Political Uncertainty, FDI, and Trade In Intermediate Goods: Evidence From Ukrainian Firms

Abstract

In this paper, we introduce a new method to measure uncertainty using quantitative text analysis and explore the effects of uncertainty on firm performance. We extend a theoretical model with heterogeneous firms and sunk investments to derive hypotheses about the impact of trade policy uncertainty (TPU) on firm-specific investment and firm’s decision to trade intermediate goods. We look at Ukraine’s trade relations with EU and Russia to measure TPU and to test our predictions. Ukrainian firms faced considerable uncertainty with regards to two mutually exclusive trade policies: the conclusion of a free trade agreement with the European Union (EU FTA) or a customs union with Russia (RU CU). Using firm-product level data of Ukrainian manufacturing firms between 2003 and 2013, we find a substantive increase in firm level FDI inflows and imported intermediate goods from EU countries and a decrease in FDI from the Customs Union, once uncertainty with regards to the EU FTA is reduced. Moreover, more protected goods respond stronger to a reduction in TPU. The novel measure of uncertainty can be easily applied to other cases where governments face multiple mutually exclusive policy options.