Factors affecting investment decision

There are theoretical considerations and empirical evidence to suggest that the relevant variables to determine the private investment in emerging countries are: the domestic product, real interest rate, public investment, credit available for investment, the magnitude of external debt, the exchange rate and macroeconomic stability. As a starting point for an empirical analysis this would be a satisfactory description of the problem. The following is a brief theoretical explanation of the expected relationship of these variables and some additional factors.

Availability of funding

According to some experts opinion, the availability of financing would be an important factor influencing the level of investment regardless of cost of capital. Loans in the banking system would probably be the most important determinant of investment in developing countries due to the shallow depth of the capital markets. Therefore, there would be a great dependence on non-financial firms for credit from banks to finance both working capital and long-term investments. This view emphasizes the importance of including the bank credit as a determinant of gross private capital formation.

Public investment

In developing countries there is evidence of a relationship between private investment and public investment. However, this relationship could be positive or negative depending on the nature of the investment. When the public sector investment focuses primarily on infrastructure, public and private investment are complementary and the relationship between them is positive, ie, that public investment could stimulate and complement private investment to generate positive externalities, stimulating aggregate demand and opening new markets for goods and services and thus increasing the productivity of private investment. Also, when public investment takes the high-risk investments, with credit tightening and underdeveloped securities markets that prevent the private sector to make investments that require large volumes of financial resources and long periods of maturation, positive effects are generated to the private sector. In general, governments in developing countries have considerable involvement in economic activities, which can be justified by the absence of private sector investment in large projects.

Moreover, in periods of economic stagnation and in accordance with Keynesian assumptions, an increase in public investment may encourage the expansion of domestic aggregate demand, including private investment. However, the theory also raises the possibility of a negative relationship which is called shift effect or crowding out. This effect implies that public investment competes with private by physical and financial resources which are scarce. Also cover areas of economic activity that are of interest to the private sector.

Gross Development Progress (GDP):

According to the neoclassical theory of investment, which originated in the work of Jorgeson, the value of a competitive firm’s desired capital stock is a positive function of the quality of their product, which may be treated as an approximation of the level of demand. If this result extends to more aggregate levels, the product of a country is considered as a measure of the level of demand for the entire private sector.

Real exchange rate

This variable can influence the desired level of investment; however, its effect could be positive or negative. A depreciation would reduce real income and wealth of the private sector by lowering the aggregate and postponing plans for future investment demand. Moreover, Depreciation affects the profitability of capital by varying the relative price in the price of capital in the economy, especially capital goods imported contains an important component and therefore acts analogously to an adverse supply shock in the production of investment goods. It is important to consider the distinction between the effects of an anticipated and unanticipated depreciation. In the first case, if the expectations of depreciation are taken care off, investment could be increased since the required return on capital tend to fall reflecting the reduction in the rate of early depreciation. However, the depreciation of the real exchange rate increases the relative price of tradables over non-tradables, which would help to stimulate investment in the tradable sector since it increases the competitiveness and the volume of exports and whether this effect is greater than the negative effect on the non-tradable sector, the total investment could be increased.

In short, the depreciation of the exchange rate can have a negative effect on investment, increasing the cost of imported capital goods. On the other hand, a devaluation or depreciation of the exchange rate can increase investment in tradable sectors of an economy, improving the competitiveness of their goods in terms of prices in the world.

Despite this theoretical ambiguity, empirical evidence supports the notion that a real depreciation has an adverse impact on investment in the short term, through the effect of cost of capital goods.

Cost of Capital

Another variable that neoclassical theory considers relevant in investment decisions is the real interest rate, which in this case would be the cost of capital or the cost of credit to the company. Since an increase in the interest rates helps to discourage investment, we should expect a negative relationship between the two variables.

Terms of trade:

Usually this variable is used as a proxy for external shocks in developing economies. Adverse terms of trade imply that require more exported units per unit of import, which affects the current account deficit with a negative effect on private investment.


Uncertainty can be a factor influencing the level of desired investment. The investment complies with the principle of irreversibility, ie activity involves costs of input and output that are not negligible. Installation costs of plant and equipment can be considered as sunk costs if capital once installed, this may not be employed in other activities (industry specific capital) or if the secondary market are not efficient. High levels of uncertainty may raise the opportunity costs of a particular enterprise – the cost of delay or wait for further information before making investment decisions, resulting in reduction in the desired level of investment. Though it is possible to measure the uncertainty in developing countries if you consider the volatility of output, inflation, real exchange rate and terms of trade.