New Research: Policy Uncertainty and the Cost of Capital

New Research: Policy Uncertainty and the Cost of Capital

Policy uncertainty can impose economic costs independent of the character of the expected regulation. As long as there is uncertainty about the future regulatory environment, the costs of raising capital for business enterprises will increase to reflect this risk.

A new study from the Journal of Financial Stability determines the costs of this policy uncertainty:

We examine the effect of economic policy uncertainty on the relation between investment and the cost of capital. Using the news-based index developed by Baker, Bloom, and Davis (2016) for twenty-one countries, we find that the strength of the negative relation between investment and the cost of capital decreases during times of high economic policy uncertainty. An increase in policy uncertainty reduces the sensitivity of investment to the cost of capital most for firms operating in industries that depend strongly on government subsidies and government consumption as well as in countries with high state ownership. Consistent with the price informativeness channel, we find that an increase in policy uncertainty reduces the investment-cost of capital sensitivity for firms from more opaque countries, firms with low analyst coverage, firms with no credit rating, and small firms. We conclude that economic policy uncertainty distorts the fundamental relation between investment and the cost of capital.

The relationship between uncertainty and investment is intuitive: if a firm cannot be certain what it will have to pay in the future to comply with unknown regulations, it will be more hesitant to invest, lest new regulations reduce the potential returns.

Of course, there are countless other factors related to market conditions that influence a firm’s decision to invest. One of the best features of the market system is the ability to turn specific, local information into something that can be more broadly understood in the marketplace in the form of prices. Unfortunately, policy uncertainty, in addition to reducing the likelihood of investment, makes firm activity less sensitive to these price signals (namely the cost of capital) and other business conditions.

Policy uncertainty “makes investors less informed, and leads to stock prices containing less private information. As a result, managers will be less willing to base their investment decisions on the information contained in stock prices during times of high policy uncertainty. Stock prices also become noisier, and managers become more informed relative to outside shareholders. We therefore expect the sensitivity of investment to stock prices to be lower during periods of high policy uncertainty.”

So, not only does increased policy uncertainty make prices less reflective of market conditions, but it also reduces the ability of investors to make informed investment decisions relative to insiders, like managers.

The study found that, in the face of uncertainty, firms generally delay investment for up to five quarters, after which firms make up for lost time by increasing investment again. Additionally, the effects of policy uncertainty were greater in industries more dependent on government subsidies or consumption, and in countries with higher degrees of state ownership.

These results imply that a regulatory regime based on straightforward, well-designed, and consistently applied rules, rather than one reliant on command-and-control style regulations from a web of government bureaus, would better preserve the benefits of the price system.

I didn't find this helpful.This was helpful. Please let us know if you found this article helpful.
By |2018-11-13T12:19:51-08:00November 13th, 2018|Blog, Financial Regulation|