Policy Uncertainty and Private Investment in Developing Countries

Abstract

A resurgence in private investment is a necessary ingredient of a sustainable recovery in heavily-indebted developing countries. Policy reforms in these countries involve a serious dilemma, especially when they include structural and microeconomic features. On the one hand, entrepreneurs, workers, and farmers must respond to the signals generated by the reform for the new policies to be successful. On the other hand, rational behavior by the private sector calls for withholding investment until much of the residual uncertainty regarding the eventual success of the reform is eliminated. This paper shows that even moderate amounts of policy uncertainty can act as a hefty tax on investment, and that otherwise sensible reforms may prove damaging if they induce doubts as to their permanence. A simple model is developed to link policy uncertainty to the private investment response.