Fundamentals, financial factors and firm investment in India: A Panel VAR approach

This study analyses the role of fundamentals and financial factors in determining firm investment in India with imperfect capital market in a panel VAR framework. Previous research in this area is based on the test of significance (or some variant of this) of the cash flow variable in the investment equation. In this strand of research, cash flow is considered to be a financial factor. The major theoretical problem of this approach is that in a forward-looking model cash flow might be correlated to fundamental variable(s) of a firm. Because in a forward looking model, current cash flow of a firm also incorporates expectation of fundamentals. There is a problem of disaggregating the fundamental effect of cash flow from the finance effect. Thus, a statistically significant cash flow may not imply that financial market imperfections determine investment. This could be resolved in a VAR framework as it uses a simultaneous equations model. An econometric model is formulated with the joint determination of investment, marginal profit (marginal with respect to capital stock), cash flow and balance sheet variables. The latter captures financial market imperfections while cash flow is modelled to reflect both fundamental factors as well as financial market imperfections while marginal profit is a pure fundamental variable. Using VAR methodology with dynamic panel is a newer approach in the panel regressions. By suitable orthogonal decomposition (such as Choleski decomposition) of the shocks (to cash flow or to fundamental or financial variables)and then looking at the impulse responses one can understand the nature of dynamic adjustments of investment, fundamentals and financial factors.