Economic Policy Uncertainty Impact on Investment

Abstract.

This paper provides additional evidence on the relationship between economic policy
uncertainty and investment. For this purpose, we gather and construct a wide range of proxy
indicators of economic and economic policy uncertainty from firms of 14 countries during the
2012-2018 period. We distinguish between the relative merits of different types of measures
based on: (i) capital expenditure; (ii) economic policy uncertainty; (iii) market capital. We
find that economic policy uncertainty produces visible negative effects on firms’ capital
expenditure.

Keywords: economic uncertainty, economic policy uncertainty, investment, capital

expenditure.

Introduction.

Economic policy uncertainty is one of the main challenges that companies face while making
investment decisions. Many researches have been conducted to understand behavior of
investments during political uncertainty arise, such as presidential elections. Presidential
elections are an intriguing situation that companies try to avoid its effects. In other words, the
uncertainty that arise because of elections may lead reductions in capital expenditure if there
is a probability for negative outcomes. If the impact is not unfavorable regardless of winner
party, then there is no need for corporations to reduce their investment (Julio and Yook
(2012)). However, practical experience shows that corporations mostly delay their investment
during the during the uncertainty, they try to avoid effect of it and invest after all uncertainties
resolved. The election-year drop in investment is followed by a small temporary increase in
investment in the year immediately following the election as the uncertainty over election
outcomes subsides. This process increases the value of option by the value of wait because it
decreases the risks regard to future. The uncertain conditions affect firms because they are not
sure about their future predictions for example, government fiscal policy, subsidies, monetary
policy, elections and etcetera. Therefore, for firms they need to do some corrective actions,
delay or postpone the project regard to relevant uncertain conditions. From this perspective,
ultimate bottom line that we can produce which an investment should be forward looking
activity to get more affected from political uncertainty.
Additionally, according to most of the research, reversibility of projects is also considerable
factor that should be taken into account during uncertain periods. Indeed, if all firms are faced
with a common uncertainty shock, the ones with more irreversible investments are more
likely to delay investments because they have more to lose if the project proves unprofitable
and downscaling is necessary. At the extreme, firms with completely reversible investment
projects would not be affected by uncertainty shocks because they would have no incentive to
delay their projects. Specifically, if uncertainty lowers investments by increasing the value of
the option to wait, then after long periods of high uncertainty, the relationship between
uncertainty and investment should weaken. This is because many investments cannot be
delayed indefinitely, and as time lapses, the cash flows forgone by delaying investment can
outstrip the value of waiting for more information. Intuitively, holding everything else
constant, the same level of policy uncertainty should translate to a higher level of demand
uncertainty for firms which are more dependent on government con- tracts for their sales.
Hence, if policy uncertainty causes delays in investment, it should do so more severely for
firms with a higher sensitivity to government spending (Gulen and Ion (2015)).

On the other hand, impact of uncertainty always does not mean as the messenger of negative
outcome, so that it can be vary in opposite direction depending on firms. For example, if we
information disclose about the increase of energy prices, it has negative impact on airlines,
but positive impact on oil refineries. In this situation firm sensitivity toward to energy price is
important to detect impact of uncertainty.

Additionally, investigating the impact of political uncertainty on investment is a challenging

task due to the potential endogeneity between uncertainty and economic growth as the
economic downturn itself has arguably generated a great deal of political uncertainty (Julio
and Yook (2012)).

Furthermore, according to findings of Jose Maria, Barrero Nicholas Bloom and Ian Wright, fi
economic policy uncertainty impact more on the long run rather than short run. From this lung
run perspective, we can conclude that during uncertain situations firms need more adjustment
cost, therefore, economic policy uncertainty impact on the research and development cost
more rather than investment.

Addition to all mentioned above, risk attitude is also considerable factor to determine the
relationship between investments and uncertainty. Because some firms are risk neutral, from
this perspective, uncertainty should not have shocked effect on their capital expenditure. Zeira
(1990) and Nakamura (1999) theoretically conclude that depend on the degrees of the risk
aversion effect of uncertainty on investment may change. In general, one can claim that the
probability of a negative effect of uncertainty on investment increases the more risk-averse
the firm is.

Market perfections is also substantial point, many can think that in competitive market
uncertainty have greater impact on reducing the investment, however, Cabellero (1991) shows
that the effect of an increase in uncertainty on irreversible investment is always positive if the
firm is operating in a perfect competitive product market using a constant return to scale
production technology.

Hypothesis Development
1. In countries with high economic policy uncertainty, negative effects of capital
expenditure are weaker.
This paper argues that high level of economic uncertainty results low level capital
expenditure by firms. That is, an increase in uncertainty causes reductions in current
investment due to some probability of a bad outcome. The study will test the
significance of the statement that economic policy uncertainty decreases capital
expenditure.

Data and Methodology.

For testing our hypothesis, we select 14 countries’ firms and use their financial datas from
2012 to 2018. Additionally, data that we used to measure economic policy uncertainty is an
aggregate index developed by Baker, Bloom, and Davis (2013). This index consists of
average of three component. One of them is about newspaper articles data per month since
1985, in other words, they combine the data from newspaper articles which use the term of
uncertainty, economy and etcetera. The second component is about the tax regulation related
to future perspective. BBD index estimate all tax related uncertainties over revenue for
particular countries over ten years. The final component of the index is about possible future
uncertainties about governments’ fiscal and monetary policies.

Our model consists capital expenditure as dependent variable, economic policy uncertainties
as independent variable and some control variables effects over these countries’ capital
expenditures.
CAPXi,t/TAi,t = αi + β1(EPUi,t) + β2(MARKET CAPi,t) + εi

We divided capital expenditure over total asset to show change of investments as a percentage
base. Economic uncertainty index is averaged for per year and market capitalization has been
used as a control variable. The data cover the period of between 2012 and 2018. Market
capitalization have significant impact on corporate investment because of access to funds.
Theory conclude that small market capitalization companies have higher investment rate in
compared with large size firms. Besides all of them market capitalization is an indicator of
risk and sensitivity to cash flow, so cash flow-investment sensitivity is generally highest in the
large firm size group and the smallest in the small size group (Kadapakkam, Kumar, Riddick
(1998)).

Analysis.

As we discussed earlier, uncertainty and investment have correlated each other by some
factors. Our main hypothesis is that if the political uncertainty increase it should negatively
affect the investments The Graphs mainly conclude these facts, however, sometimes there are
some outsiders from the illustration it may be signal for agency problem. In contrast to Julio
and Hook (2012), in corrupted countries, during the political uncertainty firms reduce their
cash holdings and try to hide their cash by acquiring more new asset and paying out more
dividend. As it is seemed, when there is a possible condition for agency problem, the
conventional relationship between political uncertainty and capital expenditure may not
match.

Addition to agency problem, our data consists of 14 countries which diversifies both
developed and less developed countries, from this perspective we can assume that some
outsiders happens because some countries are well developed and have strong capital market
and financial system. It is an undoubtful fact that, in good financial system, risks can be
managed well rather than less developed and corrupted countries. When the market is
incomplete and absence of risk awareness may lead ambiguous relationship between
investment and uncertainty.

Despite of some outsiders, our graphs mostly appropriate for the traditional claims as you see
there is a negative relationship between investment and economic policy uncertainty,
however, unfortunately, we cannot be able to test reversibility rate of our firms based on our
data. Additionally, we should have to know about growth rate of sale to identify demand
based on this we can claim that market have strong demand or not.
Furthermore, our data is dirty data which consists lots of misinformation that lead errors, from
this perspective, our regression model is not good explained in terms of R squared. On the
other hand, P value test strongly significant which means that next step that we should to
consider our T test for each of them so do reject our null hypothesis and claim that at least
there is one independent variable that we can consider linear relationship between our
dependent and independent variable although our dependent variable is not good explained by
independent variables. Our T test conclude that one independent variable has linear
relationship which is economic policy uncertainty which is considerably less than 5 percent
(Table1). On the other hand, according to T test market capitalization does not have linear
relationship with capital expenditure. Market capitalization has ambiguous relationship with
investment. If the investments do not align the shareholders’ interest then it decreases the
value, so there is negative relationship which can also again give signal about the agency
problem. Additionally, depending on the firms’ industry and cash flow, market capitalization
has ambiguous relationship with investment. Empirical results claim that companies with high
cash flow have negative relationship with investment. All in all, our regression analysis is
appropriate to our hypothesis that we reject null hypothesis and conclude that there is negative
linear relationship between uncertainty and capital expenditure.

Conclusion

This paper examines how economic policy uncertainty affects firms’ capital expenditure. We
focus on 14 countries’ firms and use their financial data from 2012 to 2018. This study has
presented empirical findings suggesting that policy uncertainty can have a significant negative
effect on financial investment. Namely, reducing economic policy uncertainty is critical
because both domestic investment and foreign investment are strongly deterred by increases
in domestic economic policy uncertainty. Our results have three main implications. Firstly,
efforts by policy makers to reduce policy uncertainty are desirable to create a good investment
environment for corporations. Second, our results indicate that in assessing the possible
impact of policy-related uncertainty on corporations, we should be aware of the fact that
different firms will be affected to different degrees, depending on characteristics such as
investment irreversibility and reliance on government spending. Furthermore, future research
into this area should focus on the unexplored issues of effect: To what extent can policy
uncertainty have long-lasting effects on firms’ capital expenditure?
References