Foreign risk, domestic problem: capital allocation and firm performance under political instability

Abstract

We argue in this paper that firms with foreign operations misallocate capital and underperform when they face political instability abroad. We develop and test a dynamic model of firm capital allocation under foreign political instability. The model shows that as a political regime becomes less stable, independent of whether the regime becomes less business-friendly or more business-friendly, firms invest suboptimally (i.e., they either overinvest or underinvest), and their marginal q's diverge further from an optimal level. Using elections and textual analysis of local media during national elections, we construct a novel index of political instability. We find that U.S. firms and industries with a greater exposure to election-induced political instability experience disruptions of investment efficiency that lead to lower valuations and lower total factor productivity. Therefore, international trade is a significant conduit of foreign political instability into U.S. markets.