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Domestic Credit Freedom, Government Procurement and Firms’ Investment

Firm Investment

Domestic Credit Freedom, Government Procurement and Firms’ Investment

In previous chapters, have discussed why companies are affected by fluctuations in its output and income potential, as well as how a company responds to fluctuations in competition. In this chapter, we discuss the effect between firm financial leveragedness and firm investment. Although it is difficult to quantify, firms with higher levels of financialized assets tend to have higher investment and output. The question is, how does financialization affect the value of an economy? We can look at this from two perspectives: first, the impact on aggregate demand; and second, the impact on firm specific investment decisions.

Our panel data analysis indicates that firms with higher levels of financialization, i.e., higher assets, tend to invest more and produce more in comparison to firms having lower levels of financialization (i.e., lower assets). When the investment decisions of firms is spread across all asset sizes, then firms with higher financialization experience positive effects of their investment decisions on output and income. However, when the decisions of firms is spread across different sizes of asset sizes, then firms with higher financialization experience lower results of their investment decisions on output and income.

To address the above-mentioned issue, we constructed a generalized asset pricing model using the Lagrange consumption model. According to this model, firms with high level of financialization are able to absorb shocks to prices with high quality and return, but not to absorb shocks to prices with lower quality and return. As such, the impact of firm fixed costs is not significant. Thus, we can conclude that while firms with higher levels of financialization are capable of absorbing shocks to investment instruments, they are not capable of absorbing shocks to output and income through the direct effect of their capital and equity investments.

Our analysis further shows that the optimal level of firm investment is determined by both firm characteristics and stock market attributes. The stock market composition of listed firms, which typically comprise of foreign-dominant and -price dominant companies, reduces the efficiency of firm investment. We also observe that the stock market composition of listed firms typically exhibits a negative mean absolute deviation of roughly 3 percentage points, indicating inefficient competition among listed firms. Further, the concentration of ownership is concentrated in a small number of stocks, which reduces the efficiency of efficient pricing.

Moreover, the existence of a stable economy enhances the efficiency of firm investments. When there is a sudden economic crisis, the effects of these crisis periods on firm investments can be devastating. Economic crises tend to cause firms to redirect their resources and activities away from productive uses and toward liquid assets. While liquid assets can be used to finance fixed costs, this process can create short-term imbalances and lead to underutilization of productive capacity. Therefore, governments should take action to prevent the recurrence of economic crisis periods and the associated negative impacts on firm investments before it leads to the emergence of adverse institutional side effects.

Finally, the availability of long-term credit increases firms’ incentives to participate in economic activities. This means that credit facilitates both investment and growth. As long as credit exists, firms will be able to use their credit leverage to invest in productive capacity and earn high returns. On the other hand, the absence of credit constrains firms’ ability to participate in economic activities and increases the risk of capital misallocation. Thus, by encouraging the expansion of economic activity through government procurement of goods and services, the supply of domestic credit can be increased and domestic credit freedom and capital freedom can be improved.