Capital Account Liberalization, Investment, and the Invisible Hand

Using a new dataset of 369 manufacturing firms in developing countries, we present the first firm-level analysis of capital account liberalization and investment. In the three-year period following liberalizations, the growth rate of the typical firm’s capital stock exceeds its preliberalization mean by an average of 4.1 to 5.4 percentage points per year. We use a simple model of Tobin’s q to decompose the firms’ post-liberalization changes in investment into: (1) the country-specific change in the risk-free rate; (2) firm-specific changes in equity premia; and (3) firm-specific changes in expected future earnings. Panel data estimations show that an increase in expected future earnings of 1 percentage point predicts a 2.9 to 4.1 percentage point per-year increase in capital stock growth. The country-specific shock to firms’ cost of capital predicts a 2.3 percentage point per-year increase in investment, but firm-specific changes in risk premia are not significant. The results stand in contrast to the view that investment and fundamentals are unrelated during liberalization episodes. University of Michigan Business School; 701 Tappan Street, Ann Arbor, MI 48109-1234. **Stanford University, Graduate School of Business; Stanford, CA 94305-5015; [email protected]. Henry gratefully acknowledges the financial support of an NSF CAREER award and the Stanford Institute of Economic Policy Research (SIEPR). We thank Jack Glenn for providing us with data. For helpful comments we thank Steve Buser, Paul Romer, Antoinette Schoar and seminar participants at the AEA, LACEA, Michigan, Stanford, and the World Bank. Any remaining errors are our own. Introduction Broadly speaking, there are two views of capital account liberalization and the invisible hand. The first view sees the invisible hand as discerning. Removing restrictions on international capital movements permits financial resources to flow from capital-abundant countries, where expected returns are low, to capital-scarce countries, where expected returns are high. The flow of resources into the capital-scarce countries reduces their cost of capital, increases investment, and raises output (Fischer, 2003; Obstfeld, 1998; Rogoff, 1999; Summers, 2000). The second view sees the first as unsubstantiated and regards the invisible hand as indiscriminate. Indiscriminate hand proponents argue that liberalization does not produce a more efficient international allocation of capital. Instead, liberalizations generate speculative capital flows that are divorced from the fundamentals and have no discernible positive effects on investment, output, or any other real variable with nontrivial welfare implications (Bhagwhati, 1998; Stiglitz 1999, 2002). While opinions about capital account liberalization are abundant, facts are scarce (Fischer, 1998). This paper attempts to increase the ratio of facts to opinions. It does so by confronting the two views of liberalization with a new data set on investment, sales, and stock prices for 369 firms in a sample of developing countries that liberalized their stock markets— opened them to foreign investment—during the late 1980s and early 1990s. Stock market liberalization may seem like a narrow way of defining capital account liberalization relative to the broad indices of capital account openness that are widely used in the literature. But there are several reasons why stock market liberalizations may be better suited to estimating the effects of capital account liberalization on investment. First, broad indices change