Do better institutions offset the adverse effect of a financial crisis on investment? Evidence from East Asia

Abstract

We extend the neoclassical investment theory to capture the deviation of current institutional quality from its ideal level. We show that an improvement in institutions increases the speed of adjustment towards desired capital stock and the marginal product of capital and hence enhances the investment demand. Next, we apply our theoretical model to East Asia. Using Generalized Method of Moments, we estimate a dynamic panel data model to investigate the effect of alternate measures of institutional quality on investment dynamics in this region. Our findings underline the role of institutions as a deep determinant of investment. We also conclude that the East Asian countries with better institutional quality are less prone to the adverse effects of financial crises on their fixed capital formation. Our results are robust to the estimation methods and changes in institutional measures and hence might have important policy implication for policymakers and investors in East Asia.