Investment in emerging markets: We’re not in Kansas anymore … or are we?

Nicolas Magud, Sebastián Sosa 13 May 2015



Emerging market economies exhibited strong investment growth from 2003 to 2011, interrupted – temporarily – in 2009 by the Global Crisis (see Figure 1). However, after peaking in 2011 investment growth has waned in most of these economies. Real output growth forecasts have been revised down significantly due to lower than projected actual investment (IMF 2014a, IMF 2014b). To explain this weakness in investment, we need to answer a number of questions:

  • What is the role of external factors?
  • Is the slowdown a generalised phenomenon across emerging markets?
  • Can recent investment trends be explained by the standard determinants?
  • How concerned should policymakers be about the recent investment disappointment?

Figure 1. Real private investment growth

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 emerging markets, putting the recent slowdown in historical perspective. We then estimate1 the determinants of investment, combining firm level data for about 16,000 listed firms with country-specific macroeconomic variables –particularly commodity export prices and capital inflows – for 38 emerging markets between 1990–2013. After identifying the key factors driving firms’ investment decisions in emerging markets, we shed light on which of these factors have been the main drivers of the recent investment weakness.

Stylised facts from our model show that although investment in emerging markets has weakened in the last few years, it has come down from cyclical highs and remains broadly at pre-crisis levels (Figure 2). Although investment-to-output ratios have flattened or declined moderately, they remain close to or above historical averages for most emerging markets (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

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

Our results suggest that:

  • We’re dealing with the usual suspects – emerging market firms’ capital expenditure is positively associated with expected profitability,2 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;3
  • Foreign financing and relaxation of financial constraints also matter – investment by emerging market 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.4

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

Source: IMF staff calculations.

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.

Who’s to blame?

The sharp decline in commodity export prices – especially in Latin America and the Caribbean – and the lower expected profitability of firms (which partly reflects the downward revisions to potential growth in many emerging markets) have been important factors behind the recent deceleration in investment (Figure 5). A moderation in capital inflows to emerging markets and increased leverage (particularly in Asia) have also played a significant role.

Figure 5. Contributions to the recent investment slowdown

Source: Magud and Sosa (2015).
1 Relative contribution of each factor to the 2011-13 investment slowdown.

Investment and potential output growth

Why does this matter? Examining the determinants of private investment is certainly important in understanding business cycle fluctuations in emerging markets. 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 moment given that most emerging markets have been experiencing significant downward revisions to potential growth. Identifying the main drivers of the recent slowdown in investment is also relevant for policymakers in emerging markets because it helps them assess the likely effectiveness of alternative measures for fostering private investment and boost potential growth.

Our work contributes to the extensive empirical literature on the determinants of corporate investment in emerging markets. In particular, our work 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 (e.g. Gilchrist and Himmelberg 1995, Fazzari et al. 1988 for studies on US manufacturing firms; e.g. Love and Zicchino 2006 for a study on emerging market companies). The study most closely linked to ours is Harrison et al. 2004, which documents that foreign direct investment 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 emerging market 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 emerging markets is not an outright slump but rather the slowdown after a boom. However, policymakers should not be complacent. 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 emerging markets are likely to moderate further, and external financial conditions are set to become tighter (in part because of the impact of the normalisation of US monetary policy). The recent declines in potential growth estimates for most emerging markets are also likely to be a drag on investment in the future. Investment ratios are still relatively low in some emerging market regions, particularly in Latin America and the Caribbean. Thus boosting private investment should remain a policy priority.

In light of our results on the size and persistence of financing constraints, especially for smaller firms, business investment in emerging markets would benefit from further deepening the domestic financial system, 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 emerging markets efforts to improve infrastructure and human capital, strengthen the business climate, and foster competition are key priorities.


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

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

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

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

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

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

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

Love, I and L Zicchino (2006), “Financial development and dynamic investment behavior: Evidence from panel VAR”, The Quarterly Review of Economics and Finance 46(2): 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.


1 Using an expanded Q-theory of investment model in panel regressions with the firm-level data.

2. Proxied by Tobin’s Q.

3. 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.

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



Topics:  Development International finance Macroeconomic policy

Tags:  emerging markets, foreign direct investment, FDI, investment

Senior Economist at the International Monetary Fund

Senior Economist in the European Department, IMF


CEPR Policy Research