Foreign Risk - Domestic Problem: Capital Allocation and Performance under Political Instability

49 Pages Posted: 11 May 2012 Last revised: 9 Aug 2016

Burcin Col

Pace University-Lubin School of Business

Art Durnev

University of Iowa - Henry B. Tippie College of Business

Alexander Molchanov

Massey University

Multiple version iconThere are 2 versions of this paper

Date Written: August 08, 2016

Abstract

We argue 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, independently of whether the regime becomes less business-friendly or more business-friendly, firms invest sub-optimally (firms either over-invest or under-invest), and their marginal qs 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 which lead to lower valuations and lower Total Factor Productivity. Therefore, international trade is a significant conduit of foreign political instability into U.S. markets.

Keywords: Capital Allocation, Political Risk, International Trade

JEL Classification: F10, G32

Suggested Citation

Col, Burcin and Durnev, Art and Molchanov, Alexander, Foreign Risk - Domestic Problem: Capital Allocation and Performance under Political Instability (August 08, 2016). Available at SSRN: https://ssrn.com/abstract=2056114 or http://dx.doi.org/10.2139/ssrn.2056114

Burcin Col

Pace University-Lubin School of Business ( email )

One Pace Plaza
New York, NY 100038
United States

Artyom Durnev (Contact Author)

University of Iowa - Henry B. Tippie College of Business ( email )

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Iowa City, IA 52242-1000
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HOME PAGE: http://www.artdurnev.com

Alexander Molchanov

Massey University ( email )

Auckland
New Zealand

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