The idea that beliefs can have a significant impact on investment spending is of course a very old one, vividly captured by Keynes' allusion to "animal spirits. "Box 1.4.1 explains how risk and uncertainty may influence investment. An individual investor faces many potential sources of uncertainty and risk: the macroeconomic outlook; the policy and regulatory environment; and the "institutional arrangements" that protect people, secure property rights, and determine the overall quality of governance. In addition, foreign investors may be concerned about transfer risks, expropriation, and other factors.
The crisis bequeathed numerous policy and institutional changes (Rocha 2007). New governments came to power in Indonesia, Korea, Philippines (a bit later), and Thailand. Macroeconomic policies were recalibrated; currencies became more flexible and most central banks refocused their sights on inflation. Steps were taken to strengthen financial sectors, and to improve regulation and competition, including allowing greater foreign equity in sectors that had hitherto been off limits. And a raft of institutional changes followed, including new laws, the creation of new organizations intended to improve oversight and regulation, and shifts in the boundaries of decision making (e.g., decentralization). Regionalism acquired fresh impetus and initiatives sprang up to fortify common, regional-level financial defenses; accelerate the development of regional capital markets; and improve economic monitoring, transparency, and information sharing.
1.4.1 Risk, uncertainty, and investment
A risk normally refers to a hazard that leads to loss. In economics, the term "risk" is sometimes also used to refer to chance occurrences that result in gain (so-called "upside risks"). Risks can be assigned a probability of their occurrence. Since risks are predictable, they can be managed. By contrast, uncertainty refers to states that are unpredictable or indeterminate and that may lie outside the realm of experience. It is not possible to assign a probability to something that is uncertain, or to manage uncertainty, or even to prepare for it.
While the distinction between risk and uncertainty is important, it is seldom retained in empirical research where risk and uncertainty are treated synonymously and are equated with statistical measures of volatility. Broadly, that is the approach followed here.
The economics of investment decisions in conditions of uncertainty suggests that an increase in the level of uncertainty may either increase or decrease the level of investment. An increase in economic uncertainty may raise the chances of a favorable outcome and trigger a positive investment decision. But this theoretical result is much less likely where firms cannot easily reverse investment decisions or where they face fixed costs-see e.g., Harris, Nguyen, and Scaramozzino (2006). These circumstances are typical of developing countries where financial and asset markets are less developed.
When investment decisions cannot be easily reversed, increased uncertainty may create a benefit to waiting, as waiting should allow a clearer picture of likely outcomes. As a consequence, investments may be delayed or canceled.
The empirical evidence on the impact of uncertainty on investment suggests that the effects are usually negative (Asteriou and Price 2005; Lensink, Bo, and Sterken 1999; and Ramey and Ramey 1995). These and other studies are based on aggregate data using cross-country panels and concentrate on risks in the economic environment.
In a path-breaking study, Brunetti and Weder (1997) looked at a variety of measures of institutional uncertainty and traced impacts on investment. Looking at information for over 60 countries, they found that the rule of law, corruption, and real exchange rate volatility have significant effects on total investment spending. Alesina and Perotti (1996) had earlier found that social and political instability had a negative effect on investment.
Micro-level evidence is more difficult to come by. But in a recent study, Harris, Nguyen, and Scaramozzino (2006) examine the impact of uncertainty on the investment behavior of Thai firms over the period 1994-2002. They measure uncertainty using historical information on the volatility of firms' own stock prices, and find that heightened uncertainty reduces investment (having controlled for other possible influences), but that this effect is modulated when investment decisions are reversible.
But the crisis also taught private investors hard lessons about the consequences of discounting risks. Bankruptcies and widespread financial distress followed the crisis. Having been caught badly off guard once, investors are now possibly much more cautious than before. Indeed, new institutional arrangements may themselves have added to uncertainty. Even positive changes have adjustment costs and institutional changes are often slow. Moreover, the removal of implicit and explicit guarantees and subsidies increased competitive pressures, and weakening insider control may have increased risks for some.
In the public sector, the crisis was a sharp reminder of the importance of matching institutional progress and capabilities (particularly in the financial world) with expansion of the real sector. As a consequence, policy makers' aspirations have now been lowered with sights set on growth rates that are more modest than those touted before the crisis. A sharp accumulation of foreign exchange reserves is another indicator of a heightened sense of caution.
Trying to measure these effects with any sense of precision and to disentangle their impacts on behavior is not possible. But information on macroeconomic forecasts, equity prices, corporate balance sheets, country risk assessments, and measures of the quality of country governance may signal how moods have changed. Although such evidence is largely circumstantial, and perceptions can diverge from reality, these data may nevertheless suggest important changes in the background conditions that affect economic activity. While micro-survey data for risks and business conditions are also now available, they do not go back to before the crisis (Box 1.4.2).
1.4.2 Microbusiness data
The Global Competitiveness Report 2006-2007 (World Economic Forum 2006), the Doing Business surveys (World Bank various years), and the Investment Climate reports (World Bank various years) provide a rich seam of information about the institutional and regulatory environments within which businesses operate.
Although the Global Competitiveness Reports go back to the 1990s, the information they provide is not readily comparable over long periods as samples and questions change. The Doing Business and Investment Climate reports both postdate the crisis, and so do not provide a benchmark with which to compare recent performance. The Global Competitiveness Reports and the Doing Business surveys rely on expert opinions and views, whereas the Investment Climate reports draw on large sample surveys of businesses.
The crisis countries fall into two broad categories when seen through the optic of these large international surveys. Korea, Malaysia, and Thailand tend to compare favorably on many indicators; Indonesia and the Philippines tend to lag.
In the Doing Business surveys, Korea, Malaysia, and Thailand rank in the top 30 countries in the world, with Indonesia and the Philippines trailing at ranks 135 and 126 (out of 175 countries), respectively.
In the most recent Global Competitiveness Report, Korea ranks 24, Malaysia 26, and Thailand 35. Indonesia ranks number 50 and the Philippines is number 71 out of 125 countries.
While there is broad agreement in the surveys about Korea, Malaysia, and Thailand, the differences in (percentile) ranks for Indonesia and the Philippines are quite large. This may reflect differences in the objectives and scope of the surveys, with the Doing Business results focusing on a narrower range of quantitative indicators that are directly related to the costs of starting and operating a business. By contrast, the Global Competitiveness Report covers a wide array of indicators, including measures of governance, social achievements and capabilities, institutions, and the environment.
Investment Climate reports are available for Indonesia, Malaysia, Philippines, and Thailand (but not Korea). These were completed in 2004 and 2005. Each report is based on survey information collected from firms, which is analyzed with a view to identifying impediments to investment. Judged from an international perspective, Malaysia and Thailand offer comparatively hospitable conditions for business, showing little hint of the convulsions they experienced during the crisis.
On the other hand, Indonesia and the Philippines compare unfavorably and are perceived to have weaknesses across the board. These results are certainly interesting, but as snapshots they do not allow a judgment about the underlying dynamics.
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