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

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