Financial Shocks and Corporate Investment in Emerging Markets

• Published date: 01 March 2020
• Author: DELONG LI,NICOLAS E. MAGUD,FABIAN VALENCIA
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/jmcb.12603

DOI: 10.1111/jmcb.12603

DELONG LI

NICOLAS E. MAGUD

FABIAN VALENCIA

Financial Shocks and Corporate Investment

in Emerging Markets

We examinehow cross-firm and cross-country heterogeneity shapes the re-

sponses of corporate investment in emerging markets to changes in U.S.

monetary policy and financial-market volatility, the latter proxying for un-

certainty. Wefind that in response to increases in U.S monetary policy rates

or financial-market volatility,financially weaker firms reduce investment by

more than financially strong firms. We also show that firms with stronger

balance sheets delay investment voluntarily when faced with higher uncer-

tainty. Finally, we find that stronger macroeconomic fundamentals (lower

public debt or higher international reserves) help to buffer corporate invest-

ment from increases in U.S. monetary policy rates.

JEL codes: E2, E6, F3

Keywords: investment,financial frictions, real options, uncertainty.

NEGATIVE FINANCIALSHOCKS STEMMING FROM the United States,

such as unexpected monetary policytightening, or heightened financial market volatil-

ity, are often followed by a reduction in corporate investment in emerging markets

(Figure 1). Beyond this aggregate effect, which has already been documented in

The authors thank Ravi Balakrishnan, Adrienne Cheasty, Sanjay K. Chugh (the editor), Stephan Dan-

ninger,Greg Duffee, Jon Faust, Tryiggvi Gudmundson, Fei Hand, Dora Iakova, Alex Klemm, Peter Linder,

Camelia Minoiu, Machiko Narita, Alejandro Werner,Jonathan Wright, two anonymous referees, and sem-

inar participants at the IMF, The Johns Hopkins University, and LACEA 2016 (Medellin, Colombia) for

valuable comments and suggestions.

DELONG LIis an Assistant Professor of Finance, Department of Economics and Finance, College

of Business & Economics, University of Guelph (E-mail: delong@uoguelph.ca). NICOLAS E. MAGUD

is a Senior Economist in the Institute for Capacity Development, International Monetary Fund (E-mail:

nmagud@imf.org). FABIANVALENCIA is a Deputy Unit Chief in the Strategy,Policy andReview Department,

International Monetary Fund (E-mail: fvalencia@imf.org).

Received May 18, 2017; and accepted in revised form November 29, 2018.

Journal of Money, Credit and Banking, Vol. 52, Nos. 2–3 (March–April 2020)

C

2019 The Ohio State University

The International Monetary Fund retains copyright and all other rights in the manuscript of

this article as submitted for publication.

614 :MONEY,CREDIT AND BANKING

FIG. 1. U.S. Financial Shocks and Investment in EmergingMarkets.

NOTES: The data come from Worldscope, CBOE, G¨

urkaynak, Sack, and Wright (2007), Gilchrist and Zakrajˇ

sek (2012)

and authors’ calculations. In each chart, the left axis denotes the median investment-to-capital ratio across emerging-

market firms (see Table A1 for the sample distribution); the right axis denotes the corresponding U.S. financial shock,

where MPHF represents unexpected U.S. monetary-policy tightening (if positive),or easing (if negative), identified from

high-frequency data; VIX is the implied volatility from 30-day S&P 500 indexoptions; GZspread and EBP are the credit

spread and excess bond premium estimated in Gilchrist and Zakrajˇ

sek (2012). See Section 3 for details.

the existing literature,1there can be a great deal of heterogeneity in the response

of investment across firms and countries. This paper aims at empirically exploiting

this heterogeneity and shedding light on the transmission channels through which

U.S. financial shocks can influence corporate investment in emerging markets, as

suggested by the theoretical literature.

Our interest lies in identifying two channels: the financing channel and the real-

options channel. After documenting how corporate investment in emerging markets

reacts to financial shocks in the United States (be it first-order shocks like mone-

tary policy surprises, or second-order shocks like volatility hikes), we focus on the

differential responses depending on firms’ financial strength, proxied by leverage.

The financing channel is that by which firms with higher leverage reduce their

investment more aggressively in response to U.S. financial shocks because their

1. See, for example, Bloom (2009), Carriere-Swallow and Cespedes (2013), Caldara et al. (2016),

and Gilchrist, Sim, and Zakrajˇ

sek (2014) for evidence on aggregate investment, and Gilchrist, Sim, and

Zakrajˇ

sek (2014) and Magud and Sosa (2015, 2017), among others, for firm-level investment.

DELONG LI, NICOLAS E. MAGUD, AND FABIANVALENCIA :615

averagecost of capital would be affected disproportionately. For the real-options chan-

nel (also known as the wait-and-see channel), heightened financial-market volatility

(or uncertainty more generally) would decrease the marginal propensity to invest

(MPI) out of cash flow, resulting from nonconvex adjustment costs to the capital

stock.2The corresponding empirical prediction is that firms’ investment sensitivity

to cash flow should become smaller when uncertainty is higher.

Firm-level data enable us to separately identify these two channels, a task not

feasible with aggregate data. Our identification approach focuses on the differential

responses of investment depending on individual firms’ leverage and cash flow. We

further exploit cross-country heterogeneity to gauge whether the macroeconomic

fundamentals of the countries where firms are located affect the strength of the

aforementioned channels.

Weconduct our empirical investigation in a data set comprising 11,000 nonfinancial

listed firms in 36 emerging markets over 1992–2013.3The empirical framework is a

standard Qmodel of investment augmented with firms’ financial-strength variables,

that is, leverage and cash flow, and U.S. financial shocks. Our baseline shocks focus on

(i) U.S. monetary policy surprises, identified using high-frequency data of Treasury

yields, and (ii) financial-market volatility (or uncertainty),4measured by the VIX

index. Empirical identification of the channels at work is achieved by looking at

interaction terms between firms’ financial variables and U.S. financial shocks. In

doing so, we explore firm-differentialbehavior along the financial strength dimension,

while including a battery of fixed effects to control for other possible factors affecting

investment—thus mitigating the omitted variable bias.

We find that firms with higher leverage reduce investment more in response to

negative U.S. financial shocks than those that are less leveraged, consistent with

the financing channel. We also find that rising financial-market volatility decreases

firms’ MPI, in line with the real-options channel, where the MPI is measured by

the sensitivity of investment to cash flow. We further show that the firms that are

relatively more leveraged are the main driversof the effects of the financing channel.

This is consistent with a view in which credit market frictions are more relevant for

firms that are already highly indebted, thus closer to default. In contrast, we find that

firms with relatively lowleverage are the main drivers of the effects of the real-options

2. The option value of wait-and-see can come from nonconvex capital adjustment cost, such as

(partial) irreversibility and fixed costs. See McDonald and Siegel (1986), Dixit and Pindyck (1994), Abel

and Eberly (1994), Bloom (2000, 2009), Bloom, Bond, and VanReenen (2007), Bloom et al. (2018), and

Magud (2008) for discussions. Gelos and Isgut (2001) document the impact of nonconvex adjustment

costs in emerging markets. Li (2017) presents a structural model of heterogeneous firms incorporating a

real-options channel of uncertainty and its effects on the marginal propensity to invest.

3. Wefocus on listed firms mainly because their behavior accounts for a significant share of emerging

market’s economic activity. The fact that they are big and could have ample financial access does not

undermine the role of financial frictions. Kaplan and Zingales (1997) point out that a wedge between the

cost of capital of internal versus external funds is enough to be regarded as a sign of financial frictions and

that such a wedge could come from sources as common as transaction costs. Another example showing

even listed firms could face financial constraints is the extensiveuse of collateral borrowing, especially in

emerging markets.

4. Both terms, volatility and uncertainty, will be used interchangeably throughout the paper.