# **6 The Role of Expectations for Investment**

An important factor in ensuring recovery is capital accumulation in the post war period. It is here that political risk of the resurgence of violence could have a very direct impact. If potential investors believe that future disruptions through violence are likely then they will stay back.<sup>36</sup> The lack of investment then makes the economy less resilient.

Measuring expectations and their impact is difficult. We therefore approach the topic in four ways. First, we discuss the literature which has found a direct impact of changes in expectations and asset prices and investment. Second, we turn towards four cases of strong recoveries and show their that economic activity is strongly correlated with the return of refugees to the country. Third we show, using several surveys, that firms report political risk and political instability as a major obstacle to their economic activity. There is some evidence that the perception of this risk is related to past violence. Forth, we use a model of expected violence to show that this can explain patterns of foreign investments in a post conflict context quite well.<sup>37</sup>

## **6.1 The Literature**

It is an accepted truth in macroeconomics that expectations are an important driver of economic activity. Empirical work has, for example, used news shocks to identify their effect. Ramey (2011) argues, for example, that economic activity reacts to the news about government spending shocks. Taking news into account is therefore crucial to understand the effect of these spending shocks. Bruckner and Pappa (2015) analyze bidding for the Olympic Games using panel data for 188 countries during the period 1950-2009. They argue that the bid attracts considerable inflows of investment several years before the Games. In other words, it is not the Olympic games that drive an improvement in economic activity but the expectation of the Games coming to a country.

More specifically, there is mounting evidence for the role of expectations in the context of episodes of violence. Zussman et al. (2008) and Willard et al. (1996) show that asset prices during conflict react to important conflict events like battles or ceasefire agreements. Events that change expectations on the final outcome of conflict therefore have direct economic effects. Abadie and Dermisi (2008) show that following the 9/11 terrorist attacks office vacancy rates increased at the three main landmark buildings in downtown Chicago relative to nearby buildings. Markets also differentiate events according to how they affect an ongoing conflict. Zussman and Zussman (2006) show that the Israeli stock market does react strongly to the assassinations of senior leaders of the Palestinian terrorist organizations: negatively in the case of political leaders but positively in the case of military leaders.

Singh (2013) analyzes the direct impact of violence on investments, using the Punjab

> 36In this perspective, Appel and Loyle (2012) analyze the role of Post Conflict Justice (PCJ) institutions have in attracting FDI in post conflict countries. They argue that post-conflict states that adopt PCJ are more likely to receive higher levels of FDI compared with post-conflict states that refrain from implementing these institutions.

> 37The discussion in this section relies on Besley et al. (2015).

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