Investment and cash flow: evidence for asymmetries in European manufacturing

Abstract

An ‘excess sensitivity’ of investment to internal funds (cash flow) is typically interpreted as evidence for the presence of financing constraints. Building on this, we empirically investigate the possibility of an asymmetric response of investment to the availability of internal funds across expectation states. According to our results the impact of cash flow on investment spending is exacerbated during periods of ‘pessimism’. Finally, allowing for both potential sources of asymmetries (across different states of expectations and the business cycle) our results indicate that both sources are significant, with the expectations-driven asymmetry being significantly deeper highlighting the paramount role of expectations.

Notes

¹ The choice of two lags for economic sentiment reflects the trade-off between allowing for a rich enough lag structure and also saving degrees of freedom. In any case, it would be very hard to defend that economic sentiment earlier than 2 years has any predictive power over current.

² A detailed description of the variables appears in the data section.

³ BACH is a database containing harmonized annual accounts data of nonfinancial enterprises and is constructed through the aggregation of a large number of individual firm balance sheet and profit and loss accounts. Before the aggregation takes place, the accounting data are harmonized across countries in a single format, which contains up to 94 accounting items on nonfinancial enterprises either from the balance sheet or the profit and loss accounts. Therefore, each observational unit has one aggregated balance sheet and one profit and loss account that should be relatively comparable across countries.

⁴ The three size classes are: small firms (turnover of less than 7 million euros, medium size firms (turnover between 7 and 40 million euros) and large firms (turnover in excess of 40 million euros).

⁵ A detailed definition of the variables used is given in Appendix A.

⁶ The Directorate General for Economic and Financial Affairs (DG ECFIN) conducts regular harmonized surveys for different sectors of the economies in the European Union (EU) and in the applicant countries. They are addressed to representatives of the industry (manufacturing), the services, retail trade and construction sectors, as well as to consumers. These surveys allow comparisons among different countries’ business cycles and have become an indispensable tool for monitoring the evolution of the EU and the Euro area economies, as well as monitoring developments in the applicant countries.

⁷ AMECO is the annual macro-economic database of the European Commission's DG ECFIN. AMECO contains data for EU-25, the euro area, EU Member States, candidate countries and other OECD countries (United States, Japan, Canada, Switzerland, Norway, Iceland, Mexico, Korea, Australia and New Zealand).

⁸ It should be noted that [ΔESI] _{j,t −1} and [ΔESI] _{j,t −2} are treated as pre-determined variables.

⁹ Equivalent restrictions apply for the error terms in Equations 1–3.

¹⁰ The relevant test detects significant first-order autocorrelation in the residuals. This was expected given the fact that the model is formulated in first differences and consequently the resulting disturbance term exhibits first-order autocorrelation by construction.