Investment in Emerging Markets: We are not in Kansas anymore…Or are we?

Financial Economics
Macroeconomics - Economic growth - Monetary Policy

We document that (i) although private investment growth in emerging markets has decelerated in recent years, it came down from cyclical highs and remains close to pre-crisis trends; and (ii) investment-to-output ratios generally remain close to or above historical averages. We show that investment is positively related to expect future profitability, cash flows and debt flows, and negatively associated with leverage. Critically, it is also positively related to (country-specific) commodity export prices and capital inflows. The latter help relax firms’ financial constraints, which tend to be tighter for smaller firms and those less integrated to international financial markets. Lower commodity export prices and expected profitability, a moderation in capital inflows, and increased firm leverage account for the bulk of the recent investment deceleration. Looking forward, prospects for a recovery of business investment are not promising.

Emerging market economies (EMs) exhibited strong investment growth in 2003–11, interrupted only temporarily in 2009 owing to the impact of the global financial crisis (Figure 1). After peaking in 2011, however, investment growth has waned in most of these economies. Furthermore, real output growth forecasts have been revised down significantly, to a large extent owing to the lower than projected actual investment (IMF 2014a, IMF 2014b). But, what explains this weakness in investment? What is the role of external factors? Is the slowdown a generalized phenomenon across EMs? Moreover, can recent investment trends be explained by the standard determinants? How concerned should policy makers be about the recent investment disappointment? 

Figure 1. Real Private Investment Growth
(Percent change)​

Sources: IMF, World Economic Outlook; and IMF staff calculations.
Note: LAC=Latin America and the Caribbean; EUR=Emerging Europe; CIS=Commonwealth of Independent States.1 PPP-weighted average.

In Magud and Sosa (2015), we address these questions by first identifying and documenting key trends in private investment across EMs, putting the recent slowdown in historical perspective. Then, we study the determinants of investment using an expanded Q-theory of investment model in panel regressions that combine firm level data for about 16,000 listed firms with country-specific macroeconomic variables—particularly commodity export prices and capital inflows—for 38 EMs over the period 1990–2013. After identifying the key factors driving firms’ investment decisions in EMs, we shed light on which of these factors have been the main drivers of the recent investment weakness.

The stylized facts show that although investment in EMs has weakened in the last few years, it came down from cyclical highs and remains broadly at pre-crisis levels (Figure 2). And although investment-to-output ratios have flattened or declined moderately, they remain close to or above historical averages for most EMs (Figure 3). 

Figure 2. Real private investment

Sources: IMF, World Economic Outlook; and IMF staff calculations.
Note: LAC=Latin America and the Caribbean; EUR=Europe; CIS=Commonwealth of Independent States.1 PPP-weighted average.

Figure 3. Real private investment, 1980-2014
(Percent of real GDP)

Sources: IMF, World Economic Outlook; and IMF staff calculations.1 PPP-weighted average per region. Simple average per decade.

The main results from the panel regressions can be summarized as follows:

  • The usual suspects: EM firms’ capital expenditure is positively associated with expected profitability (proxied by Tobin’s Q), cash flows (suggesting the existence of borrowing constraints), and debt flows. It is negatively associated with leverage.
  • Commodities matter: Investment is positively associated with changes in (country-specific) commodity export prices.1
  • Foreign financing and relaxation of financial constraints: Investment by EM firms is positively influenced by the availability of foreign (international) financing. Moreover, capital inflows help relax firms’ financial constraints, with the sensitivity of investment to cash flow weakening as capital inflows increase. This effect is particularly strong for non-tradable sector firms.The results are not only statistically significant but also economically significant. Figure 4 illustrates the estimated effect on the investment-to-capital ratio of a one standard deviation shock to each of the main variables in the baseline specification.2

Figure 4. Investment-capital ratio response to a one standard deviation shock

Source: IMF staff calculations.

  •  After the boom: Firms’ investment has not been abnormally weak in the past three years, at least not above and beyond what can be explained by the evolution of its main determinants mentioned above.
  • Who to blame? The sharp decline in commodity export prices (especially in Latin America and the Caribbean, LAC) and the lower expected profitability of firms (which partly reflects the downward revisions to potential growth in many EMs) have been important factors behind the recent deceleration of investment (Figure 5). A moderation in capital inflows to EMs and increased leverage (particularly in Asia) have also played a significant role.

Figure 5. Contributions to the recent investment slowdown

Why does this matter? Examining the determinants of private investment is important to understand business cycle fluctuations in EMs. But the topic is also relevant because capital accumulation is a key driver of potential output growth. The latter is of particular interest at the current juncture given that most EMs have been experiencing significant downward revisions to potential growth. Moreover, identifying the main drivers of the recent slowdown in investment is relevant for policy makers in EMs to the extent that it helps assessing the likely effectiveness of alternative measures to foster private investment and boost potential growth.

Our work is related to the extensive empirical literature on the determinants of corporate investment in EMs. In particular, it relates to a strand that studies financing constraints, typically relying on Tobin’s Q investment models or Euler investment equations. Most of these studies have documented the importance of internal financing for firms’ investment owing to capital markets imperfections (see, for example, Gilchrist and Himmelberg 1995, Fazzari and others 1988 for a study on U.S. manufacturing firms, and Love and Zicchino 2006 for emerging market companies). The study most closely linked to ours is Harrison and others 2004, which documents that foreign direct investment (FDI) flows to emerging markets are associated with a reduction in firms’ financing constraints. Like us, they examine whether—and to what extent—the availability of foreign capital helps relaxing financing constraints in EM firms by combining firm-level data on cash flows with country-specific capital flows. Forbes 2007 and Gelos and Werner 2002 also find that the latter relax when capital account restrictions are eased.

Policy implications

The private investment weakening in EMs has not represented a slump, but rather a slowdown after a period of boom. Yet, policymakers should not be complacent. First, prospects for a recovery of business investment are not promising, as the outlook for most of its determinants is generally dim. Commodity prices are expected to remain weak, capital inflows to EMs are likely to moderate further, and external financial conditions are set to become tighter, including because of the impact of the normalization of the U.S. monetary policy. The recent declines in potential growth estimates for most EMs are also likely be a drag on investment going forward. Moreover, investment ratios are still relatively low in some EM regions, particularly in LAC, so boosting private investment remains a policy priority.

In light of our results on the size and persistence of financing constraints, especially for smaller firms, business investment in EMs would benefit from further deepening domestic financial systems, strengthening capital market development, and promoting access to finance—of course, subject to sufficient safeguards to ensure financial stability. Strengthening financial infrastructure and legal frameworks, and enhancing capital market access to funding for small and mid-sized firms would be positive measures.

More generally, and beyond the scope of our study, structural reforms to boost productivity could help unlocking private investment and output growth. The design of a policy agenda of structural reforms is a difficult task and entails country-specific considerations, but in many EMs efforts to improve infrastructure and human capital, strengthen the business climate, and foster competition are key priorities.

This piece appeared originally in on May 13, 2015.

1. Before running regressions, Magud and Sosa (2015) show that the correlation of private investment growth and commodity export price growth is 0.84 in Latin America and in the Commonwealth of Independent States, 0.82 for Emerging Europe, and 0.36 in Emerging Asia—where it has decreased more recently in the latter.

2. Notice that commodity export prices are, by far, the variables with the largest standard deviation.


Fazzari, S., G. Hubbard, and B. Petersen (1998), “Financing Constraints and Corporate Investment,” Brooking Papers on Economic Activity, 1:1998, pp. 141-195.

Forbes. K. (2007), “The Microeconomic Evidence on Capital Controls: No Free Lunch,” in Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences, Sebastian Edwards (editor), University of Chicago: University of Chicago Press for the National Bureau of Economic Research pp. 171–199.

Gelos, G. and A. Werner (2002), “Financial Liberalization, Credit Constraints, and Collateral: Investment in the Mexican Manufacturing Sector,” Journal of Development Economics Vol. 67, pp. 1-62.

Gilchrist, S. and C. Himmelberg (1995), “Evidence on the Role of Cash Flow for Investment,” Journal of Monetary Economics, 36, pp. 541-572.

Harrison, A., I. Love, and M. McMillan (2004), “Global Capital Flows and Financing Constraints,” Journal of Development Economics 75, pp. 269–301.

International Monetary Fund (2014a), World Economic Outlook, October 2014.

International Monetary Fund (2014b), Regional Economic Outlook—Western Hemisphere, October 2014.

Love, Inessa, and Lea Zicchino (2006), “Financial development and dynamic investment behavior: Evidence from panel VAR,” The Quarterly Review of Economics and Finance, Vol. 46, No. 2, pp. 190–210.

Magud, N. and S. Sosa (2015), Investment in Emerging Markets: We are not in Kansas any More…Or are We?,” IMF working Paper No. 15/77, International Monetary Fund, Washington.

Share this