Foreign Risk, Domestic Problem: Capital Allocation and Firm Performance Under Political Instability
Burcin Col, Art Durnev, Alexander Molchanov
Management Science · 2018 · Volume 64 · Issue 5
Abstract
We argue in this paper that firms with foreign operations misallocate capital and underperform when they face political instability abroad. We develop and test a dynamic model of firm capital allocation under foreign political instability. The model shows that as a political regime becomes less stable, independent of whether the regime becomes less business-friendly or more business-friendly, firms invest suboptimally (i.e., they either overinvest or underinvest), and their marginal q ’s diverge further from an optimal level. Using elections and textual analysis of local media during national elections, we construct a novel index of political instability. We find that U.S. firms and industries with a greater exposure to election-induced political instability experience disruptions of investment efficiency that lead to lower valuations and lower total factor productivity. Therefore, international trade is a significant conduit of foreign political instability into U.S. markets. The online appendix is available at https://doi.org/10.1287/mnsc.2016.2638 . This paper was accepted by Gustavo Manso, finance .
Keywords
political instability, foreign operations, investment efficiency
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