Fixed investment, uncertainty and financial market volatility in Japan

Luke Meehan, PhD Candidate in Economic Policy AJBCC Scholar @ AJRC Crawford School of Public Policy

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Outline •  Aim •  Why is investment interesting? •  Why may uncertainty be important? •  A simple model •  Which variables and data sources matter? •  What empiric method is appropriate? •  Simulation results •  Conclusion

Aim

To consider the theory that “uncertainty shocks” embody variations in the distribution of expected returns to capital goods investment By evaluating the stochastic impact of uncertainty on Japanese private fixed investment patterns And so understand the causes of Japanese private fixed investment variation during the ‘Lost Decade(s)’.

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Why is investment interesting?

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Machinery Investment

Horioka (2006) found that the proximate cause of Japan’s Lost Decade were falls in inventory and fixed investment, particularly private fixed investment.

This sits well with most modern macro models, in which investment is a key driver of cycles and trends.

The question about what caused these investment falls remains open, with financing constraints, long-term TFP / demographic trends and policy uncertainty all found in the literature.

But neither supply nor demand factors seem able to provide the necessary richness of relationship. (Kasahara, Sawada, Suzuki 2012) -4.00

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Mfn Labor Costs, %

Real interest rates

A simple model...

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…with uncertainty

•  Uncertainty might be important for investment if it is related the anticipated returns on irreversible investment under uncertainty.

–  As per a theory first sighted in Nick Bloom’s IMF presentation, but probably existing elsewhere

•  Under this concept, uncertainty is the anticipated shape of the return to investment distribution. This can impact investment decisions by increasing the ‘real option’ value of waiting as well as via manager risk-aversion.

•  Note, volatility is the realisation of unanticipated uncertainty.

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Variables and data, (1) Wanted: E(R), Var(E(R)), E(Costs)

–  Also important to distinguish between anticipated and unanticipated variance

E(R), Var(E(R)), E(Costs) are unobservable at a macro level –  and imperfectly observable at the micro

And so we need to use a series of instruments which are: –  available to decision-makers –  theoretically-sound –  useful to the wider literature

Period: 1987Q2: 2011Q1, quarterly 7

Variables and data, (2) Private fixed investment: Property, Plant, Equipment.

•  property likely to be a bit odd post-bubble, so want plant and equipment •  use ESRI’s ‘Private machinery orders’ data, seasonally adjusted

E(Costs): Labour and Capital •  whilst both are relatively stable, real interest rates show more variation •  use BoJ’s discount rate, turned into real rate with CPI from MIAC

E(R): the current value of mean anticipated future returns •  this sounds usefully similar to definition of fundamental value of a

financial asset, so Nikkei 225 Index used

Var(E(R): the spread and skew of the returns distribution curve •  significant behavioural literature showing as distribution of potential

outcomes increases, so does the degree to which individuals are decreasingly confident in making a decision entailing risk

•  use BoJ’s ‘Tankan’ business confidence survey, seasonally adjusted 8

Empiric issues and method

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TVP-VAR • 

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Results 1 – investment impulses •  In the short term, machinery exhibits

positive autocorrelation, typically becoming neutral after 8-quarters.

•  Increases in machinery purchases consistently and constantly lower Tankan indications.

•  Real interest rate responses appear consistent and negative at 4- quarters, becoming volatile and positive in 8-12 quarters.

•  The Nikkei Index responds consistently positively at 4- quarters, becoming volatile and generally positive in 8-12 quarters.

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Results 2 – real interest impulses •  Machinery purchases are

relatively unresponsive at early time periods, but in later periods a short-term positive response is observable. This response decays to a slight negative response at the 1 year point.

•  Real interest rate autocorrelation appears to decay over 3 years.

•  Throughout the estimation period, real interest rates spikes increase business confidence in the short-term, but with varying results in the medium-term.

•  The Nikkei 225 Index typically exhibits at negative short- and medium-term response to real interest rate increases

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Results 3 – Tankan impulses •  Machinery purchases exhibit

significant ‘noise’ in response to Tankan variations.

•  Tankan autocorrelation is does not appear to fully decay over the 3-year period

•  The Nikkei relation is generally neutral, but becomes strongly positive during and after the Asian Financial Crisis and the Global Financial Crisis

•  The real rate of interest falls in response to Tankan spikes, but this response typically decays over 3 years

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Results 4 – Nikkei impulses •  Machinery purchases respond

positively to Nikkei innovations over the 1- and 2-year horizon, typically decaying by 3 years.

•  The Tankan reacts positively over 1- and 2-years to the Nikkei. The 3-year points are less clear, but appear to inversely reflect business cycle trends.

•  The real interest rate is neutral to slightly negative in response, a consistent relation across the period.

•  The Nikkei’s level response appears consistent and positive after 12 quarters.

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Machinery reactions during periods of low volatility.

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Machinery reactions during periods of high volatility.

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Conclusion •  This paper sought to understand the relationship between

investment, uncertainty and Japan’s Lost Decade. •  The simulations present evidence of a relationship between

uncertainty and investment that of important magnitude and duration.

•  The direction of investment responses to uncertainty shocks are as anticipated in the model

•  The results add credence to the theory that variations in uncertainty alter the shape of the distribution of expected returns to investment and are therefore important business cycle events.

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