Policy Uncertainty and Foreign Direct Investment: Evidence from the China-Japan islands dispute

Abstract

Can a temporary negative shock generate long-lasting effects on economic activities? To show causal evidence, we utilize data from Japanese multinational corporations (MNCs) and explore the economic impact of the unexpected escalation of an islands dispute between China and Japan in 2012. Our difference-in-differences (DID) estimation substantiates that a sharp but temporary fall in the local sales of Japanese MNCs in China led to a persistent downward deviation in the trend of foreign direct investment (FDI). Moreover, despite the quick recovery of local sales, Japanese MNCs in China have continued to underestimate this figure, which has generated pessimistic and more dispersed forecast errors since the island crisis. We view this as evidence for a belief-driven channel through which a large and unexpected shock leads agents to revise their beliefs and start tail risk hedging.