Irreversibility of investment – financial constraints

There are additional factors not considered by the theories which largely respond to criticism that the aforementioned approaches, including liquidity constraints to finance the accumulation of physical capital in an environment of asymmetric information and the role of uncertainty and irreversibility of the investment.

Since the early eighties there is growing concern on the adverse effects of financial constraints on investment in developing countries. At the aggregate level, the availability of savings could be limited due to the absence of foreign savings in economies with significant levels of debt and high levels of fiscal deficits which would reduce the volume of available domestic savings. At the micro level, companies may face financial constraints if the quantity settings are common in domestic capital markets. This situation could arise due to the existence of controlled interest rates and credit rationing is a feature to maintain equilibrium in the credit market (Stiglitz and Weiss).

The impact of financial constraints on investment have also been widely studied. It is recognized that domestic financing (retained earnings) and external financing are not perfect substitutes (bonus shares or bank loan). The underlying asymmetric information explains the difference in the cost of these types of financing. According to this view the investment would be very sensitive to certain financial factors such as availability of funding or access to capital markets. This vision differs from the approach of a perfect capital market where the financing structure of a firm is irrelevant for making investment decisions.

The neoclassical investment theory assumes the existence of symmetric adjustment costs, ie the costs of investing and divesting are equal, so that investment is reversible; but this assumption is extremely weak, lacking sufficient empirical evidence to support it. The majority of investment expenditures have two important features to be considered. First, investment expenditures are irreversible, ie firms can not disinvest without incurring high costs, which may be higher than investing. Second, investments may be delayed by giving the company the opportunity to wait for new information about the price, cost and other market conditions for capital goods before carrying out their investment decisions. Thus, the decisions of investors may be affected by the irreversibility of investment, even if there is uncertainty.

According to Frank Knight, irreversibility of investment arises from the existence of a secondary market for capital goods underdeveloped, the presence of specific capital for businesses and adverse selection associated with the quality of the various capital goods. Developing countries are characterized by the existence of a secondary market for capital goods underdeveloped.

Pindyck in his research paper emphasized that the irreversible nature of the investment can be exacerbated by risk factors, because in a context of uncertainty, firms are forced to take precautions regarding their fiscal expansion decisions. Irreversibility of investment may also affect policy choices. For example, if the objective is to stimulate investment, to establish an atmosphere of trust and confidence may be more appropriate to give another type of incentive measures.

Contrary to the neoclassical view of Jorgenson on investment, it is much more realistic to higher vantage point asymmetric adjustment costs resulting from the investment irreversibility, uncertainty and expectations of economic agents. Thus, under the assumption of irreversible investment under uncertainty, even when economic conditions improve, the investment could not be restored because investors who face an uncertain future could be found with an excess of capital goods which could not be undone. There have been cases in which interest rates have fallen and the investment has not undergone any changes. Dixit and Pindyck op.cit., argue that Volatility is more important than the level of interest rates for investment decisions of economic agents. Therefore, if you want to motivate investments, policies should be established to correct and eliminate undesirable fluctuations that occur in the behavior of the interest rate.

Finally, another characteristic of developing countries is the high component of imported capital goods. Therefore, a shortage of foreign exchange, or changes in its price, could lead to a restriction to achieve higher rates of investment. In economies where domestic capital and foreign capital are highly complementary, lack of foreign exchange to import machinery and equipment would be an impediment to growth.