# **Annex 1. Determinants of investment: Empirical framework**

_Framework._ As in Hall and Jorgenson’s (1967) seminal work, private investment is modelled as the level of private investment _I_<sup>_p_</sup> chosen such that the marginal return on capital ( _MPK_ ) equals the cost of capital, which consists of the real interest rate _r_ and the rate of depreciation of capital ( � ):

# �������

As a result, private investment _I_<sup>_p_</sup> also depends on the determinants of the marginal product of capital— especially total factor productivity _TFP_ , the existing stock of private capital _K_<sup>_p_</sup> , and the availability of complementary public capital _K_<sup>_g_</sup> . In the presence of uncertainty, the cost of capital include a risk premium � : Higher cost of capital—whether due to higher risk premia or higher risk‐free real interest rates—would reduce investment, whereas higher productivity and complementary public capital would raise it. In the data used in this study, the distinction between private and public capital is not available for a broad set of countries. Hence, the analysis is based on aggregate investment _I_ , including both private and public investment.

# �������, �, �, �, ��

The investment growth regression employed in the paper includes explanatory variables as proxies for elements of this equation. The returns to capital ( _MPK_ ) are proxied by output growth and terms of trade growth. The risk premium is proxied by measures of political uncertainty and financial market uncertainty. The cost of financing investment is proxied by FDI inflows, private credit, and the business climate.

These explanatory variables are also used in an extensive literature that has examined the determinants of investment growth. These include weak output growth, the terms‐of‐trade shocks caused by the slide in commodity prices since 2011, slow FDI flows, and intermittent bouts of political and policy uncertainty.

_Weak output growth._ The weakness in investment growth has coincided with weakness in output growth and a deteriorating growth outlook for EMDEs (Didier et al. 2015). The growth slowdown in EMDEs has reflected both structural factors and cyclical components. Weak growth prospects signal reduced opportunities for firms selling their goods and services and thus lead to lower investment. This is captured in the “accelerator model,” which assumes that firms aim to maintain a constant capital‐to‐output ratio, in line with their expectations of future output growth (Jorgenson 1963; Jorgenson and Siebert 1968). Recent work on advanced economies has shown that output growth captures broad trends in investment, but actual investment often falls short of the model predictions.<sup>16</sup> In the regression, weak growth prospects are proxied by lagged output growth to reduce concerns about endogeneity.<sup>17</sup>

> 16 Lewis et al. (2014); Barkbu et al. (2015); Banerjee, Kearns, and Lombardi (2015); and Leboeuf and Fay (2016).

> 17 Ideally, growth prospects would be captured by forecasts for several years ahead. However, these are highly endogenous to investment and highly correlated with FDI inflows. Alternatively, a truly exogenous source of output growth would be used, such as changes in public investment. However, the available panel data on public and private investment are sparse to conduct a panel regression. Some authors include measures of foreign demand into similar types of panel regressions. However, when included here, export growth is insignificant as its effect is captured by domestic output growth.

19