia 2008) and for firms in less financially developed economies (Love 2003). Criticism of the use of cash flow as a measure of financial frictions (e.g., Kaplan and Zingales 1997, Gomes 2001, and Abel and Eberly 2011) have been addressed by Gilchrist and Himmelberg (1995), who establish the existence of financial constraints by testing the significance of investment-cash flow sensitivities beyond the effect of the “Fundamental Q.”
The study most closely linked to ours is Harrison and others 2004, which documents that foreign direct investment (FDI) flows to emerging markets are associated with a reduction in firms’ financing constraints. Like us, they examine whether—and to what extent—the availability of foreign capital helps to relax financing constraints in emerging market firms by combining firm-level data on cash flows with country-specific capital flows. Forbes 2007 and Gelos and Werner 2002 also find that the latter relax when capital account restrictions are eased.
The private investment weakening in emerging market economies has not represented a slump, but rather a slow-down after a period of boom. Yet, policymakers should not be complacent. First, prospects for a recovery of business investment are not promising, as the outlook for most of its determinants is generally dim. Commodity prices are expected to remain weak, capital inflows to EMEs are likely to moderate further, and external financial conditions are set to become tighter because of the impact of the normalization of the U.S. monetary policy. The recent declines in potential growth estimates for most EMEs are also likely to be a drag on business investment going forward. Moreover, investment ratios are still relatively low in some emerging market regions, particularly in Latin America and the Caribbean, so boosting private investment remains a policy priority.
In light of our results on the size and persistence of financing constraints, especially for smaller firms, business investment in EMEs would benefit from further deepening domestic financial systems, strengthening capital market development, and promoting access to finance—of course, subject to sufficient safeguards to ensure financial stability. Strengthening financial infrastructure and legal frameworks, and enhancing capital market access to funding for small and mid-sized firms would be positive measures.
More generally, and beyond the scope of our study, structural reforms to boost productivity could help unlock private investment and output growth. The design of a policy agenda of structural reforms is a difficult task and entails country-specific considerations, but in many emerging markets, the efforts to improve infrastructure and human capital, strengthen the business climate, and foster competition are key priorities.
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