Investment Frictions Research Articles

Accounting for the role of investment frictions in recessions

AbstractOur business cycle accounting exercise reveals that both capital and investment efficiency declines played a prominent role in accounting for the output downturn during the US Great Recession. The evidence indicates that an increase in firms' investment costs may have played a substantial role during the US Great Recession, consistent with business cycle models in which firms face financial frictions. The negligible role played by the total factor productivity decline in accounting for the output downturn during the US Great Recession found by previous works can be explained by the movement in opposite directions of both labour and capital efficiency. However, we find that labour efficiency falling was the main force driving output downturn in the 1982 recession and the euro area Great Recession.

Accounting for the Role of Investment Frictions in Recessions

Accounting for the Role of Investment Frictions in Recessions

Investment Facilitation for Development and the Reform of International Investment Dispute Settlement Mechanism: The Choice of Developing Countries

ABSTRACT The trend of ‘investment facilitation’ is increasingly attracting lively discussions in the field of international investment policies. The reason for this is that countries expect to use ‘investment facilitation’ as a policy tool to improve the domestic investment environment. In this trend, as an important part of the realization path of ‘investment facilitation’, there is an increasing concern on how to reform the international investment dispute settlement mechanism to achieve amicable settlement of investment frictions between investors and host states. China, Brazil and South Africa have proposed three different options for reforming the international investment dispute settlement mechanism under the trend of ‘investment facilitation’. Based on the analysis of the three countries’ dispute settlement mechanism reform models, this article examines their impact on the international investment governance mechanism and finally proposes inspirations for the design and reform of future international investment dispute settlement models in developing countries.

Patterns of Labour Market Adjustment to Trade Shocks with Imperfect Capital Mobility

Abstract We explore how different investment frictions affect the patterns of responses of labour markets to tariff cuts. To investigate these patterns, we formulate a multi-sector dynamic model featuring capital and labour adjustment costs that we fit to Argentine data. Using counterfactual simulations of a tariff decline in the textile sector, we show that capital adjustment can create long-run responses of real wages that are larger than the short-run responses. This happens as textile firms disinvest during the transition. We also show that the reduction of tariffs on capital inputs boosts investment and real wages across sectors.

Gravity, counterparties, and foreign investment

We propose a new explanation for the persistence of gravity in international investment flows based on new facts about large cross-border commercial real estate transactions. Buyers in these transactions preferentially match with counterparties from own or proximate countries; such affinity-based matching helps alleviate financial investment frictions. We set up and structurally estimate a model of capital allocation in a decentralized market with an investment friction, which delivers the price, volume, and counterparty matching patterns in the data. The model shows that if clusters of high-affinity counterparties lie along historical routes, as in the data, preferential matching can perpetuate gravity relationships.

Predicting Bond Returns: 70 Years of International Evidence

We use 70 years of international data from the major bond markets to examine bond return predictability through in-sample and out-of-sample tests. Our results reveal economically strong and statistically significant bond return predictability. This finding is robust over markets and time periods, including 30 years of out-of-sample data, prolonged periods of rising or falling rates, and a dataset of nine additional countries. Furthermore, the results are not explained by market or macroeconomic risks, nor can they be easily attributed to transaction costs or other investment frictions. These results reveal predictable dynamics in government bond returns relevant for academics and practitioners.

Public Entrepreneurial Finance around the Globe

This paper examines how government funding programs geared towards early-stage companies interact with private capital markets. Using hand-collected data on 755 government programs worldwide, we find that governments’ allocations to such funding programs have been comparable to global venture capital disbursements in the past decade. Government programs were more frequent in periods with more private venture activity, a relationship that was stronger in nations with better public governance. The programs’ structures often relied on the local private sector. The private sector’s involvement was greater when government programs targeted earlier-stage companies and when rankings of government effectiveness were higher. We find that such government funding programs increased local innovation, particularly when the programs focused on early-stage ventures or collaborated with the private sector. These findings are most consistent with the explanation that the reliance on private capital markets enabled governments to mitigate investment frictions and improve capital allocation.

Explaining Greenium in a Macro-Finance Integrated Assessment Model

I investigate how firms' environmental responsibilities affect expected stock returns. Using the environmental pillar score from the ASSET4 ESG dataset, I find that greener stocks have lower expected returns. This greenium remains significant after controlling for systemic and idiosyncratic risks. I explain the greenium through event studies showing that green stocks hedge physical climate-change risks. A macro-finance integrated assessment model (MFIAM) featuring time-varying climate damage intensity, recursive preferences, and investment frictions supports the empirical findings. The model implies that climate damages are pro-cyclical, leading to a high discount rate and a relatively low social cost of carbon.

International Cooperation for the Belt and Road Initiative: Key Issues and Future Prospects

Abstract International Cooperation for the Belt and Road Initiative (BRI) is of great significance to China and the other BRI countries. By the end of January 2020, China has signed 200 cooperation documents with 138 countries and 30 international organizations to build the “Belt and Road”. The BRI faces challenges from some Western and ASEAN countries, differences among the Belt and Road Countries, and also global emergency issues. In addition to grave threats to human life, the COVID-19 coronavirus carries serious risks for the global economy. In the implementation process of the BRI, it will inevitably encounter various trade and investment frictions, and it needs a long-term dispute settlement mechanism. In the post-epidemic era, we need to construct top-level design, accelerate further trade cooperation, promote China-ASEAN cooperation, strengthen China-African Cooperation, and jointly fight against the epidemic.

Systematic Financial Intermediation and Business Cycles

Theory suggests that financial intermediation (FI) spurs economic growth by reducing investment frictions. Prior literature focuses on bank lending as a driver of economic growth, with limited success for US GDP. We augment bank balance sheet data with that from shadow banks, mutual and pension funds, insurers, and brokers, finding that aggregate FI assets lead GDP growth and forecast recessions up to three quarters in advance, although the weight of each FI group in the aggregate fluctuates. Aggregated FIs expand their total assets when the slope of the Treasury yield curve is upward sloping and the effective Federal funds rate is higher, thereby revealing the importance of monetary policy in the financial intermediation process. We further show that aggregate FI contains leading information about investment and consumption and predicts industrial production and unemployment.

Dissecting the effectiveness of firm financial strength in predicting Chinese stock market

This paper studies whether the financial strength measure, F-score, can predict returns in the Chinese stock market and its economic explanations. The results suggest that high F-score firms can generate high expected stock returns. Additionally, the predictability of F-score is robust after controlling for common factors in Fama–French models, and other firm characteristics and risks. We find that the premium generated by F-score in Chinese stock market is stronger following higher level of investor sentiment and for firms with higher limits to arbitrage and lower investment frictions, consistent with both the behavioral mispricing and the investment-q asset pricing theories.

The Investment-Return Relation

The q-theory of asset pricing predicts a negative relation between a firm’s investment and its future stock returns, and the negative relation is stronger among firms with higher investment frictions. These predictions arise from each firm’s decision. Therefore, testing it does not require that the amount of investment be in investors’ information set, and skipping between the investment and future stock returns is unnecessary. We document a positive relation between a firm’s investment and its immediate future stock returns. This positive relation, in most empirical specifications, fully subsumes the traditionally documented negative investment-return relation that starts several quarters after investment. After considering immediate future returns, the investment-return relation is more positive among firms with higher investment frictions. These findings challenge the q-theory based interpretation of the investment-return relation.

Limits‐to‐arbitrage, investment frictions, and the investment effect: New evidence

AbstractThis study comprehensively reexamines the debate over behavioral and rational explanations for the investment effect in an updated sample. We closely follow the previous literature and provide several differences. Our tests include five prominent measures of corporate investment and corporate profitability in q‐theory and recent investment‐based asset pricing models. Both classical and Bayesian inferences show that limits‐to‐arbitrage tend to be supported by more evidence than investment frictions for all investment measures. When idiosyncratic volatility and cash flow volatility are used in measuring investment frictions, the inference is more favorable for the rational explanation.

Shock Transmission and the Interaction of Financial and Hiring Frictions

We model the interactions of financial frictions and real frictions, using a DSGE model calibrated for the US economy, with households, banks, firms and wage bargaining. The model features labour and investment frictions, in the form of convex costs, and financial frictions, in the form of credit constraints and the risk of banks diverting their funds. In addition, there are price frictions and habits in consumption. We examine technology, monetary policy, and credit shocks. We look at the response to these shocks of real aggregate variables, financial market variables, and labour market variables. We find that the interactions of real frictions and financial frictions have important implications for the effects of financial shocks on the macroeconomy.

Dissecting the Effectiveness of Firm Financial Strength in Predicting Chinese Stock Market

Our study tries to explore whether the financial strength proxied by F-score can predict the returns in Chinese stock market and its economic explanations. Results show that the financially stronger firms can generate higher expected raw returns and abnormal returns in Fama-French five-factor models. Additionally, predictability of F-score is robust after controlling for other firm characteristics and risks. We find that the F-score effect is stronger for the firms with a higher limits-to-arbitrage and lower investment frictions. Therefore, both behavioral mispricing and investment-based q-theoretical asset pricing models can partially explain the premium generated by F-score in Chinese stock market.

Business Cycle Accounting for India in a Multi-Sector Dynamic General Equilibrium Model

The Indian economy’s remarkable growth experience since the last decade, which continues through today, has been a source of continuous empirical research. While several studies have been conducted in an attempt to explain the underlying triggers, general equilibrium analysis of growth using business cycle accounting is a new technique. The objective of this method is not only to figure out the primitives that have brought about the economic growth in India, but the channels through which these primitives were transmitted. This question is relevant since the liberalization policies in the decade of eighties and nineties are thought of as catalysts to growth. But did the policies affect productivity or did they reduce labor market frictions or did they lower investment friction in the economy? This paper provides answer to these questions by modeling the frictions as wedges or divergence from first-best conditions and feeding them in various combinations to see which of them can replicate data. The results indicate that primitives affected the Indian economy through productivity channels in all sectors, especially the service sector. Labor market frictions, investment frictions and government expenditures have limited role to play in enhancing growth. The multi-sector framework enriches the single sector analysis done before, by reflecting the sector where the impact of productivity has been the highest. Additionally, I look at the long-term “trend” component of growth and come to the same conclusion as that in the business cycle accounting exercise - the service sector productivity has been the primary transmission channel. The results obtained here emphasize the importance of the service sector productivity from a policy standpoint. Overall economic growth of the Indian economy has been propelled by the service sector and hence policies tailored towards enhancing the productivity of this particular sector are of immense importance.

Limits-to-arbitrage, investment frictions, and innovation anomalies

This paper examines whether the limits-to-arbitrage and investment frictions hypotheses explain the research and development (R&D) premium. We find that the R&D premium is stronger for stocks that are hard to arbitrage and for stocks with investment frictions. The limits-to-arbitrage explanation explains more of the R&D premium than does the investment frictions explanation. Our results hold under the two-way sorts on limits-to-arbitrage and investment frictions measures. We also examine the impact of limits-to-arbitrage and investment frictions on innovation efficiency and R&D ability. We find that the limits-to-arbitrage and investment frictions are equally effective in explaining the two new innovation anomalies.

How Do Frictions Affect Corporate Investment? A Structural Approach

This paper provides a structural approach to testing investment equations based on the log-likelihood function of a nonlinear investment rule. The analysis integrates the predictions of theq-theory for the commonly studied active region of investment and provides new inferences on how real and financing frictions affect the probability that a firm invests. The empirical findings are consistent with the macro-finance literature suggesting thatq-theory models with nonconvex investment frictions better explain the data. I also find that both real and financing costs of investment are related to the capital intensity of the industry in which firms operate.

Asset Prices and Optimal Monetary Policy

We construct a New Keynesian DSGE model that features financial frictions, investment frictions, long-run productivity risk and Epstein-Zin preferences. The model successfully reproduces key features of both asset prices and macroeconomic quantities such as consumption, investment, and output. Under this set up, we examine the implications of different monetary policy rules where the central bank responds to inflation, output and asset prices in the presence of productivity shocks, monetary policy shocks and financial shocks. This paper contributes to the current debate on how central bankers ought to respond to asset price volatility, in the context of an overall strategy for monetary policy.

The Dynamics of Tobin’sQ

In this article, I propose a general-equilibrium model with proportional adjustment costs and industry-specific capital to study the firm migration phenomenon across market-to-book ratio. In my model, investors’ desire to diversify their portfolios and investment frictions generate a mean-reverting dynamics of Tobin’s q consistent with the probabilities of migration found in the data, and a non-linear pattern in the conditional volatility of Tobin’s q. In addition, since firms’ market-to-book ratios are function of the state of the economy and contain information about stock returns, stock prices inherit these properties, yielding asset-pricing implications in line with the empirical evidence, namely the value premium and a non-monotone relationship between the volatility of stock returns and the Tobin’s q.