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by

Oliver Morrissey and Manop Udomkerdmongkol School of Economics, University of Nottingham and the Bank of Thailand

This version June 2008

Abstract The paper investigates the impact of exchange rates on US foreign direct investment (FDI) inflows to a sample of 16 emerging market countries using panel data for the period 1990-2002. Three variables are utilized to capture separate exchange rate effects. The bilateral exchange rate to the US$ captures the value of local currency (a higher value implies a cheaper currency and attracts FDI). Changes in real effective exchange rate index (REER) proxy for expected changes in the exchange rate: an increasing (decreasing) REER is interpreted as devaluation (appreciation) being expected, so that FDI is postponed (encouraged). The transitory component of bilateral exchange rates is a proxy for volatility of local currency, which discourages FDI. The results support the ‘Chakrabarti and Scholnick’ hypothesis that, ceteris paribus, there is a negative relationship between the expectation of local currency depreciation and FDI inflows. Cheaper local currency (devaluation) attracts FDI as volatile exchange rates discourage FDI.

Authors The authors are respectively Professor in Development Economics in the School of Economics, University of Nottingham UK, and Senior Economist in Monetary Policy Group, the Bank of Thailand. Contact author manopu@bot.or.th. The views expressed in this article are those of the authors and do not necessarily represent those of the Bank of Thailand or Bank of Thailand policy.

1.

Introduction

Empirical studies on FDI and exchange rate linkages are important for the formulation of FDI policies given that there has been an increase in the number of countries adopting floating exchange rates (or abandoning fixed pegs, if only temporarily). During the last two decades, many studies attempted to examine whether exchange rates are determinants of foreign direct investment (FDI) inflows to host countries. The existing literature has generally found a positive effect of local currency depreciation on inward FDI. Various reasons are suggested, with some studies clarifying the effect of the exchange rates as a supply-side or push factor on the FDI inflows. Specifically, stronger home currency increases outward FDI (see Froot and Stein (1991) and Klein and Rosengren (1994)). Others explain it as the allocation effect - FDI goes to countries where the currency is weaker as a given amount of foreign currency can buy more investment (see Cushman (1985, 1988), Campa (1993), Goldberg and Kolstad (1995), Blonigen (1997) and Chakrabati and Scholnick (2002)). Froot and Stein (1991) investigate the impact of US dollar value on FDI (in US dollar terms) from industrialised countries to the United States (US) using annual data covering 1974-87. They find that US dollar value is statistically negatively correlated with FDI. Blonigen (1997) confirms that the depreciation of US dollar is significantly related to the number of Japanese acquisitions in the United States. Chakrabati and Scholnick (2002) also examine the effect of US dollar exchange rates in 20 OECD countries from 1982-95 on FDI inflows (in US dollar terms) from the United States. Their results, however, are inconclusive, and it seems to be difficult to show robust effects. This paper contributes to the literature on the impact of exchange rates on US FDI inflows to host countries in several ways. The first main contribution is that we employ recent annual aggregate data for 16 emerging market countries over 19902002, which are collected from various official data sources. Secondly, not only do we utilise average official bilateral exchange rates (local currency unit against US dollar) adjusted for inflation to evaluate such effect, but we also employ changes in real effective exchange rate indices (REER) to capture the effect of local currency value expectations on inward FDI. Lastly, based on the Hodrick-Prescott filter, we estimate the temporary component of the bilateral exchange rate to capture the effect of host countries’ exchange rate volatility on FDI flows into the countries. This paper therefore specifically tests three hypotheses: 1. 2. 3. An expected devaluation of local currency lowers current inward FDI. FDI rises when devaluation occurs. Exchange rate volatility discourages FDI.

In line with the hypotheses, we discover three related effects of exchange rates on FDI inflows. First, an expected devaluation postpones FDI. Second, a devaluation attracts FDI. Finally, we find that a volatile exchange rate discourages FDI.

2

1 Then the expected net payoff of the home country’s firm from the venture is expressed as: π = N R( N )E (e1 ) − C ( N )e0 1+ r (1) where N is a measure of the scale of project. the last part summarises findings and concludes the paper. We give a brief synopsis of the model here. Thus. Finally. to investigate the impacts of exchange rates. Assume that there is a multinational enterprise (MNE) in a source country contemplating FDI in a host country. this implies that immediately after devaluation the foreign currency would be temporarily ‘cheap’ (temporary change in foreign currency value). Also. and r is opportunity cost of capital over the project’s life. such a stream may be represented by a single payment coming at the end of project. R is revenue in local currency occurring at a future point in time for unit N. investors do not revise their expectations of future exchange rates to the full extent of changes in current exchange rate. 1 3 . followed by a discussion of the results. The authors support this assumption with an argument that although most FDI projects would lead to a stream of earnings rather than a single earning. As a consequence. C is cost of the project in host country currency payable up-front for unit N. a government’s ability to provide a good investment environment for foreign entrepreneurs will secure greater amounts of FDI inflows to its country. if they believe that a devaluation of a foreign currency will be followed by a mean reversion of the exchange rate. 2. for simplicity. ceteris paribus. e0 is exchange rate (home country currency unit per host country currency unit) at time of making the investment. FDI would flow to the country under these circumstances because foreign assets currently appear to be cheap relative to their expected future income stream. which outlines the theoretical background. As a result. The project concerned is subject to diminishing returns to scale. The subsequent section describes the data set and the econometric framework. E(e1) is expected exchange rate at time when the project pays back. and exchange rate volatility on FDI to emerging market countries. Chakrabarti and Scholnick (2002) argue that owing to inelasticity in expectations. exchange rate expectations. The remainder of this paper begins with section 2. assume that it makes a single payment at a certain point in the future. albeit with different specification and variables. Theoretical Background The paper follows the model of Chakrabarti and Scholnick (2002).Moreover. we find that good economic conditions and foreign investors’ confidence in political and economic conditions of the countries are significant determinants of inward FDI.

which solves the problem. Under this scenario obviously the investor cannot purchase the plant. the model is probably inappropriate for explaining export-oriented FDI in the country. say.d) . In this case when the foreign investor expects that an appreciation of local currency may happen. Analytically. say N*. The investor would gain benefits from the expected devaluation when repatriating profits (in dollar terms). 40 baht. The effect can be seen most easily using a stylised example. Imagine first that a US investor is interested in buying a plant in. The opposite happens in case of depreciation (Chakrabarti and Scholnick (2002)). Moreover. the depreciation of the baht has increased the relative wealth of investor and changed the purchasing outcome. In conclusion. is a function of the opportunity cost of capital and the expected level of depreciation of a home country currency. Thus. the investor may expect the dollar would soon depreciate to a value of. The exchange rate is 25 baht/US dollar.Given diminishing returns to scale assumption. the devaluation of local currency and the expectation of (future) local currency appreciation lead to higher FDI inflows to a host country. an appreciation in a local currency raises expectation of future level of the exchange rate by less than the amount of current appreciation. creating expectation of a future devaluation (of the currency). ∂N*/∂r < 0 and ∂N*/∂d < 0 (2) According to the concept of inelasticity in expectation (as found by Frankel and Froot (1987)). say. agents do not revise their expectations of future exchange rate level to the full extent of changes in current level of exchange rate. Therefore. FDI would not be higher in the country and a negative relationship between the expectation in local currency appreciation and FDI inflows would exist 4 . given this set-up there exists an expected dollar-profit maximising value of N. Now just suppose that the dollar appreciates to a value of 50 baht. the authors summarise that dN* / de0 < 0 (4) (3) In other words. The effects of exchange rates will depend on the motives for FDI. he would deter the export-oriented FDI. the MNE maximises expected net payoff value by choosing an appropriate value of N. Thailand. As a result. dE(e1) / de0 < 1 From equations 2 and 3. in this circumstance. and reducing FDI inflows to the host country. The plant costs 50 million baht (Thai currency unit). say d = log [e0] – log [E(e1)] such that: N* = N*(r. For example. The optimal level of N. The investor’s baht wealth increases to 50 million baht and now he is able to make the investment. The investor has one million US dollar of funds available and no other sources of finance.

among other things.t (5) where FDIi. Malaysia. Froot and Stein (1991). ∆ REERi. We estimate cyclical and irregular components of exchange rate as a proxy of exchange rate variation rather than standard deviation of exchange rate used in their analysis. differences in capital market liberalisation across countries. In addition to specifying the proxy for the hypothesized variables. Pakistan. 5 . the full econometric model to be estimated is specified as follows: FDIi.t + β 3 TFXDi. Venezuela). FDI rises when devaluation occurs and exchange rate volatility discourages FDI. other traditional factors (e. We utilise average official bilateral exchange rates (local currency unit against US dollar) adjusted for inflation (FXD) to specifically capture the impact of exchange rate level on FDI to an emerging market. (2001)) because previous studies suggest that apart from exchange rates. as utilised in Cushman (1985. Empirical Methodology and Data We aim to test three hypotheses: an expected devaluation of foreign currency lowers current inward FDI.t+ β 4 Xi. Uruguay. Schneider and Frey (1985). Yet.t = β0 + β 1 ∆ REERi. As a consequence. µ i is a country specific time invariant effect. Morocco. Paraguay.t is change in log of real effective exchange rate index (REER). and ε i . The hypothesized variables are bilateral exchange rates adjusted for inflation (logged. FXD). TFXDi. exchange rate shock). 1988). export potential. (1998). labour costs. We adapt this framework since we have no high frequency (monthly or daily) data on exchange rates in some emerging market countries (such as Tunisia. Previous empirical literature is used as a guide to the variables that should be included in our work. China.t is US FDI inflows to country i. Bolivia. for example.instead. market potential.t is a vector capturing other country level determinants of inward FDI.t is bilateral exchange rates adjusted for inflation (logged). The exchange rate measures are explained below. Thus skewness of exchange rate as a proxy of exchange rate shock is excluded from our model. We modify and extend Chakrabarti and Scholnick (2002)’s framework: inflows of FDI = f (level of exchange rate. exchange rate volatility. for example. 3. Tuman and Emmert (1999). FXDi. Gastanaga et al. Costa Rica.t is the remaining white noise error term.t + β 2 FXDi.g. effects of government policy and institutions that are slow to change over time. it is important to specify control variables (see. we cannot test for this in the paper due to unavailability of detailed data on FDI motives. and Xi.t+ µ i + ε i . inflation) are also important determinants of FDI. TFXD). Noorbakhsh et al.t is temporary component of bilateral exchange rates (logged). change in log of REER (∆REER) and temporary (cyclical and irregular) component of the exchange rates (logged. This captures.

so the change ‘predicts’ how nominal exchange rate will move in future. Findings show that in most cases real exchange rate appreciations (overvaluations) are reversed with nominal devaluations. Chinn (2005) argues that calculating the overvaluation as a deviation from an estimated trend is not a valid procedure unless time series being examined are I(0) variables. relative to its main trading partners. we use the proxy of changes relative to a base year. This method refers to a calculation of average exchange rates of major trading partners by giving weightings in accordance with each country's trade proportion prior to adjusting it to differences in inflation rates between a country and its trade partners. As we do not have data for this. to decide whether REER at a given time is too weak or strong. an overvalued currency generates unsustainable current account deficits through the loss of competitiveness leading to a possible recession and losses of reserves. as Froot and Stein (1991) and Chakrabarti and Scholnick (2000) argue. However. to test the hypothesis. it is difficult to identify the equilibrium REER. one likes to know if REER is at its equilibrium value. albeit imperfectly. The International Monetary Fund (IMF) defines REER as nominal effective exchange rate adjusted for relative movements in national price indicators of a home country and selected countries. Nonetheless. An increase (decrease) in REER implies that MNEs may expect local currency devaluation (appreciation).Klein and Rosengren (1994). Goldfajn and Valdes calculate the overvaluation series as deviations of real exchange rate from a Hodrick-Prescott (H-P) filter series. we would consider if the REER is above or below the equilibrium value. Blonigen (1997) and Goldberg and Klein (1998). and. assuming that first difference proxies deviation from equilibrium. Goldberg and Kolstad (1995). Goldfajn and Valdes (1999) empirically analyse a broad range of real exchange rate appreciation cases in 93 countries over the period 1960-94 and hypothesize that real appreciations or overvaluations are reversed with nominal depreciations. Perhaps the most common and natural application of REER is to assess a country’s competitiveness. REER can play an important and useful role in conveying key summary information to policy makers. REER can be used to assess the competitiveness and overvaluation in a host country. Strictly speaking. hence. In practice. comparison to the index of a base year fixed at 100 must be undertaken. so. In fact. Due to data limitation in sample countries. 2 6 . exchange rate data from futures markets cannot be used in this study to investigate the exchange rate expectations impact on FDI. We calculate the change in log of host country’s REER2 ( ∆ REER) as a proxy of local currency (value) expectation. for example the country competitiveness and overvaluation (Waiquamdee et al. exchange rate series of emerging markets do not appear to be I(0) processes. the H-P filter procedure is not justified (Chinn (2000)). Hence. (2005)). we assume that it tends on average to move towards equilibrium. Policy makers thus correct the overvaluation through nominal devaluation. Ideally. that FDI rises when devaluation occurs.

but. In our investigation. The overvalued currency generates unsustainable current account deficits through the loss of competitiveness that leads to a possible recession and losses of reserves. In other words.If domestic economy is improving relative to its trading partners. Its central bank therefore corrects the overvaluation through nominal devaluation (Goldfajn and Valdes (1999)). we therefore calculate and employ the temporary component as a proxy of exchange rate volatility to test the hypothesis: volatile exchange rates discourage FDI inflows. whereas we investigate three separate effects of exchange rates on US FDI to emerging markets – the impacts of exchange rate level. Therefore. as argued by Campa (1993). the two elements in the temporary component of exchange rate generate exchange rate variability. Based on the additive model. in this study we use annual data to test the hypotheses. Turning our attention to the variable of exchange rate variability (TFXD). 3 7 . current inflows of FDI would decrease (as argued by Chakrabarti and Scholnick (2000)). One may argue that seasonal factor may cause exchange rate volatility too. This study differs from Chakrabarti and Scholnick (2002): they evaluate the impacts of exchange rates and exchange rate volatility on US FDI to OECD countries. exchange rate expectations and exchange rate volatility. although the H-P filter procedure is not appropriate for capturing the exchange rate expectations effect on FDI. Technically. exchange rate – trend component = cyclical component + irregular component. exchange rate as the sum of its components is: exchange rate = trend component + cyclical component + irregular component. Newbold (1995) documents that cyclical and irregular elements appear to exhibit oscillatory and unpredictable behaviour of series (exchange rates series in particular). it could be used to capture long-term trends in (bilateral) exchange rate series and allow us to focus on cyclical and irregular components of exchange rates (Goldfajn and Valdes (1999)) that generate exchange rate volatility3 (Newbold (1995)). the real exchange rate should be appreciating or the local currency is over-valued – REER is higher than that of the base year. Thus the element can be dropped from our consideration. An expected devaluation of local currency lowers current FDI inflows. increased REER (caused by real exchange rate appreciation) implies that local currency would devalue in the near future. In sum. it is a smoothing technique to receive a smooth estimate of the long-term trend component of a series. Under this circumstance. We utilise H-P filter approach (see Appendix for details) to estimate the trend component. it is a curve fitting procedure to estimate the long-term trend path of a series subject to the constraint that the sum of squared differences of the trend series is not too large (Hodrick and Prescott (1997)). attracting both FDI and portfolio investment. The opposite happens in case of real exchange rate depreciation.

Portfolio investment. Number of telephone lines. Schneider and Frey (1985) find that in developing countries high inflation discourages FDI using cross-section data estimation. This is an indicator of infrastructure level. Empirical studies also confirm that (domestic) market potential. the country specific factor (in equation 5) could capture its impact on inward FDI. we control for other determinants that could significantly determine an entry of a MNE to invest in the country. A possibility might be that as an inverse proxy for political and economic uncertainty portfolio investment may reflect the uncertainty in a developing country. A large domestic market permits the exploitation of economies of scale. Therefore. Labour costs. as in Wheeler and Mody (1992). Gastanaga et al. • • Share of manufacturing in GDP.Furthermore. We recognize that degree of openness is also an important determinant of FDI. Singh and Jun (1995). (1998). however. which is likely to stimulate FDI. MNEs can reduce production costs by transferring more mobile production factors to a cheaper labour country. MNEs are attracted to a country with high export potential. attracts FDI (see Gastanaga et al. Moreover. More industrialised countries attract more technology intensive FDI. Aseidu (2002)). Inflation rate. Schneider and Frey (1985) show that relative labour costs are an important factor of FDI inflows to 80 developing countries. it does not significantly vary over time. (1998). especially over short period. In contrast to capital and technology. the export-oriented country has better economic records suggesting a more stable economic climate (see Singh and Jun (1995). This proxies for industrialisation degree of a host country. This represents a measure of foreign investor confidence and may be positively correlated with FDI.g. The absence of infrastructure in a host country can be a deterrent of FDI since low infrastructure level substantially increases operational costs. The importance of labour costs as a factor of FDI to a host country is almost self-evident. measured by GDP growth. labour has low mobility. Empirical studies examine the effect of host country’s macroeconomic management on FDI. inclusion of the variable may introduce multicollinearity. we include the following variables: • Real GDP growth. as identified in the previous empirical literature (e. Neumayer and Spess (2005)). Aseidu (2002). Neumayer and Spess (2005)). To some • • • • 8 . In addition. Export ratio (exports over GDP). Specifically. There is empirical support for the argument that export orientation attracts FDI. Its importance results from informal skills embodied in the labour force. as in Aseidu (2002).

Other coefficients are expected to be negative. On the other hand. It is because the FDI data is in US dollar. in our sample. Malaysia. for example. then an investment of a given investment size (in local currency) now requires fewer US dollar. may exist in an exceptional case – FDI in an economy giving very limited investment opportunity to investors. Tuman and Emmert (1999). One may argue that lagged FDI is also a significant factor of FDI in a dynamic context. Dominican Republic. Lucas (1993). and treated as the dependent variable. Due to data limitation in developing countries. Under this circumstance. Chile. portfolio investment however represents a measure of foreign investor confidence. Colombia. and Venezuela). on one hand. 5 countries from Asia (China. This would mean that local currency devaluation would be negatively associated with FDI by definition. In the selection and transformation of most of our data. The countries consist of 8 Latin American countries (Bolivia. Net US FDI (constant 2000. using dynamic panel data model. and asymptotic properties are considered as N becomes large with T fixed (Bond (2002). N > 40 and T ≤ 5). Goldberg and Klein (1998). Baum (2006)).extent the rise in portfolio capital. UNCTAD (1999) moreover suggests that FDI is positively correlated with portfolio investment. GDP growth. indicating higher (foreign) investor confidence (lower underlying uncertainty). and 3 African countries (Morocco. Paraguay. We use balance of payments data to construct the dependent variable but are aware that the data represent financial flows generated by MNEs. share of portfolio investment and exports in GDP. we expect positive coefficients on the exchange rate level. manufacturing/GDP ratio. as documented in Busse and Hefeker (2005). N (16) is low relative to T (13) (typically. Pakistan. If a currency depreciates. One may ask a question relating to the dependent variable. The negative relationship. most of the empirical studies (see. we follow established practice in the field of research. for GMM. Wezel (2003)) construct the dependent variable based on the balance of payment data. the Philippines. In addition. Costa Rica. In our estimation. the number of individuals for which data is available (N) is assumed to be large whilst the number of time periods for which data is available (T) is assumed to be small. South Africa. the number of telephone mainlines. We collect annual aggregate data representing those variables for the estimation. Uruguay. Billions of US dollar) to the countries is available from Bureau of Economic Analysis at the US Department of Commerce. and Thailand). and do not totally represent MNEs’ real activity (Lipsey (2001)). which provide many chances for FDI (Wells and Wint 9 . The data covering 1990-2002 for 16 emerging market countries are selected from International Monetary Fund (2003) on basis of data availability. inflows of FDI would not rise. In our study. boosts the relative attraction of the country for direct investment. we concentrate on US FDI in emerging markets. and Tunisia). since it reflects MNEs’ confidence in economic fundamentals and political environment is an important attractor for FDI.

Driven by market seeking and efficiency seeking FDI. At the same time. the decline was attributed to cyclical movements reflecting. following the 1997 Asian economic crisis. The devaluation advantage (the wealth effect as presented in Froot and Stein (1991)) would stimulate new FDI projects by US investors or make US MNEs change their investment plans to undertake FDI in the emerging market countries. growth trends in the world economy and fallout from the bursting of technology and telecommunications bubble. 000 10. 000 0 19 90 19 91 19 92 19 19 19 19 19 20 20 20 19 93 19 94 95 96 97 99 00 01 02 98 -5. Millions of US dollars) 20. US FDI to the countries fell rapidly owing largely to falling investments in Latin America. the acquisitions of distressed banking and corporate assets surged in several Asian countries.(2000)). 000 15. On the other hand. In the 1990s. among other things. To some extent. regional and domestic growth prospects affected FDI. Net FDI Flows from the United States to the Emerging Market Countries (constant 2000. direct investment in Asia increased in the late 1990s (IMF (2003)). Figure 1 presents US FDI trends in the countries. 000 5. US Department of Commerce and Author’s Computation Figure 1 10 . 000 The Emerg ing Market Countries Th e Asian Countries The Latin Ame rica Countries The African Countries Source: Bureau of Economi c Analysis.

US dollar) to obtain portfolio investment (PORT)/GDP ratio as a proxy of foreign investors’ confidence. International Monetary Fund (IMF) through World Development Indicators (WDI) 2004. (1998). US dollar) is from WDI 2004. constant 2000. Real effective exchange rate indices (REER. 4. Aseidu (2002)). 8. GDP growth (GGDP. used as a proxy of market potential (see. Singh and Jun (1995). Tables 1 and 2 provide descriptive statistics and the correlation of those variables. Exports of goods and services (EXP) as a ratio of GDP (constant 2000. for example.1988). where differences in labour costs across country can be expected to be highly correlated with differences in GDP per capita. 2000=100) are from International Financial Statistics. It is adjusted by GDP (current. 5. Klein and Rosengren (1994)). Average official bilateral exchange rates (local currency unit against US dollar) are from WDI 2004. The IMF defines NEER as a ratio of period average exchange rates currency in question (index) to a trade weighted geometric average of exchange rates for selected country currencies. Data on number of telephone mainlines (TEL) extracted from WDI 2004. They are adjusted by CPI (2000=100) of host countries to acquire real exchange rates (see Cushman (1985. 9. The IMF defines REER as nominal effective exchange rate4 (NEER) adjusted for relative movements in national price indicators (CPI) of a home country and selected countries. measured as percentage annual growth of GDP deflator. Froot and Stein (1991). US dollar) is from WDI 2004 as a proxy of labour costs (see Cohen (1991)). 7. US dollar) is from WDI 2004. US dollar) are from WDI 2004 as a proxy of export potential (see. Neumayer and Spess (2005)). utilised as a proxy of infrastructure (see Aseidu (2002)). is from WDI 2004 as a proxy of macroeconomic conditions (see Schneider and Frey (1985). Gastanaga et al. GDP per capita (PGDP. 3. Inflation (INF). Manufacturing (MNU) as a share of GDP (constant 2000. 2. While this is admittedly a rough proxy it may not be too problematic in our cross-country context. constant 2000. 4 11 . US dollar) is from WDI 2004 as a proxy of industrialisation (see Wheeler and Mody (1992)). Tuman and Emmert (1999)).The independent variables are measured as: 1. Portfolio investment (current. for example. 6.

87 -11.08 0.97 0.91 32.30 0.10 Source: the US Department of Commerce.12 1 -0.88 124.02 0.18 1 Source: the US Department of Commerce.76 20.20 2.86 -0.96 3.47 34.93 -4.95 91.04 -0.03 363.93 -7.75 20.Table 1: Descriptive statistics Sample: 16 countries and 1990-2002 Variable FDI (Millions of US dollars) FXD REER GGDP PGDP MNU/GDP INF TEL PORT/GDP EXP/GDP Mean 522.21 1 -0.03 0.04 -0.48 95.03 -0.10 43.56 999.12 0.13 -0.58 8.37 0.27 14.18 0.19 0.15 0.71 65.D.87 4.53 S.01 0.25 -0.04 5.26 1 -0.04 0.01 1 0.05 0.01 -0.85 1.52 282.95 2408.33 0.68 5.25 -0.38 -0.11 1 0.12 1596. 1406.20 133.18 -0.63 14.25 -0.01 -0.02 0.16 -0. WDI 2004 and the author’s computation Table 2: Correlation matrix Sample: 16 countries and 1990-2002 FDI FDI ∆REER FXD TFXD GGDP PGDP MNU/GDP INF TEL PORT/GDP EXP/GDP ∆REER FXD TFXD GGDP PGDP MNU/GDP INF TEL PORT/GDP EXP/GDP 1 0.13 0.20 6377.822.13 0.03 0.03 4.19 0.02 0.45 1 0.08 0.07 Max 11320. WDI 2004 and the author’s computation 12 .28 1 -0.12 0.12 -0.08 0.21 1 -0.33 0.39 115.07 -0.31 0.21 0.08 1 -0.02 0.65 500.21 -0.73 35.03 0.83 14.97 16.15 -0.15 0.41 Min -1586.57 12.

The expected positive response of FDI inflows to depreciation of local currency is also shown. fixed-effects model generates consistent estimators while random effects estimation provides inconsistent coefficients of regressors. The estimates reveal negative responses of the FDI inflows to expectations of local currency devaluation and local currency volatility. An increase in foreign investors’ confidence encourages inward FDI. In the final column in Table 3. The Hausman test (Baltagi (2001)) is used to justify which technique is more appropriate and. Fixed effects model is built on an assumption that there is correlation between country specific factors (unobserved specific effects) and independent variable(s). The estimated 5 It is implemented using STATA. If the correlation is zero. The estimated coefficients of these variables are statistically significant at 5 percent level. random effects estimation then generates consistent and efficient estimators whilst estimators given by fixed effects model are still consistent but inefficient (Wooldridge (2002)). We also check for first-order autocorrelation of the residuals by the LM test.4.48 is greater than the 5% critical value of the chi-squared distribution with 10 degrees of freedom. Econometric Analysis and Results We firstly estimate equation (5) by employing (within-groups) fixed and random effects (or pooled OLS estimation if summation of estimates of unobserved effect equals zero) to allow for country specific time invariant effects. showing for the data fixed-effects estimation is more appropriate than random effects estimation (since the correlation is not equal to zero). This allows us to perform estimation again with fixed-effects. In presence of such correlation. the results provide evidence that high inflation discourages FDI inflows. based on random effects estimation. In addition. Its statistic of 85. We finally perform a robustness check of regional effects on FDI determination by dividing the countries into two regions: Latin America and Asia. If the errors are not independent and identically distributed (iid) (generating inefficient estimators (Beck and Katz (1995)). the results reveal a positive association between FDI inflows and local currency depreciation. Industrialisation degree (MNU/GDP ratio) and market potential (real GDP growth) of host country are positively correlated with inflows of FDI. The Hausman test is undertaken to check presence of correlation between country specific factors and the independent variables. 13 . The other independent variables are not statistically significant. The estimated coefficients are statistically significant at 5 percent level. in our case. fixed-effects with firstorder autocorrelation disturbances estimation5 (Baltagi and Li (1991)) is employed (to remedy the problem). Fixed effects estimation results (192 observations) are presented in Table 3. the test shows a preference for the fixed effects technique. Tables 3 and 4 report estimated coefficients of the independent variables on the (net) US inward FDI to the emerging market countries and the Latin American and Asian countries for the 1990-2002 period.

Table 3: Basic estimation results.02(0.06(0.07) -0.01(0.65 0.38) -0.83) -40.13) 6.17) 0.89(0.89) -41.39(0.11(0.01) 6.01(0.28(0.53(0.32(0.03(0.00) 179.26(0.00) 0.41(0.02(0.92(0.14 85.76(0.61(0.08(0.83(0.61) -0.01) -0.55) 176 176 176 192 192 Notes: The figures in parentheses are P-values (significant coefficients in bold).01(0.95(0.06(0.91) 2.83(0.01(0.01(0.21) 0. 1990-2002 Dependent variable: FDI VARIABLES FIXED EFFECTS WITH AR(1) DISTURBANCES FIXED EFFECTS RANDOM EFFECTS ∆ log of REER FXD (logged) TFXD (logged) MNU/GDP INF EXP/GDP PGDP (logged) PORT/GDP TEL (logged) GGDP Constant TIME ∆REER*TFXD (logged) Coefficient of determination Hausman test statistic LM test statistic Koenker-Bassett test statistic Number of observations -0.25(0.16) 3.69(0.51(0.06) -0.02(0. The other coefficients are statistically insignificant.04(0.65(0.02(0.01) -0.14(0.02) -9.00) -6.17(0.47(0.66) -0.91) -0.01(0.14) 0.26) - -0.01) -0.44) 0.01(0.99(0.43(0.64(0. 14 .08) -0.47(0.91) 0.33(0.41 0.01(0.04(0.48(0.09) -0.49) 1.09) -0.08) -0.01(0.11) 0.54) 3.08) 5.91) 3.16) -0.95) -41.10(0.17) 0. the 5% critical value of Chi-squared distribution with 1 degree of freedom is 3.00) -1.04(0.84.10) -0.49(0.01(0.61(0.43) -0.21 0.01(0.30 0.03) -0.00) -0.07) 5.54(0.12) 0.34 0.68) 0.04) -0.00) -0.19) 0.00) -7.03(0.17) 0.04) 0.58) -0.coefficients are statistically significant at 10 percent level.87) -0.67(0.00) -6.00) -6.01(0.18) 0.03(0.74(0.01) -0.

the estimated coefficient of exchange rate expectation is not statistically significant whilst the impacts of foreign currency devaluation and volatility of the exchange rate on the inward FDI are comparable to those obtained before: local currency depreciation stimulates FDI and volatile exchange rate discourages FDI. As a result. Including the interaction term improves the overall performance of the regression (R2 = 0. In this regression. In line with the hypotheses. To test the hypothesis that the 1997 economic crisis may decrease inflows of FDI to the emerging markets as found in Siamwalla (2004). These suggest that a rise in foreign investor’s confidence and lower inflation in a host country stimulate inflows of FDI. There is no evidence that the economic crisis has any impact on US MNEs decision to undertake FDI in the emerging markets. To remedy the problem. Chakrabarti and Scholnick (2000) and Campa (1993) argue. however. Carlson and Osler (2000). as Froot and Stein (1991). there is no evidence that other independent variables have any impacts on US FDI inflows. 6 15 . the fixed effects estimation allowing for first-order autocorrelation is used (176 observations). FDI rises when devaluation occurs. The other independent variables are statistically insignificant. we reject the null hypothesis of no first-order autocorrelation. volatile exchange rate discourages FDI. Finally. The coefficients on inflation and portfolio investment also turn out to have the expected signs (statistically significant) in this regression. has a positive impact on the inward FDI. Results show that the estimated coefficient of the interaction variable We perform the Koenker-Bassett test to check for the heteroscedasticity problem. It turns out that inflation has no explanatory power on US MNEs decision but foreign investor’s confidence. Honohan (1985) documents that in a rumor-prone foreign exchange market volatile exchange rate generates large forecasting errors since professionals abandon their view and concentrate instead on guessing what the amateurs are going to do. With the importance of the expectations and volatility interaction. we examine whether exchange rate expectations interact with exchange rate volatility to affect the FDI inflows. in equation 5 we include a time dummy variable (TIME). On the other hand. argue that speculative activities in an economy in which all agents are rational. which equals to 1 if the period is 1997-2002 and 0 otherwise (see second column in Table 3). we thus include the interaction variable (∆REER*TFXD) in equation 5 (see first column in Table 3). however. have identical priors and have access to identical information can increase exchange rate variation. The estimated coefficients are statistically significant at 10 percent level. findings (as presented in Table 3) indicate that an expected devaluation of local currency lowers current inward FDI. measured by portfolio capital/GDP ratio. who develop a theoretical model highlighting a positive connection between rational expectations and exchange rate volatility. From the regression.34). the calculated test statistic suggests homoscedastic errors.We undertake the LM test for the fixed-effects model to check for first-order autocorrelation. The results are broadly consistent with prior expectations and with the evidence found in previous studies of FDI determination such as Schneider and Frey (1985) and Tuman and Emmert (1999).6 The calculated test statistic is greater than the 5% critical value of the chi-squared distribution with 1 degree of freedom.

t+ β5ASIA + β6 ASIA* ∆ REERi. an expected devaluation of foreign currency lowers current inward FDI. The LM test however suggests misspecification due to first-order autocorrelation.t+ β 4 Xi.e.(-0. as Cushman (1985. it is important to test the regional effects on US FDI inflows. Previous results are largely confirmed in this regression. Using fixed effects estimation.t + β 3 TFXDi.25) is negative and statistically significant. Higher inflation decreases the FDI inflows.25*∆REER.t (6) where ASIA is a dummy variable that is 1 for Asian countries and 0 otherwise. The Koenker-Bassett test statistic shows that the errors are homoscedastic. In line with our hypotheses. The estimated coefficients on change in REER and transitory component of exchange rate are negative and statistically significant whilst the level of exchange rate has positive and statistically significant coefficient. exchange rate expectations give weight on exchange rate variation. The coefficient on portfolio capital/GDP ratio is positive and statistically significant. To have a sensible comparison group we include Latin American countries in this sample (i. In case of expected appreciation (∆REER < 0). the exchange rate variation effect on FDI is negative if ∆REER is between 0 and -3. Regional Effects on FDI Inflows The three separate exchange rate effects on FDI may quantitatively differ across regions. as discovered in previous regression. In case of expected appreciation. 8 16 . In addition. FDIi. Therefore. volatility of exchange rate discourages direct investment in general. In addition.t+ µ i + ε i . 1988) and Goldberg and Kolstad (1995) argue. volatility of exchange rate lowers FDI.32.t + β7 ASIA*FXDi. after the crisis some of the countries adopted floating exchange rate regime (Waiquamdee et al. (2005)).t + β8 ASIA*TFXDi.0.32 otherwise the volatility stimulates FDI7.83 .t + β 2 FXDi.8 The calculated test statistic is 7 ∂ FDI/ ∂ TFXD = -0. If devaluation is expected (∆REER > 0). omit the African countries). This implies that given change in REER. This confirms that foreign investor’s confidence stimulates FDI to emerging markets.t = β0 + β 1 ∆ REERi. the variation discourages FDI if change in REER is between 0 and -3. FDI increases when depreciation occurs. We estimate a version of equation (5) which includes a dummy variable for Asian countries interacted with the core explanatory variables. The 1997 economic crisis has a significant and direct impact on level of exchange rates in Asian countries (Siamwalla (2004)). as found in the previous literature. the greater is volatility the greater the extent to which FDI is discouraged. the previous results are largely confirmed but Asia exhibits some differences compared to Latin America (the samples are too small to reliably estimate each region separately). as found in Campa (1993).

17 . The findings for fixed effects allowing for first-order autocorrelation show that the results on inflation and market potential variables are broadly consistent with prior expectations and with the evidence found in other studies of FDI determination.0. the impacts of volatile exchange rates and local currency appreciation effects are slightly weaker for Asian countries. Tuman and Emmert (1999) and Wezel (2003). albeit with some regional variations.greater than the 5% critical value of the chi-squared distribution with 1 degree of freedom so we can reject the null hypothesis of no first-order autocorrelation9. the impacts of exchange rate devaluation. we re-estimate by fixed-effects with AR(1) disturbances. The other independent variables are statistically insignificant.95 (i.e. local currency devaluation increases FDI inflows. the expectation in local currency devaluation (increasing REER) coefficient is –4. As a result..93. An estimate of the extent of extra FDI to Asia compared to Latin America is 2. the impact of expected local currency devaluation is considerably greater for Asian countries. Inflation discourages whereas market potential encourages inflows of FDI. evaluated at mean values of variables. volatility of exchange rate and the expectations on US FDI inflows to emerging markets are consistent with those reported in Table 3. The F-test statistic of 18. The remaining variables are not statistically significant. In contrast. Gastanaga et al. 1998. for both Latin American and Asian countries. Using pooled OLS estimation. local currency appreciation and expectations of local currency depreciation all discourage FDI flows into both Latin America and Asia. such as Schneider and Frey (1985).76 is greater than the 5% critical value of the F-distribution with 12 and 130 degrees of freedom. but for Asian countries it is –9. In line with the hypotheses. β1 + β12 = -4+-5.95). exchange rate volatility. the estimates show positive responses of the FDI inflows to GDP growth in all of the countries. However. Thus. in the Latin American countries. indicates that fixed effects estimation is more appropriate than pooled OLS estimation for the data. and.10 In Latin America. 10 9 ∂ FDI / ∂ ASIA = β11 + β12 ∆ REER + β13FXD + β14TFXD.

02(0.00) -9.01) 0.48 10.05(0.76(0.55 1.01) 3.02) 9.20) 0.00(0.17) 143 156 156 Notes: The figures in parentheses are P-values (significant coefficients in bold).02(0.01(0.84.93(0.37(0.29(0.95(0. β9) GGDP (β10) ASIA (β11) ASIA*∆ log of REER (β12) ASIA*FXD (logged) (β13) ASIA*TFXD (logged) (β14) Constant Coefficient of determination F-test: H0: β1+ β12 = 0 F-test: H0: β2+ β13 = 0 F-test: H0: β3+ β14 = 0 F-test statistic LM test (Chi-squared) statistic Koenker-Bassett test statistic Number of observations -4.01) 0.81(0.64(0. 18 . β2) TFXD (logged.27) -0.04) -0.88) -0.01(0.29(0.73) -0.05) 6.11(0.87(0.23) -0.06) 0.24(0.26 18.42(0.69(0.74) -0.00) -0.38(0.14(0.74(0.00) 143.07) 24.49) 0.67(0.16) -0.05(0.00) -0.76(0.00) -10.08) 0.11) 0. the 5% critical value of Chi-squared distribution with 1 degree of freedom is 3.38(0.04(0.00) 0.01(0.07) -3.03(0. β3) MNU/GDP (β4) INF (β5) EXP/GDP (β6) PGDP (logged.38) -0. β7) PORT/GDP (β8) TEL (logged.01) 1.06(0.68) 4.76(0.00) -3.02(0.37(0.39) -0.03) 1.28) -0.Table 4: Regression results: is Asia different? Dependent variable: FDI VARIABLES FIXED EFFECTS WITH AR(1) DISTURBANCES FIXED EFFECTS OLS ∆ log of REER (β1) FXD (logged.36(0.89) 5.44(0.01(0.99(0.00) -67.55 (0.01) 9.07(0.05) 2.22(0.58(0.07(0.01) 4.01) -5.01) -7.14) 0.03(0.47(0.41) -7.17) -0.79(0.37) 0.00) 0.12) 0.19(0.43 0.56(0.03) 1.09) 6.87(0.

The interaction variable (∆REER*TFXD) is significant. we expect that exchange rate volatility has probably a significant role on FDI inflows. Our results can be summarised as: 1. perhaps because this is correlated with economic and political uncertainty. Concluding Remarks This paper investigates the effects of exchange rates. There is evidence of the negative relationship of volatile exchange rates and FDI inflows. In addition. exchange rate expectations give weight on exchange rate variation.5. telecommunications. The result implies that FDI in the countries is increasingly being undertaken to service domestic demand for finance. the greater is volatility the greater the extent to which FDI is discouraged. and exchange rate volatility on (net) US FDI to 16 emerging market countries. exchange rate expectations. US investors are discouraged by volatile exchange rates. We find that economic conditions and foreign investors’ confidence in host countries are significant. We employ annual aggregate data over the period of 1990-2002. which then affect FDI.32 otherwise the variability encourages FDI. If devaluation is expected. wholesaling. There is evidence of the negative (positive) relationship of expectations of local currency depreciation (appreciation) and FDI inflows. 19 . and retailing rather than to tap cheap labour. This supports an argument by IMF (2003). although an expected devaluation postpones FDI. In addition. Our hypotheses based on the model are that expectations of local currency appreciation and local currency depreciation may stimulate inward FDI. Foreign investors in emerging markets do respond to the exchange rate: devaluation attracts FDI (as it reduces the price of assets abroad). especially in Asia. 4. a volatile exchange rate discourages FDI. which also appears to discourage FDI. 6. 3. Our empirical estimation starts from. Given change in REER. 5. There is robust evidence of the positive (negative) relationship of local currency devaluation (appreciation) and FDI inflows. a model by Chakrabarti and Scholnick (2002). 2. and extends. In case of expected appreciation. the variation decreases FDI when change in REER is between 0 and -3. The 1997 economic crisis has no impact on US FDI in emerging markets possibly because the impact is on exchange rates.

However. particularly when MNEs have different FDI objectives. Another improvement of this paper would be to utilise data from future exchange rate markets and the standard deviation of high frequency (monthly or daily) exchange rate data to re-analyze the effects of exchange rate expectations and volatility on FDI inflows. One is interested in low cost production (export-oriented FDI). this investigation indicates the need to undertake the firm-level analysis. which requires detailed information on firm activities. The other is interested in domestic sales (marketseeking FDI). 20 . The country-level analysis moreover has some limitations. Suppose two types of MNEs with two different FDI objectives exist in a host country. As a consequence.Our analysis contributes to the discussion of the impacts of exchange rates on FDI. The utilisation of longer and/or broader data series would extend and test the results. the country-level analysis cannot clearly clarify the FDI types (in the country) by capturing the exchange rate expectation impact on inward FDI. a limitation is the sample used here. The period of study starts from 1990 and the sample is restricted to relatively few countries since REER data are not available for earlier years and for many emerging market countries. Under such circumstances.

this technique widely used among economists is a smoothing method to receive a smooth estimate of the long-term trend component of a series. 21 . at the optimum all the gt+1 . 2. The ct are deviations from gt but their average is near zero over long time periods. The larger the value of λ . For a sufficiently large λ .APPENDIX A summary of Hodrick-Prescott filter approach According to Hodrick and Prescott (1997). which is seasonally adjusted. they consider a given time series yt. and a cyclical component ct: yt = gt + ct for t = 1. Technically. Their measure of the smoothness of the {gt} path is the sum of the squares of its second difference. …. The parameter λ is a positive number. which penalises variability in the growth component series. is the sum of a growth component gt. These considerations lead to the following programming problem for determining the growth components: Min gt T T −1 T 2 c + λ ((g t +1 − g t ) − (g t − g t −1 ))2 ∑ ∑ t t =1 t =1 t =2 where ct = yt – gt. This implies that the limit of solutions to program the function as λ approaches infinity is the least squares fit of a linear time trend model. the smoother is the solution series.gt must be arbitrarily near some constant β and therefore the gt arbitrarily near g0 + β t. which varies ‘smoothly’ over time. T.

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