Is the Invisible Hand Discerning or Indiscriminate? Investment and Stock Prices in the Aftermath of Capital Account Liberalizations

By Peter B. HenryAnusha Chari
2004| Working Paper No. 1839

We confront the two opposing views of capital account liberalization in developing countries with a new firm-level dataset on investment, stock prices, and sales. In the three-year period following liberalizations, the growth rate of the typical firms capital stock exceeds its pre-liberalization mean by an average of 5.4 percentage points. The return to capital rises in the post-liberalization period, suggesting that the investment boom does not constitute a wasteful binge. In the cross section, changes in investment are significantly correlated with the signals about fundamentals embedded in the stock price changes that occur upon liberalization. Panel data estimations show that a 1-percentage point increase in a firms expected future cash flow predicts a 4.1-percentage point increase in its investment; the country-specific shock to the cost of capital predicts a 2.3-percentage point increase in investment; firm-specific changes in risk premia do not affect investment.

asset pricing
capital budgeting
economic policy
international finance
economic development