On some economic consequences of political instability

Over the past few months, even a casual follower of Indian news cannot have failed to notice the often wild reactions of the stock markets, those dubious oracles of an economy’s prospects, to the results of several prominent state elections and the general consensus (purportedly represented by opinion polls) condemning the ruling Congress party to an ignominious defeat in this year’s general election. In the RBI’s Financial Stability Report last December, the governor too highlighted political instability as a detrimental force. This is in addition to the rather bold assertions by certain ratings agencies that suggested that a victory for Narendra Modi would be better for India’s economic future.

Their conclusions seem to have found much support among the investing community if the stock market’s reaction to a resounding BJP victory in some major states is any indication. It is no secret that many prominent members of the business community have been agitating for more pro-growth policies despite the scourge of inflation rearing its head once again. As the government entered its last six months in office with populist measures seeming to be all it could think about, and the recent state debacles leaving it hamstrung to build consensus on politically tough but economically necessary reforms, it was felt by many that a change in government, particularly one shepherded by the poster-boy for higher growth, Narendra Modi, was the way forward.

Even the unembellished narrative of events presented above raises some pertinent questions. Why should the possibility of an event (here, a change in government) elicit such a significant response? How much are voters too motivated by a need for stability? And why should political factors be accorded such significance in the presence of numerous other problems, structural and otherwise, that affect the Indian economy?

Investment and uncertainty
One channel through which political uncertainty could affect the economy is via the investment decisions of firms. Investment is a key driver of the economy, helping to augment the productivity that is so vital for sustained growth. Most investment decisions, especially those by firms in the manufacturing sector, involve significant outlays and considerable time before they become active. As a consequence, evaluating the costs and benefits of investing, as usually done in Net Present Value (NPV) calculations, is fraught with uncertainty, having to account for several risks that could delay the project or affect expected returns. These returns would depend (among other things) on the state of the economy at the time the project would start generating returns, which could depend considerably on government policies expected then. 

Further, these expectations of future policy and economic environment would depend on current policy and the macroeconomic scenario. Expectations of a dim future would deter expansion today, which would further worsen the current economic situation.

The fact that interest rates affect investment decisions is hardly surprising, as most investments involve lengthy loans and the “cost of capital” is the rate of interest. However, political instability essentially affects expectations of the future, and it is this concomitant uncertainty that is relevant here. Traditionally, the approach has been to account for some of the risks associated with the future through a risk premium, which basically raises the interest rate or discounts the future more heavily to account for uncertainty and the possibility of non-repayment. The greater the perceived risk, to which political instability is likely to contribute, the more the future would be discounted, which would then raise the cost of financing projects.

This traditional approach overlooks many realities about the investment process. Most investments are lumpy, i.e. are staggered over time and are often irreversible, i.e. sunk. Consequently, the timing of the investment process is vital. The real options theoretical literature emphasises these two aspects of the investment process, and suggests an analogy between the investment timing decision and financial options literature. In particular, the value of delaying an investment can be derived using methods similar to those employed in the financial options literature. 

Holding such a “call option” would give the firm the right to invest at the time of its choosing without facing the obligation to do so, thereby allowing it to hedge. By delaying, the firm can attempt to gather more information in order to arrive at an investment decision. Typically, option rights arise from ownership of land or resources, patents or through a firm’s position and influence in industry. The option value of delay is high if uncertainty is high, so that firms might want to wait before deciding to commit, although in certain cases (like competition in a new market) getting a head start might prove critical.

The main conclusion here is that NPV valuations alone are incorrect if they do not account for the value of delaying investment, which in turn would be affected by political instability and policy uncertainty. Uncertainty also leads to firm inertia and stasis, which might confound an intended policy effect. This has also been the suggested reason behind pro-cyclical productivity, i.e. productivity growth during booms, as the process of weeding out inefficient firms and projects that should be aided by a downturn gets impeded.

Related to political instability is policy uncertainty, the idea that policy might be reversed at some point in the future, for example if a new government with a different economic agenda or approach comes to power. The prominent case of environmental clearances for projects is another germane example. The idea here is that investors, while deciding whether to invest in a project, would account for the possibility that the conditions might change in the future. So, if they are attracted by a favourable economic policy decision, they must also consider the possibility that that policy might be reversed later. 

Again, the idea of adjustment costs, costs of exit and entry (commencing another project), is vital. An investor would no longer be satisfied by just a competitive rate of return, but would demand compensation for the adjustment costs borne and, most important, for the reversal risk borne. Aggregate investment would then be negatively related to the likelihood of reversal. 

The very presence of uncertainty, therefore, might stymie investment inducements.

Of course, not all reforms come accompanied by a reversal risk. The credibility of the policymaker is at stake, while reforms might have (indeed, might spawn) their own support system or lobby. Considering the babble about early elections and the potential impossibility of a single-party dominated government forming, the recent successes of the BJP may have actually reduced the level of uncertainty by, at the very least, solidifying the perception of a dominant anti-Congress sentiment, besides also capturing the positive economic expectations from Modi.

There are some interesting political economy theories describing the impact on the economy. One approach is drawn from the political economy world, and has re-election concerns playing a vital role. Governments that face uncertainty regarding their election prospects engage in suboptimal policies (“strategic inefficiencies”) in order to worsen the state of the world inherited by their successors, or even to signal their own competence as crisis managers. 

Another approach deals with policymaking in particular, and suggests that weaker governments are more prone to being “captured” by vested interests, e.g. lobbies, resulting in not necessarily efficient outcomes. Possibly related are the multifarious populist schemes (which would tend to increase as the outcome for an incumbent looks bleaker), and the possible transfer of resources away from their most productive uses, impacting growth.

There are other stories that seek to explain the impact of institutions on growth and therefore what attenuation could bring about. The main narrative is that redistributive tendencies, which would tend to be stronger the wider the franchise and more unequal the society, would result in inefficient levels of taxation, distorting in particular the incentive to invest and thereby affecting growth.

Uncertainty about the identity of a reform-affected group could delay its implementation, which would eventually occur when conditions deteriorated enough to override objections. Such uncertainty could also explain gridlock between different arms of the government or different allies concerning reform implementation.

Other studies consider the dynamic implications of expected policy decisions. For example, a government that is pursuing unsustainable fiscal policies would raise expectations of future restraint. However, the actual effects would depend considerably on uncertainty regarding when and how such an adjustment would be made, which in turn would be intimately linked to political factors.

It is now firmly established that secure property rights are foundational for economic growth. Secure property rights are vital for investment, and the flux that accompanies instability would make investors demand a premium against confiscation or even lockdowns following disputes. While this does not deal directly with politics, inconsistent policies and even forced confiscation would inevitably dampen investment incentives.

The channels we have laid out above deal with short to medium term investment. Longer-term investment, like R&D, might even be encouraged by uncertainty. The idea here is that a bad state of the world might lead only to a loss of development costs, but getting the rub of the green could mean even greater expected profits. The relevance of this link would depend on the nature of the industry and therefore the possible policy effect.

Other aspects
We have hitherto focused mainly on investment under uncertainty. Consumption too might be adversely affected, as uncertainty would result in more precautionary saving. Higher saving should tend to lower interest rates and boost investment, but our earlier discussion suggests that this tendency does not often get realised, possibly due to the interest rates not being too responsive.

One might also consider the impact of political instability on voting behaviour. Turnout issues notwithstanding, voters choose between alternatives (candidates representing parties or independents) based on the utility they derive from their platforms. In an environment where one’s own preferred candidate is unlikely to win, citizens might vote strategically based on an expectation of how the future will pan out. In a situation where there is considerable uncertainty, like a tight race where the favoured candidate is a contender, the likelihood of being decisive goes up and strategic behaviour might not be too relevant. However, in a situation where one’s favoured candidate is highly likely to be booted out, strategic concerns might dominate. Of course, there could be uncertainty about which of the other alternatives stand the best chance of winning.

One could interpret a preference for stability using the same framework as above. Voters have preferences over issues, like economic policy, and would like to vote for the party that is closest to their position. There might be considerable ex post uncertainty, however, regarding the likely winner of the election. This is particularly true in an environment where coalition governments are the norm. Consequently, there might not be much clarity regarding the actual policy to be implemented. Voting for a less preferred option that is likely to win might then be better for a voter. In effect, the voter is choosing over degrees of uncertainty. 

Stock market responses
As mentioned earlier, the BSE has responded to virtually every major development in the electoral scene over the past few months, unafraid to highlight the lack of confidence in the incumbent’s ability to shepherd the economy in the future. Such significant responsiveness to political developments is hardly peculiar to India. During the uncertain period of the European debt crisis, with the possibility of no bailout agreement materialising, stock markets around the world latched on to every titbit of information. A similar effect was noticed during the Debt Ceiling episode in the United States. The interconnectedness of economies in a globalised world implies that even slightly significant developments that might affect an economy resonate in markets around the globe, depending of course on the degree of connectedness.

There have been recent theoretical developments motivated by these fluctuations, which aim to understand the implications of political instability for stock markets. Given the importance of the stock market as a source of raising funds for expansion/investment and the spillover effects of crashes on other indicators and sectors of the economy, this is clearly of considerable importance.

These concerns are nicely discussed in a recent paper by Lubos Pástor and Pietro Veronesi. Uncertainty could affect stock markets in two ways. If uncertainty forced the government to undertake corrective action, i.e. not just window dressing but dealing with the root of the problem, it would help resolve immediate problems and perhaps deter future ones. This is like the famous "Greenspan Put", effectively a put option that eased liquidity during busts.  On the other hand, political uncertainty is a common risk, so it isn’t fully diversifiable. This could depress asset prices by raising discount rates, a channel we described above.

Political uncertainty might affect the profitability of individual firms differently and, crucially, in unknown ways. Over time, however, firms learn about the impact of the implemented policy and revise their beliefs accordingly. There are thus two types of uncertainty, concerning which policy will be implemented, and how the chosen policy will affect individual firms.

The first source depends on government choice, which in turn depends on a cost-benefit analysis of the options available. With rational, forward-looking agents, this becomes interesting if there is uncertainty about the nature and magnitude of costs and/or benefits. In an environment where the current policy is not having its desired impact, the government is more likely to (and agents promptly anticipate) change, going by the rationale that the costs of persisting are higher. Although elections are not considered in their analysis, an uncertain outcome would only add to the uncertainty regarding policy choice.

These shocks have consequences for asset prices, over and above the normal impact on investment incentives. Uncertainty about the impact of policies affects investment decisions and asset prices, as do expectations of likely policies or policy changes in the future (political shocks). It is this factor that explains the unusual responsiveness of markets to information: information alters beliefs and hence expectations of a policy change. As discussed, in a weaker environment, change becomes more likely and thus information becomes more impactful. This potential change then counters the impact shock effect by making current policies temporary. However, investors demand a premium for the political shock effect. Further, as is expected given the common nature of the shock, political uncertainty causes asset prices to move together, while the learning process raises volatility.

Besides supportive anecdotal evidence and its general plausibility, this particular description also has some empirical backing. Stock markets, more than anything else, are taken as indicators of that elusive idea, sentiment. As we have seen, the common story of uncertainty impacting investment decisions is an important factor affecting their response. Political uncertainty then is not simply media fodder but has wide-ranging and uncertain real world consequences. The implications of political uncertainty are not confined to temporary (although perhaps extreme) swings, but have the potential to alter the economic trajectory of a nation.

References for the reader
As the title indicates, the above is by no means a comprehensive description, attempting which is way beyond the scope of such an article, but a subjective one. 

There are numerous books and papers on investment and uncertainty. For an overview of theoretical progress pertaining to investment, see the chapter on Aggregate Investment by Ricardo Caballero in the Handbook of Macroeconomics, Volume 1 (Part B), 1999. The Real Options literature is ably surveyed by Robert Pindyck in his paper, "Irreversibility, Uncertainty and investment", Journal of Economic Literature, volume 29 (3), 1991. A more comprehensive study is the book Investment under Uncertainty by Avinash Dixit and Pindyck, Princeton University Press, 1995. Two fascinating papers are "The Impact of Uncertainty Shocks", Econometrica, 2009; and "Fluctuations in Uncertainty", Journal of Economic Perspectives (forthcoming), both by Nicholas Bloom (accessible from his webpage).

On policy uncertainty, see the wonderfully clear analysis by Dani Rodrik in "Policy Uncertainty and Private Investment in Developing Countries", Journal of Development Economics, November 1991. An empirical reference is "Political Instability and Economic Growth", Journal of Economic Growth, Volume 1 (2), 1996, by Alberto Alesina, Sule Ozler, Nouriel Roubini and Phillip Swaegel. A discussion of strategic inefficiencies, dynamic implications and most other macro implications of political economy can be found in the fantastic exposition by Allan Drazen, Political Economy and Macroeconomics, Princeton University Press, 2000; a must for all political economy students.

Strategic voting is discussed in "A Theory of Voting Equilibria", American Political Science Review, 1993, by Roger Myerson and Robert Weber; and "On the theory of Strategic voting", Review of Economic Studies (74), 2007, by David Myatt.

The Pástor and Veronesi paper is "Political Uncertainty and Risk Premia", Journal of Financial Economics (110), 2013 which is very technical. A companion paper is "Uncertainty about Government Policy and Stock Prices", Journal of Finance (67), 2012, which treads similar ground but does not include political shocks and policy heterogeneity, but focuses on the stock market response to a policy announcement.

Lalit Contractor has a MPhil in Economics from Oxford University and is curious about Economics and its interactions with politics and society.