Trade and Investment under Policy Uncertainty: Theory and Firm Evidence

By Kyle Handley, N. Limão. World Scientific Studies in International Economics, 2015

632 citations recorded by the source corpus.

We provide theoretical and empirical evidence that policy uncertainty can significantly affect firm level investment and entry decisions in the context of international trade. When market entry costs are sunk, policy uncertainty can create a real option value of waiting to enter foreign markets until conditions improve or uncertainty is resolved. Using a dynamic, heterogeneous firms model we show that: (i) investment and entry into export markets is reduced when trade policy is uncertain, and (ii) preferential trade agreements (PTAs) are valuable to exporters even if applied trade barriers are currently low or zero. We derive a structural equation that predicts how firm entry responds to changes in applied tariffs and a theory-based measure of policy uncertainty. Our novel approach using observable trade policies allows us to estimate the impact of policy uncertainty and quantify its aggregate implications. We apply this method to Portugal's accession to the European Community in 1986 using new firm-level trade data. We find that (i) the trade policy reform accounted for a large fraction of the observed Portuguese exporting firms' entry and sales upon accession (ii) the accession removed uncertainty about future preferences and (iii) this uncertainty channel accounted for a large fraction of the predicted growth. These results have broader implications for other PTAs and our approach can be applied to analyze other sources of policy uncertainty.

Subfields: Economics and Econometrics

View Paper: https://www.semanticscholar.org/paper/d4b98be02b7ed7a6de3490822237ffdc4bdbcb82

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Citations in the corpus

Economic Policy Uncertainty Spillovers in Booms and Busts (2019, neutral): “…or uncertainty to be relevant for the open economies they model. sc This ﬁnding is corroborated by Born, Mller, and Pfeifer (2013), Handley (2014) and Handley and Lim˜ao (2015, 2017), whose focus is on the link between policy uncertainty, trade, and real activity. u Turning to time series…”
Policy Uncertainty, Trade, and Welfare: Theory and Evidence for China and the United States (2017, background): “In doing so we extend the partial equilibrium framework from Handley and Limão, 2012 (HL) in two important ways. First, we allow rms to not only make sunk cost investments to enter foreign markets (as in HL) but also to upgrade their technology (to one with lower marginal cost). The model then pred”
Policy uncertainty, derivatives use, and firm-level FDI (2017, background): “Handley and Limao (2012) find that trade policy uncertainty delays firm entry, and Gulen and Ion (2015) find negative responses of corporate investment to the EPU index.”
Economic policy uncertainty (EPU) and firm carbon emissions: Evidence using a China provincial EPU index (2020, background): “Handley and Limão (2015) theoretically and empirically demonstrated ou r na e p r oo Journal Pre-proof that firms’ investment and exports are damaged by trade policy uncertainty.”
Trade and Uncertainty (2014, methodology): “We build on Hassler’s (1996) setting of investment under uncertainty to construct a model of trade in intermediate goods.”
Firms in international trade (2016, background): “For example, Handley and Limao (2015) find that firm behavior changes significantly in the presence of policy uncertainty and firms may choose to delay entering a foreign market until conditions improve.”
Policy Uncertainty in Japan (2017, neutral): “The political uncertainty measure from Ito (2016) reflects the relative approval ratings of ruling and opposition parties. The Global EPU index from Davis (2016) is the GDP-weighted average of newspaper-based EPU indices for 21 countries.”
Policy uncertainty and aggregate fluctuations (2018, neutral): “Using (cid:133)rm-level data, Julio and Yook (2010) report that the timing of national elections has a dampening e⁄ect on corporate investment while Handley and Limao (2012) assess the impact of uncertainty about trade policies on (cid:133)rms(cid:146)investment and entry decisions.”
The COVID‐19 Pandemic and Its Impact on the Global Economy: What Does It Take to Turn Crisis into Opportunity? (2020, neutral): “…than domestic ones since inventory costs are larger for foreign inputs, leading to trade contraction (Novy and Taylor, 2014), and trade policy uncertainty limits firms’ entry into export markets due to sunk export costs associated with firms’ entry and trade decisions (Handley and Limão, 2015).”