nep-fdg New Economics Papers
on Financial Development and Growth
Issue of 2022‒10‒10
twenty-two papers chosen by
Georg Man

  1. Financial development, institutions, and economic growth nexus: A spatial econometrics analysis using geographical and institutional proximities. By Ahmad, Mahyudin; Siong Hook, Law
  2. Effect of abnormal credit expansion and contraction on GDP per capita in ECOWAS countries By Ozili, Peterson K; Oladipo, Olajide; Iorember, Paul Terhemba
  3. Households’ liquidity preference, banks’ capitalization and the macroeconomy: a theoretical investigation By Marco Missaglia; Alberto Botta
  4. Liquidity and Investment in General Equilibrium By Nicolas Caramp; Julian Kozlowski; Keisuke Teeple
  5. What Really Drives Economic Growth in Sub-Saharan Africa? Evidence from The Lasso Regularization and Inferential Techniques By Isaac K. Ofori; Camara K. Obeng; Simplice A. Asongu
  6. The Impact of FDI Income on Income Inequality in Home Countries By Joyce, Joseph
  7. Uncertainty shocks and the monetary-macroprudential policy mix By Valeriu Nalban; Andra Smadu
  8. New forecasting methods for an old problem: Predicting 147 years of systemic financial crises By du Plessis, Emile; Fritsche, Ulrich
  9. Predicting European Banks Distress Events: Do Financial Information Producers Matter? By Quentin Bro de Comères
  10. Economic System Entanglement on Intra-Firm Trade Portfolios: The Impact of Counterparty Credit Ratings on Business-to-Business Credit Dynamics By Desogus, Marco; Casu, Elisa
  11. Debt Overhang, Risk Shifting and Zombie Lending By Nicolas Aragon
  12. Monetary Interventions and the Rise of Non-Bank Lenders By Gianluca Cafiso; Giulia Rivolta
  13. Private insurance, public welfare, and financial markets: Alpine and Maritime countries in comparative-historical perspective By van der Heide, Arjen; Kohl, Sebastian
  14. The integration of life and non-life insurance in financial inclusion index By Shen Yap; Hui-Shan Lee; Ping-Xin Liew
  15. Demand-side mobile money drivers of financial inclusion: minimum economic growth thresholds for mobile money innovations By Simplice A. Asongu; Raufhon Salahodjaev
  16. Do IMF Programs Stimulate Private Sector Investment? By Rima Turk-Ariss; Pietro Bomprezzi; Silvia Marchesi
  17. Supporting small firms through recessions and recoveries By Diana Bonfim; Cláudia Custódio; Clara Raposo
  18. Improving MSMEs’ access to start-up financing in ASEAN countries By Maran, Raluca
  19. The Fiscal State in Africa: Evidence from a Century of Growth By Albers, Thilo N. H.; Jerven, Morten; Suesse, Marvin
  20. Democratic Republic of the Congo: Technical Assistance Report-Financial Sector Stability Review By International Monetary Fund
  21. Bank Stress Testing of Physical Risks under Climate Change Macro Scenarios: Typhoon Risks to the Philippines By Ms. Hiroko Oura; Mr. Fabian Lipinsky; Stephane Hallegatte; Paola Morales; Nicola Ranger; Martijn Gert Jan Regelink; Henk Jan Reinders
  22. Climate Risks and FDI By Grace Weishi Gu; Galina Hale

  1. By: Ahmad, Mahyudin; Siong Hook, Law
    Abstract: This paper investigates the nexus between financial development (FD), institutions, and economic growth by employing a spatial autoregressive model on a panel dataset covering 82 countries from 1990 to 2019. The spatial dependence between countries is measured via geographical and institutional proximities, the latter hitherto has rarely been explored in the finance-growth literature. Institutional proximity concept postulates that institutionally similar countries are expected to have similar level of economic growth and greater size of spillover once the spatial effects of FD and institutional quality are controlled for. Overall, the findings give empirical support to the above proposition, as FD and political institutions are shown to have significant positive effects on growth. In the case of FD, its growth-effect is beneficial up to a certain threshold beyond which it becomes negative. The results also find significant positive spatial lag growth term in the model indicating the presence of indirect spillover effects of FD and institutions onto the growth of neighbouring countries, both in geographical institutional spheres. Furthermore, the spatial growth model with institutional proximity matrix is shown to have higher rate of convergence and greater size of spillover than the model with geographical proximity. These findings are robust to various model specifications, and the paper concludes with some policy recommendations.
    Keywords: Economic growth, financial development, institutional proximity, spatial fixed effects, spatial lag model.
    JEL: C31 O16 O43
    Date: 2022–09–07
  2. By: Ozili, Peterson K; Oladipo, Olajide; Iorember, Paul Terhemba
    Abstract: We investigate the impact of abnormal credit expansion and contraction on the GDP per capita of ECOWAS countries. We analyse abnormal credit from two dimensions: first, the impact of abnormal credit contraction on GDP per capita, and second, the impact of abnormal credit expansion on GDP per capita. Using data for 10 ECOWAS countries from 1993 to 2021, we find evidence that abnormal credit contraction reduces the GDP per capita of ECOWAS countries. We also find some evidence that abnormal credit expansion reduces the GDP per capita of ECOWAS countries. More specifically, a unit increase in abnormal credit contraction decreases GDP per capita by 0.99 percent while a unit increase in abnormal credit expansion decreases GDP per capita by only 0.1 percent. The findings confirm that ‘too little’ or ‘too much’ credit does not improve economic output per person in immature financial systems. We also observe that banking sector solvency and a strong legal system have a positive effect on the GDP per capita of ECOWAS countries while banking sector efficiency has a negative effect on GDP per capita.
    Keywords: finance, credit, economic growth, economic output, ECOWAS, GDP per capita, abnormal credit, domestic credit to private sector.
    JEL: E32 G21 G28
    Date: 2022
  3. By: Marco Missaglia; Alberto Botta
  4. By: Nicolas Caramp; Julian Kozlowski; Keisuke Teeple
    Abstract: This paper studies the implications of trading frictions in financial markets for firms' investment and dividend choices and their aggregate consequences. When equity shares trade in frictional asset markets, the firm's problem is time-inconsistent, and it is as if it faces quasi-hyperbolic discounting. The transmission of trading frictions to the real economy crucially depends on the firms' ability to commit. In a calibrated economy without commitment, larger trading frictions imply lower capital and production. In contrast, if firms can commit, trading frictions affect asset prices but have no effect on capital and production. Our findings rationalize several empirical regularities on liquidity and investment.
    Keywords: liquiditiy; investment; Present bias
    JEL: E44 G32 G12
    Date: 2022–09–14
  5. By: Isaac K. Ofori (University of Insubria, Varese, Italy); Camara K. Obeng (University of Cape Coast, Cape Coast, Ghana); Simplice A. Asongu (Yaoundé, Cameroon)
    Abstract: The question of what really drives economic growth in sub-Saharan Africa (SSA) has been debated for many decades now. However, there is still a lack of clarity on variables crucial for driving growth as prior contributions have been executed at the backdrop of preferential selection of covariates in the midst several of potential drivers of economic growth. The main challenge with such contribution is that even tenuous variables may be deemed influential under some model specifications and assumptions. To address this and inform policy appropriately, we train algorithms for four machine learning regularization techniques— the Standard lasso, the Adaptive lasso, the Minimum Schwarz Bayesian information criterion lasso, and the Elasticnet to study patterns in a dataset containing 113 covariates and identify the key variables affecting growth in SSA. We find that only 7 covariates are key for driving growth in SSA. Estimates of these variables are provided by running the lasso inferential techniques of double-selection linear regression, partialing-out lasso linear regression, and partialing-out lasso instrumental variable regression. Policy recommendations are also provided in line with the AfCFTA and the green growth agenda of the region.
    Keywords: Economic growth; Elasticnet; Lasso; Machine learning; Partialing-out IV regression; sub-Saharan Africa
    JEL: C52 C53 C55 O11 O4 O55
    Date: 2022–01
  6. By: Joyce, Joseph
    Abstract: Income generated by foreign direct investments (FDI) has grown since the 1990s, and now represents a substantial portion of many countries’ current accounts. Some of these flows are routed through Special Purpose Entities in financial centers that multinational firms use to minimize their tax liabilities. We use IMF and OECD data to evaluate the impact of this income on the income share of the top 1% of households in the multinationals’ home countries. We distinguish between FDI equity income and FDI interest income arising from intra-firm lending. We also consider separately the effects in advanced economies and countries that serve as financial centers. FDI equity income contributes to the income share of the top 1% of households in advanced economies, while FDI interest income has no impact in these economies. Similar results are recorded when we use the OECD non-SPE data. As a result, total FDI income reinforces the income share of the top 1% of households in these countries. While there is some evidence of a similar impact by FDI equity income on the top 1% income households in the financial centers, this result is not apparent when non-SPE income data are used.
    Keywords: FDI income, multinational firms, inequality
    JEL: F21 F23
    Date: 2022–09–14
  7. By: Valeriu Nalban; Andra Smadu
    Abstract: How should policymakers respond to uncertainty shocks? To analyze the macroeconomic effects of uncertainty shocks associated with various conventional structural shocks, we develop a New Keynesian model with financial frictions and time-varying volatility, which features a monetary- acroprudential policy mix. We find that it matters whether the economy experiences heightened demand, supply or financial uncertainty. More specifically, the underlying source of uncertainty matters for the shocks’ propagation, aggregate economic outcomes and appropriate policy responses. Financial uncertainty shocks appear to generate stronger effects and a broad complementarity between the interest rate response and the macroprudential policy stance. Supply-side and demand-side uncertainty shocks reveal important trade-offs between price stability and financial stability objectives, despite their quantitative effects being overall modest. Importantly, simulating a financial turmoil scenario reveals that heightened financial uncertainty exacerbates the negative macroeconomic effects triggered by a first-moment financial shock. Our results underscore the importance of timely and accurate identification of uncertainty surges, which is crucial for the appropriate design and calibration of the monetary-macroprudential policy mix.
    Keywords: Uncertainty shocks, financial frictions, monetary policy, macroprudential policy
    JEL: E30 E32 E44 E47 E50
    Date: 2022–02
  8. By: du Plessis, Emile; Fritsche, Ulrich
    Abstract: A reflection on the lackluster growth over the decade since the Global Financial Crisis has renewed interest in preventative measures for a long-standing problem. Advances in machine learning algorithms during this period present promising forecasting solutions. In this context, the paper develops new forecasting methods for an old problem by employing 13 machine learning algorithms to study 147 year of systemic financial crises across 17 countries. It entails 12 leading indicators comprising real, banking and external sectors. Four modelling dimensions encompassing a contemporaneous pooled format through an expanding window, transformations with a lag structure and 20-year rolling window as well as individual format are implemented to assess performance through recursive out-of-sample forecasts. Findings suggest fixed capital formation is the most important variable. GDP per capita and consumer inflation have increased in prominence whereas debt-to-GDP, stock market and consumption were dominant at the turn of the 20th century. Through a lag structure, banking sector predictors on average describe 28 percent of the variation in crisis prevalence, real sector 64 percent and external sector 8 percent. A lag structure and rolling window both improve on optimised contemporaneous and individual country formats. Nearly half of all algorithms reach peak performance through a lag structure. As measured through AUC, F1 and Brier scores, top performing machine learning methods consistently produce high accuracy rates, with both random forests and gradient boosting in front with 77 percent correct forecasts. Top models contribute added value above 20 percentage points in most instances and deals with a high degree of complexity across several countries.
    Keywords: machine learning,systemic financial crises,leading indicators,forecasting,early warning signal
    JEL: C14 C15 C32 C35 C53 E37 E44 G21
    Date: 2022
  9. By: Quentin Bro de Comères (CRIEF - Centre de recherche sur l'intégration économique et financière - Université de Poitiers)
    Abstract: This article assesses the predictive power of sell-side stock analysts and credit rating agencies on the prevision of European banks distress events by introducing their respective disclosures into a logit early-warning system over the 2000-2019 period. As direct bank failures are rare in Europe, we construct a dataset accounting for direct failures and state and private sector interventions. The model is calibrated to minimize the loss of a decision-maker committed to prevent impending distress events and is estimated in a real-time fashion. We also control for bank- and macro-level data. We find both financial information producers' disclosures to display informative and predictive performance on bank distress risk up to two years in advance.
    Keywords: Bank Distress,Early Warning Systems,Financial Analysts,Credit Rating Agencies
    Date: 2022–08–17
  10. By: Desogus, Marco; Casu, Elisa
    Abstract: In the last five years, Italy has seen a noticeable and steady increase in the supply of trade credit, granting of extensions, and general systemic business-to-business financial support. Focusing on system entanglement, this paper examines the impact in Italy of bank valuations of creditworthiness and credit intermediation on intra-firm trade portfolio dynamics. We further consider the impacts of exogenous shocks to the economy and other disruptive events on payment regularity and risks of insolvency in intra-firm transactions. Mapping portfolio dynamics to a quantum super-system with a Hamiltonian space of phases, we demonstrate that the performance of intra-firm portfolios depends concurrently on bank valuations and that system entanglement allows us to examine the extent to which economic disruptions shift portfolio dynamics from their state of equilibrium.
    Keywords: system entanglement; intra-firm trade; portfolio dynamics; credit valuation
    JEL: C02 C61 G24 H12 M21
    Date: 2021
  11. By: Nicolas Aragon (National Bank of Ukraine; Universidad Carlos III de Madrid; Kyiv School of Economics)
    Abstract: After bubbles collapse, banks have often rolled-over debt at subsidized rates to insolvent borrowers or "zombie firms." This paper explores the incentives to restructure debt in a game with risk shifting under debt overhang. We provide conditions under which it is privately optimal to zombielend even when it is socially ineffcient. When a farm becomes insolvent, the firm loses access to competitive funding and its bank can exert monopoly power. The bank prefers to zombie-lend given that owing funds for investment is not profitable due to risk shifting and liquidation entails costs. The model explains the inefficiency of traditional policies in the presence of zombies such as bank recapitalization and monetary policy and highlights the necessity of debt haircuts.
    JEL: G2 G21 G28 G33 G32
    Date: 2022–01
  12. By: Gianluca Cafiso; Giulia Rivolta
    Abstract: The amount of assets managed by non-bank lenders has increased significantly over the last decades. Our research aims to clarify whether such an increase has had any impact on the effectiveness of monetary policy. To this end, we consider several credit aggregates granted from bank and non-bank institutions for different scopes and developments in the US economy. Our analysis is based on the estimation of a large Bayesian VAR. The results suggest that the rise of non-bank lenders has reduced and altered the monetary policy transmission mechanism.
    Keywords: bank loans, non-bank loans, monetary interventions, Bayesian VAR
    JEL: E44 E51 G20 G21 C11
    Date: 2022
  13. By: van der Heide, Arjen; Kohl, Sebastian
    Abstract: Contemporary capitalist societies use different institutions to manage economic risks. While different public welfare state and financial institutions (banks, capital markets) have been studied across coordinated and liberal market economies, this paper adds the private insurance sector to the study of countries' security arrangements, following up on Michel Albert's classical distinction between Alpine and Maritime insurance cultures. Building on extensive new insurance data collections (1880-2017) and institutional analysis, this paper corroborates the long-run historical existence of two worlds of private insurance. Maritime countries (USA, GBR, CAN) developed much bigger life and non-life insurance earlier, with no state-associated insurance enterprises and riskier investments steered towards financial markets. Alpine insurance (AUT, DEU, CHE), by contrast, was initially smaller, with strong state involvement, a significant reinsurance tradition and relatively heavy investments in mortgages and property, due to economic and financial backwardness. We argue that the larger and more "Maritime" the insurance sector, the more it made welfare states liberal and securities markets large. Insurance is thus a hidden factor for countries' varieties of capitalism and world of welfare. The recent convergence on the Maritime model, however, implies that the riskier and risk-individualizing type of private insurance has added to privatization and securitization trends everywhere.
    Keywords: financial development,historical comparison,insurance,varieties of capitalism,welfare,finanzielle Entwicklung,historischer Vergleich,Spielarten des Kapitalismus,Versicherungen,Wohlfahrtsstaat
    Date: 2022
  14. By: Shen Yap (Universiti Tunku Abdul Rahman); Hui-Shan Lee (Universiti Tunku Abdul Rahman); Ping-Xin Liew (Universiti Tunku Abdul Rahman)
    Abstract: Motivated by the lack of a harmonised financial inclusion measure in the existing literature which accounts for the role of insurance, this paper constructs a multidimensional financial inclusion index which incorporates life and non-life insurance indicators for 79 countries for the year 2019. The computed financial inclusion indices reveal higher financial inclusion in high-income countries in Europe region vis-à-vis that of medium-income countries from the Asian and African regions. When only life insurance indicators are considered, some countries leapfrogged in their financial inclusion level whereas most of the developed and developing countries see a decline in their financial inclusion. On the other hand, non-life insurance appears to have only marginal positive impact on overall financial inclusiveness in the sample countries. The findings of this study indicate the lack of contribution of the insurance spectrum of financial services to financial inclusion.
    Keywords: Life Insurance, Non-Life Insurance, Financial Inclusion
    Date: 2022–07
  15. By: Simplice A. Asongu (Yaounde, Cameroon); Raufhon Salahodjaev (Tashkent, Uzbekistan)
    Abstract: This study provides minimum economic growth (or GDP growth) critical masses or thresholds that should be exceeded in order for demand-side mobile money factors to favorably drive mobile money innovations for financial inclusion in developing countries. The considered mobile money innovations are: mobile money accounts, the mobile phone used to send money and the mobile phone used to receive money. The empirical evidence is based on Tobit regressions. For positive net relationships that are established, an extended analysis is engaged to provide minimum GDP growth levels required to sustain the positive net nexuses. From this extended analysis, in order for economic growth to modulate demand-side mobile money drivers to favorably influence mobile money innovations, minimum GDP growth rates are: (i) 3.875% for the nexus between bank accounts and the mobile phone used to send money; (ii) 3.769 % for the relationship between automated teller machine (ATM) penetration and the mobile used to send money and (iii) 3.666% for the nexus between ATM penetration and the mobile phone used to receive money.
    Keywords: Mobile money; technology diffusion; financial inclusion; inclusive innovation
    JEL: D10 D14 D31 D60 O30
    Date: 2022–01
  16. By: Rima Turk-Ariss; Pietro Bomprezzi; Silvia Marchesi
    Abstract: This paper provides new evidence on the role of IMF programs in stimulating private sector investments. Using detailed firm-level data on tangible fixed assets and a local projection methodology, we first estimate the dynamic response of firm investments to the approval of an IMF arrangement. We find that distinguishing between GRA and PRGT financing matters for the path of firm investment and its growth, and we also document the presence of two financial channels; the degree of firms’ external financial dependence and firms’ sectoral uncertainty. Exploiting these firm-level characteristics, we employ a difference-in-differences approach to understand the mechanisms through which the approval of an IMF arrangement propagates in the private sector. We find that the more firms rely on external finance and the more they are subject to uncertainty, the less binding these financial frictions become, and hence the more firms invest following a program approval. Finally, using ownership data, we find that private investments are stimulated more for domestic firms. The presence of a private investment transmission channel could help improve our understanding of what factors could affect the success and effectiveness of IMF programs.
    Keywords: IMF; Firm investment; Local Projection; Financial Frictions; Difference-in-Differences; IMF arrangement; IMF working papers; firm investment response; AIPW estimate; program approval; Private investment; Financial statements; Balance of payments need; Sub-Saharan Africa
    Date: 2022–07–29
  17. By: Diana Bonfim; Cláudia Custódio; Clara Raposo
    Abstract: We use variation in the access to a government credit certification program to estimate the financial and real effects of supporting small firms. This program has been implemented during the global financial crisis, but has remained active ever since, allowing us to analyze its effects both during recessions and recoveries. Eligible firms have access to government loan guarantees and a credit quality certification. We estimate real effects using a multidimensional regression discontinuity design. We find that eligible firms borrow more and at lower rates than non-eligible firms, allowing them to increase investment and employment during crises. Industry-level analysis shows reduced productivity heterogeneity in more exposed industries, which is consistent with improved credit allocation. However, when the economy is recovering the effects of the program are less pronounced and centered on the certification component.
    Keywords: Small Firms’ Financing, Credit Rating, Credit Certification, Cost of Debt, Investment
    JEL: G38 G30 G01
    Date: 2022–09
  18. By: Maran, Raluca
    Abstract: Lack of access to finance constitutes a major setback to the development of the MSME sector in ASEAN countries. MSMEs are confronted with stringent funding constraints in traditional lending and capital markets, in particular at the early stages of their activity. Demand and supply of capital to MSMEs thus entails more complex issues compared to the larger firms. This paper presents a number of policy actions that have the potential to mitigate the financing challenges faced by MSMEs in ASEAN at the start-up stage by enhancing the potential of alternative funding sources such as business angel investment, crowdfunding, venture capital investment and SME stock markets.
    Keywords: MSMEs; ASEAN; start-up financing; business angels; crowdfunding; venture capital; MSME stock markets; loans and guarantees
    JEL: G32
    Date: 2022–09–02
  19. By: Albers, Thilo N. H. (HU Berlin and Lund University); Jerven, Morten (Norwegian University of Life Sciences); Suesse, Marvin (Trinity College Dublin)
    Abstract: What is the level of state capacity in developing countries today, and what have been its drivers over the past century? We construct a comprehensive new dataset of tax and revenue collection for 46 African polities from 1900 to 2015. Descriptive analysis shows that many polities in Africa have been characterized by strong growth in fiscal capacity. As a next step, we explain this growth using a fixed-effects long-run panel setting. The results show that canonical state-building factors such as democratic institutions and interstate warfare can increase revenue collection, while government turnover reduces it. Access to external credit and foreign aid are even more important, and both negatively affect fiscal capacity. In addition, access to external revenues, especially from commodity exports and debt, moderates the operation of canonical state-building factors such as democracy and conflict. These insights add important nuances to established theories of state building. Not only are states in Africa more capable than hitherto thought, but the international environment shapes their capacity, both directly and indirectly.
    Keywords: fiscal capacity; Africa; statehood; resources; external finance;
    Date: 2022–01–29
  20. By: International Monetary Fund
    Abstract: In response to a request from the Central Bank of the Congo (BCC), the Monetary and Capital Markets Department of the International Monetary Fund (IMF) conducted a Financial Sector Stability Review (FSSR) mission virtually, during January 5–28, 2022. The FSSR performed a diagnostic of the financial system, reviewed progress in implementing previous IMF technical assistance (TA) recommendations, and developed a draft Technical Assistance Roadmap to help strengthen the BCC’s capacity in the areas covered by the FSSR. The FSSR also for the first-time covered gender inclusion in financial supervision. It identified five macrofinancial vulnerabilities pertaining to: (i) the quality of the banking system’s capital base; (ii) the difficulty in evaluating nonperforming loans following the COVID 19 financial support measures; (iii) risks related to financial dollarization; (iv) the impact on correspondent banking relationships of “de-risking”; and (v) intragroup exposures, as bank subsidiaries in the DRC place surplus funds with parent companies abroad. The BCC’s adoption of COVID-19 exit measures in December 2021, including specific reporting requirements, should provide momentum for additional TA in the near term to help the BCC analyze banks’ asset quality going forward.
    Keywords: bank stress tests; bank funding; IMF resident representative; draft banking law; bank resolution function; Financial sector stability; Stress testing; Bank supervision; Bank resolution framework; Central Africa; Africa; Maghreb; Global
    Date: 2022–09–01
  21. By: Ms. Hiroko Oura; Mr. Fabian Lipinsky; Stephane Hallegatte; Paola Morales; Nicola Ranger; Martijn Gert Jan Regelink; Henk Jan Reinders
    Abstract: Bank stress tests of climate change risks are relatively new, but are rapidly proliferating. The IMF and World Bank staff collaborated to develop an experimental macro scenario stress testing approach to examine physical risks for banks by building a dynamic stochastic general equilibrium model linked to global climate and a catastrophe risk model specifically for the Philippines. Our model shows that the impact of extremely rare typhoons on GDP could already be systemic and worsen substantially with climate change. However, bank capital declines only modestly unless the event is compounded with other disasters, partly thanks to the strength of Philippines’ banks and economy before the COVID crisis. However, more work is needed before drawing strong conclusions about the relevance of climate risk, as the model focused only on typhoons’ physical capital destructions and their macroeconomic-level transmissions to banks.
    Keywords: Climate change; bank; stress test; financial stability; CAT model; disasters; bank stress testing; bank stress tests; climate change macro scenario; annex I. macro scenario model; climate change stress test; Natural disasters; Stress testing; Financial sector stability; Global; climate scenario; climate model; physical capital; simulation result
    Date: 2022–08–19
  22. By: Grace Weishi Gu; Galina Hale
    Abstract: Climate-related risks have increased in recent decades, both in terms of the frequency of extreme weather events (physical risk) and implementation of climate-change mitigation policies (transition risk). This paper explores whether multinational firms react to such risks by altering their presence in countries that are more affected. We measure this by examining foreign direct investment (FDI) dynamics at different levels of aggregation as well as at firm level. We propose a theoretical framework for firm production location choice that explicitly incorporates transition and physical risks. The model predicts a reduction in FDI resulting from both physical and transition risks but an ambiguous interaction effect of these risks with emission productivity of the firm. In an extensive empirical analysis we find some support for model predictions, but overall we do not find consistent evidence for statistically significant effects of physical and transition risks on FDI. However, firm-level evidence suggests that firms that are more exposed to climate risks react more negatively to physical climate risk following Paris Climate Accord. We also find that FDI outflows following extreme weather events from affected countries are smaller for industries with higher emission productivity. Our theory and empirical results point to the importance of accounting for heterogeneity in emission productivity when analyzing effects of climate risks.
    JEL: F21 F23 F64
    Date: 2022–09

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