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Macroeconomic uncertainty and private investment
Economics Letters 41 (1993) 207-210 0165-1765/93/$06.00 © 1993 Elsevier Science Publishers B.V. All rights reserved
207
Macroeconomic uncertainty and private investment * Joshua Aizenman
*, Nancy P. Marion
Economics Department, Dartmouth College, Hanover, NH 03755, USA NBER, Cambridge, MA 02138, USA
Received 11 September 1992 Final revision received 12 February 1993 Accepted 18 February 1993
Abstract
This paper provides empirical support for a link between macroeconomic uncertainty and private investment in developing countries. Cross-section regressions with constructed measures of uncertainty confirm that for developing countries uncertainty is negatively correlated with private investment.
1. Introduction
Studies o n i n v e s t m e n t b e h a v i o r show that w h e n i n v e s t m e n t is s u b j e c t to s u n k c o s t s - i r r e v e r s i b i l i t i e s - u n c e r t a i n t y g e n e r a t e s an o p t i o n value for waiting [ B e r n a n k e (1983), v a n W i j n b e r g e n (1985), P i n d y c k (1988), Dixit (1989) a n d others]. U n d e r these circumstances, higher u n c e r t a i n t y t e n d s to lower i n v e s t m e n t . This literature has g e n e r a t e d a n u m b e r of theoretical insights r e g a r d i n g the i n t e r p l a y b e t w e e n u n c e r t a i n t y a n d i n v e s t m e n t b u t little if any empirical tests of its p r e d i c t i o n s . T h e p u r p o s e of this p a p e r is to p r e s e n t evidence of a link b e t w e e n m a c r o e c o n o m i c u n c e r t a i n t y a n d private i n v e s t m e n t in d e v e l o p i n g c o u n t r i e s over the 1970-85 period. ~ We c o n s t r u c t m e a s u r e s of m a c r o e c o n o m i c u n c e r t a i n t y a n d add t h e m to previous i n v e s t m e n t regressions i n c o r p o r a t i n g e n d o g e n o u s growth e l e m e n t s such as h u m a n capital.
2. Results
I n o r d e r to o b t a i n m e a s u r e s of domestic m a c r o e c o n o m i c u n c e r t a i n t y for o u r s a m p l e of n e a r l y 40 d e v e l o p i n g c o u n t r i e s , we fit a first-order autoregressive process of the form: * The research reported here is part of the NBER's research program in international studies. Any opinions expressed are those of the authors and not those of the NBER. Financial support from the Reiss Family Fund is gratefully acknowledged. Corresponding author. ~For many developing countries, data on fiscal and monetary variables are unavailable prior to 1970. The choice of countries to include in the sample was determined by the availability of data on private and public investment expenditures. Data come from the IMF's International Financial Statistics tape, the World Bank study on public and private investment shares by Pfeffermann and Madarassy (1991), and the Summers-Heston (1988) project.
208
J. Aizenman, N.P. Marion / Economics Letters 41 (I993) 207-210
(l)
M,=/31~+/3 IM, I + E , ,
where M is the macroeconomic variable and /3~ is the autoregressive parameter. With only 15 years of annual data, no attempt is made to test for more complicated autoregressive schemes. Macroeconomic uncertainty over the sample period is measured by the standard deviation of the residuals. One shortcoming of this measure is that future changes in the environment that are fully anticipated are nevertheless treated as uncertain. On the fiscal side, selected policies include the share of government consumption expenditure in G D P ( G O V ) and the share of public investment in G D P ( I P U B ) . Since there is no reason to believe that uncertainty about levels matters more than uncertainty about growth rates (although uncertainty about one implies uncertainty about the other), we also look at uncertainty surrounding the g r o w t h in the share of government consumption expenditures ( G G O V ) . O t h e r fiscal variables are the average tax rate, as measured by the ratio of government revenue to G D P ( R E V ) , and the government budget deficit scaled by G D P ( D E F ) . Scaling the fiscal variables makes the standard deviation measure unit free and thus acceptable for cross-country comparisons. Our choice of fiscal variables is not meant to be all-inclusive. On the m o n e t a r y side, we focus on the unexpected parts of domestic credit expansion ( D O ) and of m o n e y growth ( M O ) . Though not a policy instrument, we also consider inflation surprises (IN), since they might capture uncertainty in the underlying policy stance and have been studied before ]Edwards and Tabellini (1990)]. We estimate cross-section investment regressions using our sample of about 40 developing countries. In the regressions, the dependent variable is the average share of private investment in G D P over the 1970-85 period (IP7085). For regressions, we follow the work of Barro (1991) and others by including both the initial level of per capita income ( G D P 7 0 ) and a h u m a n capital variable. As in Barro (1991), the human capital variable is the UN measure of the n u m b e r of students enrolled in primary grades in 1970 relative to the total population of six to eleven year olds ( P R I M 7 0 ) . Although technically a flow variable, it is used to proxy the stock of h u m a n capital over the period. Two additional regressors are included. One is lagged growth ( G R 6 5 7 0 ) and the other is the uncertain c o m p o n e n t of the macroeconomic variable as measured by the standard deviation of the residuals over the sample period ( M U ) . The basic regression is thus of the form: IP7085 = a o + e q G D P 7 0 + c~2PRIM70 + c~3GR6750
+ ol4MU
+ EI .
(2)
Table 1 displays the regression results. Because heteroskedasticity could be important across developing countries, the standard errors for the coefficients are based on White's (1980) heteroskedasticity-consistent covariance matrix. Because the macroeconomic surprise variable is a constructed variable measured with error, instruments are used in estimating (2). 2 A n u m b e r of instruments were tried, such as the frequency of coups, revolutions and assassinations, terms-oftrade variance, measures of market distortions, inflation variance, and various grouping methods, but typically the instruments were not highly correlated with the uncertainty variable. Consequently, the instrumental variable estimator was not significant in the regression. We ended up using the mean and variance of the macroeconomic variable as instruments for each of the m a c r o e c o n o m i c surprise variables. The results in Table 1 show a negative relationship between macroeconomic uncertainty and private investment in all cases. Moreover, the coefficient on the macroeconomic uncertainty z The problem of measurement error in developing country data is an important one but without any clear solution. For further discussion, see Pagan (1984) and Maddala (1988).
J. Aizenman, N.P. Marion / Economics Letters 41 (1993) 2 0 7 - 2 1 0
~0
~
~5oo6eq,.;c5c5oc5c5
r.i.1
;> e-.
3
5
2 o
>. ©
0
8 .=_ > ~0 ~0 o
~.~
=_ ~== ~3 o
209
210
J. Aizenman, N.P. Marion / Economics Letters 41 (1993) 207-210
v a r i a b l e is h i g h l y s i g n i f i c a n t in all b u t o n e c a s e ( t h a t o f u n c e r t a i n t y a b o u t p u b l i c i n v e s t m e n t e x p e n d i t u r e s ) . In a d d i t i o n , p a s t g r o w t h a n d s c h o o l e n r o l l m e n t a r e p o s i t i v e l y c o r r e l a t e d w i t h private investment.
3. Concluding remarks Our investigation confirms the existence of a negative relation between macroeconomic u n c e r t a i n t y a n d p r i v a t e i n v e s t m e n t in d e v e l o p i n g c o u n t r i e s , as p r e d i c t e d by t h e i r r e v e r s i b l e i n v e s t m e n t l i t e r a t u r e . T h e r e s u l t s l e n d s u p p o r t to t h e n e w w i s d o m t h a t it m a y n o t b e e n o u g h to set m a c r o e c o n o m i c p o l i c i e s at t h e ' r i g h t ' l e v e l s - u n c e r t a i n t y a b o u t t h e m a c r o e c o n o m i c e n v i r o n m e n t m u s t also b e m i n i m i z e d .
References Barro, R., 1991, Economic growth in a cross-section of countries, Quarterly Journal of Economics 106, 407-444. Bernanke, B., 1983, lrreversibility, uncertainty, and cyclical investment, Quarterly Journal of Economics 98, 85-1(16. Dixit, A., 1989, Entry and exit decisions under uncertainty, Journal of Political Economy 97. 62(I-638. Edwards, S. and G. Tabellini, 199(I, Explaining fiscal policies and inflation in developing countries, NBER Working Paper 3493. Maddala, G., 1988, Introduction to econometrics (Macmillan, New York). McDonald, R. and D. Siegel, 1985, The value of waiting to invest, Quarterly Journal of Economics 101, 7(17-728. Pagan, A., 1984, Econometric issues in the analysis of regressions with generated regressors, International Economic Review 25, 221-247. Pfeffermann, G. and A. Madarassy, 1991, Trends in private investment in developing countries, 199(I-91 edition, International Finance Corporation Discussion Paper No. 11, The World Bank. Pindyck, R., 1988, Irreversible investment, capacity choice, and the value of the firm, American Economic Review 78, 969 985. Summers, R. and A. Heston, 1988, A new set of international comparisons of real product and price levels: Estimates for 13(1 countries, 1950-85, Review of Income Wealth 34, 1-25 and accompanying computer diskettes. White, H., 19811, A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity, Econometrica 48, 817-838. van Wijnbergcn, S., 1985, Trade reform, aggregate investment, and capital flight, Economic Letters, 19, 369-372.
207
Macroeconomic uncertainty and private investment * Joshua Aizenman
*, Nancy P. Marion
Economics Department, Dartmouth College, Hanover, NH 03755, USA NBER, Cambridge, MA 02138, USA
Received 11 September 1992 Final revision received 12 February 1993 Accepted 18 February 1993
Abstract
This paper provides empirical support for a link between macroeconomic uncertainty and private investment in developing countries. Cross-section regressions with constructed measures of uncertainty confirm that for developing countries uncertainty is negatively correlated with private investment.
1. Introduction
Studies o n i n v e s t m e n t b e h a v i o r show that w h e n i n v e s t m e n t is s u b j e c t to s u n k c o s t s - i r r e v e r s i b i l i t i e s - u n c e r t a i n t y g e n e r a t e s an o p t i o n value for waiting [ B e r n a n k e (1983), v a n W i j n b e r g e n (1985), P i n d y c k (1988), Dixit (1989) a n d others]. U n d e r these circumstances, higher u n c e r t a i n t y t e n d s to lower i n v e s t m e n t . This literature has g e n e r a t e d a n u m b e r of theoretical insights r e g a r d i n g the i n t e r p l a y b e t w e e n u n c e r t a i n t y a n d i n v e s t m e n t b u t little if any empirical tests of its p r e d i c t i o n s . T h e p u r p o s e of this p a p e r is to p r e s e n t evidence of a link b e t w e e n m a c r o e c o n o m i c u n c e r t a i n t y a n d private i n v e s t m e n t in d e v e l o p i n g c o u n t r i e s over the 1970-85 period. ~ We c o n s t r u c t m e a s u r e s of m a c r o e c o n o m i c u n c e r t a i n t y a n d add t h e m to previous i n v e s t m e n t regressions i n c o r p o r a t i n g e n d o g e n o u s growth e l e m e n t s such as h u m a n capital.
2. Results
I n o r d e r to o b t a i n m e a s u r e s of domestic m a c r o e c o n o m i c u n c e r t a i n t y for o u r s a m p l e of n e a r l y 40 d e v e l o p i n g c o u n t r i e s , we fit a first-order autoregressive process of the form: * The research reported here is part of the NBER's research program in international studies. Any opinions expressed are those of the authors and not those of the NBER. Financial support from the Reiss Family Fund is gratefully acknowledged. Corresponding author. ~For many developing countries, data on fiscal and monetary variables are unavailable prior to 1970. The choice of countries to include in the sample was determined by the availability of data on private and public investment expenditures. Data come from the IMF's International Financial Statistics tape, the World Bank study on public and private investment shares by Pfeffermann and Madarassy (1991), and the Summers-Heston (1988) project.
208
J. Aizenman, N.P. Marion / Economics Letters 41 (I993) 207-210
(l)
M,=/31~+/3 IM, I + E , ,
where M is the macroeconomic variable and /3~ is the autoregressive parameter. With only 15 years of annual data, no attempt is made to test for more complicated autoregressive schemes. Macroeconomic uncertainty over the sample period is measured by the standard deviation of the residuals. One shortcoming of this measure is that future changes in the environment that are fully anticipated are nevertheless treated as uncertain. On the fiscal side, selected policies include the share of government consumption expenditure in G D P ( G O V ) and the share of public investment in G D P ( I P U B ) . Since there is no reason to believe that uncertainty about levels matters more than uncertainty about growth rates (although uncertainty about one implies uncertainty about the other), we also look at uncertainty surrounding the g r o w t h in the share of government consumption expenditures ( G G O V ) . O t h e r fiscal variables are the average tax rate, as measured by the ratio of government revenue to G D P ( R E V ) , and the government budget deficit scaled by G D P ( D E F ) . Scaling the fiscal variables makes the standard deviation measure unit free and thus acceptable for cross-country comparisons. Our choice of fiscal variables is not meant to be all-inclusive. On the m o n e t a r y side, we focus on the unexpected parts of domestic credit expansion ( D O ) and of m o n e y growth ( M O ) . Though not a policy instrument, we also consider inflation surprises (IN), since they might capture uncertainty in the underlying policy stance and have been studied before ]Edwards and Tabellini (1990)]. We estimate cross-section investment regressions using our sample of about 40 developing countries. In the regressions, the dependent variable is the average share of private investment in G D P over the 1970-85 period (IP7085). For regressions, we follow the work of Barro (1991) and others by including both the initial level of per capita income ( G D P 7 0 ) and a h u m a n capital variable. As in Barro (1991), the human capital variable is the UN measure of the n u m b e r of students enrolled in primary grades in 1970 relative to the total population of six to eleven year olds ( P R I M 7 0 ) . Although technically a flow variable, it is used to proxy the stock of h u m a n capital over the period. Two additional regressors are included. One is lagged growth ( G R 6 5 7 0 ) and the other is the uncertain c o m p o n e n t of the macroeconomic variable as measured by the standard deviation of the residuals over the sample period ( M U ) . The basic regression is thus of the form: IP7085 = a o + e q G D P 7 0 + c~2PRIM70 + c~3GR6750
+ ol4MU
+ EI .
(2)
Table 1 displays the regression results. Because heteroskedasticity could be important across developing countries, the standard errors for the coefficients are based on White's (1980) heteroskedasticity-consistent covariance matrix. Because the macroeconomic surprise variable is a constructed variable measured with error, instruments are used in estimating (2). 2 A n u m b e r of instruments were tried, such as the frequency of coups, revolutions and assassinations, terms-oftrade variance, measures of market distortions, inflation variance, and various grouping methods, but typically the instruments were not highly correlated with the uncertainty variable. Consequently, the instrumental variable estimator was not significant in the regression. We ended up using the mean and variance of the macroeconomic variable as instruments for each of the m a c r o e c o n o m i c surprise variables. The results in Table 1 show a negative relationship between macroeconomic uncertainty and private investment in all cases. Moreover, the coefficient on the macroeconomic uncertainty z The problem of measurement error in developing country data is an important one but without any clear solution. For further discussion, see Pagan (1984) and Maddala (1988).
J. Aizenman, N.P. Marion / Economics Letters 41 (1993) 2 0 7 - 2 1 0
~0
~
~5oo6eq,.;c5c5oc5c5
r.i.1
;> e-.
3
5
2 o
>. ©
0
8 .=_ > ~0 ~0 o
~.~
=_ ~== ~3 o
209
210
J. Aizenman, N.P. Marion / Economics Letters 41 (1993) 207-210
v a r i a b l e is h i g h l y s i g n i f i c a n t in all b u t o n e c a s e ( t h a t o f u n c e r t a i n t y a b o u t p u b l i c i n v e s t m e n t e x p e n d i t u r e s ) . In a d d i t i o n , p a s t g r o w t h a n d s c h o o l e n r o l l m e n t a r e p o s i t i v e l y c o r r e l a t e d w i t h private investment.
3. Concluding remarks Our investigation confirms the existence of a negative relation between macroeconomic u n c e r t a i n t y a n d p r i v a t e i n v e s t m e n t in d e v e l o p i n g c o u n t r i e s , as p r e d i c t e d by t h e i r r e v e r s i b l e i n v e s t m e n t l i t e r a t u r e . T h e r e s u l t s l e n d s u p p o r t to t h e n e w w i s d o m t h a t it m a y n o t b e e n o u g h to set m a c r o e c o n o m i c p o l i c i e s at t h e ' r i g h t ' l e v e l s - u n c e r t a i n t y a b o u t t h e m a c r o e c o n o m i c e n v i r o n m e n t m u s t also b e m i n i m i z e d .
References Barro, R., 1991, Economic growth in a cross-section of countries, Quarterly Journal of Economics 106, 407-444. Bernanke, B., 1983, lrreversibility, uncertainty, and cyclical investment, Quarterly Journal of Economics 98, 85-1(16. Dixit, A., 1989, Entry and exit decisions under uncertainty, Journal of Political Economy 97. 62(I-638. Edwards, S. and G. Tabellini, 199(I, Explaining fiscal policies and inflation in developing countries, NBER Working Paper 3493. Maddala, G., 1988, Introduction to econometrics (Macmillan, New York). McDonald, R. and D. Siegel, 1985, The value of waiting to invest, Quarterly Journal of Economics 101, 7(17-728. Pagan, A., 1984, Econometric issues in the analysis of regressions with generated regressors, International Economic Review 25, 221-247. Pfeffermann, G. and A. Madarassy, 1991, Trends in private investment in developing countries, 199(I-91 edition, International Finance Corporation Discussion Paper No. 11, The World Bank. Pindyck, R., 1988, Irreversible investment, capacity choice, and the value of the firm, American Economic Review 78, 969 985. Summers, R. and A. Heston, 1988, A new set of international comparisons of real product and price levels: Estimates for 13(1 countries, 1950-85, Review of Income Wealth 34, 1-25 and accompanying computer diskettes. White, H., 19811, A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity, Econometrica 48, 817-838. van Wijnbergcn, S., 1985, Trade reform, aggregate investment, and capital flight, Economic Letters, 19, 369-372.