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INTERNATIONAL ECONOMIC JOURNAL Volume 12, Number 1, Spring 1998


THE EFFECTS OF INFLATION AND EXCHANGE RATE POLICIES ON DIRECT INVESTMENT TO DEVELOPING COUNTRIES YOUNG SEOK AHN Korea Development Institute SLAMET SENO ADJI The National Development Planning Agency, Indonesia THOMAS D. WILLETT* Claremont Graduate School and Claremont Mckenna College

This study focuses on the effects of inflation and exchange rate policy on direct investment flows to developing countries. We find that inflation does have a substantial negative effect on capital inflows. Our estimates indicate that this effect can be significantly reduced, but not eliminated, by following exchange rate policies which avoid substantial overvaluation of the currency. [F30]

1. INTRODUCTION In recent years there has been considerable research interest in the effects of inflation on economic performance. The old structuralist and Phillips curve views that inflation (at least up to some point) is good for growth have been replaced by the belief that higher inflation will tend to retard economic growth and a number of recent studies have found empirical support for this view. 1 The channels through which inflation works to retard growth remain the subject of considerable controversy, however. Two types of mechanisms have received particular emphasis. One focuses on the tendency for higher rates of inflation to be more variable and more difficult to predict, thus generating greater uncertainty. While the reasons why higher rates of inflation tend to be more variable are not well understood, there is considerable empirical evidence that such a relationship frequently holds. As a result, higher inflation reduces the information content of price signals and increases economic uncertainty.
*The authors wish to thank Richard C. K. Burdekin, Menzie Chinn, Cheryl Holsey, Manfred Keil, Pamela Martin and two anonymous referees for helpful comments on an earlier version of this paper. 1 See, for example, Burdekin et al. (1995) and Fisher (1993).



A second major source of adverse economic effects from inflation occurs from the interaction of inflation with government policies which fix nominal prices. One major example is nominal ceilings on interest rates which with high rates of inflation often result in negative real interest rates. A second common distortion is the maintenance of a fixed nominal exchange rate which becomes increasingly overvalued as inflation continues. Such overvaluation typically leads to a rising trade deficit and falling reserves which often prompts the increased use of exchange controls and import barriers. We would also expect overvaluation to stimulate capital flight and retard investment inflows. For developing countries, direct investment inflows are widely considered to be a major source of economic growth. Thus policies which discourage such inflows would be expected to have a negative effect on growth. A number of studies have investigated the effects of inflation and exchange rate changes on direct investment, but there has been little attention paid to the interaction of these variables. This is the primary focus of our paper. Another innovation is our use of black market exchange rates as a proxy for exchange rate overvaluation. We also investigate the effects of a number of other variables such as measures of political instability and trade policy orientation. Our study focuses on direct investment flows to a large sample of developing countries. Our empirical findings suggest that exchange rate policies to offset inflation differentials can help reduce the adverse effects of inflation on direct investment flows, but that they are far from sufficient to fully neutralize these effects. In our estimates such realistic exchange rate policies are found to offset only about ten to twenty percent of the adverse effects of inflation on investment flows. Thus while our results present support for the use of prompt exchange rate adjustments if inflation cannot be brought under control, we find that such exchange rate policies can play only a limited role in reducing the adverse economic consequences of continuing inflation. Following such policies does not substantially reduce the case for bringing inflation under control. 2. EXCHANGE RATES, INFLATION AND DIRECT INVESTMENT FLOWS A number of studies have looked at the effects of inflation or of exchange rate changes on direct investment flows.2 Typically, inflation by itself has been found to have a negative effect on direct investment inflows. The effects of devaluation, while more mixed, have most often been found to be positive. 3 What has been seldom analyzed, however, is the relationship between the two. The empirical papers on exchange rates and direct investment flows do not present a consistent theoretical picture. It is sometimes hypothesized that devaluation will reduce capital inflows by destabilizing speculative expectations. This is certainly possible in situations where the devaluation was unexpected and most market

See, for example, Edwards (1991) and Schneider and Frey (1985). See Seno Adji (1995) and Seno Adji et al. (1996).



participants didnt believe that it was needed. On the other hand a devaluation that removes a substantial exchange rate overvaluation should increase the incentives for capital inflows. Within a rational expectations framework, exchange rate expectations would be a function of the degree of over- or undervaluation of the nominal exchange rate relative to perceptions of its equilibrium value. We attempt to capture this condition through two types of proxies. One is the difference between the official and the unofficial or black market exchange rate. There are many reasons why a black market rate may not correspond to the equilibrium free market rate for all transactions.4 Still it seems a reasonable proxy to use. A second proxy is the level of the real exchange rate. Possible changes in the true equilibrium real exchange rate and well-known price indice problems make this also a crude proxy for over- or undervaluation, but it is again one which we believe is worth investigating. Our a priori expectation, however, is that the black market rate should be a better explanatory variable. In addition to the expectations of revaluation that are generated by over- or undervaluation of exchange rates, there is a complementary effect from the level of the real exchange rate on the incentives for direct investment. An appreciation of the real exchange rate gives foreign firms less incentive to invest in the home economy. Exchange rate appreciation acts like a tax on home country exports and a subsidy on imports. Thus for firms from the industrial countries the appreciation creates greater incentives to service the host country market through exports rather than direct investment. It also reduces the incentives for direct investment designed to use the home economy as an export base. Thus on both expectations and trade related grounds we would expect currency overvaluation to reduce direct investment inflows. To investigate the effects of inflation and exchange rate policies on direct investment flows, we control for a number of other variables which have been identified in the literature as potentially important determinants of capital flows. A brief discussion of the rationales for including these variables and their expected effects follows. 5 Direct investment inflows should be a positive function of the expected return on investment and a negative function of the expected risk. For a dependent variable we use is net flows of direct investment to the developing country in question. Direct investment in a developing country, will normally be dominated by investment flows from abroad rather than investment by the countrys own firms. Thus we focus on economic and political developments in the developing country for our explanatory variables. The data used are described in the Appendix.
See Agenor (1992), Agenor and Flood (1992), and Kamin (1993). A more detailed discussion of the rationales for the additional control variables included is presented in Seno Adji et al. (1996). That paper focuses on the effects of a range of political variables on capital flows.
4 5



Our first two of independent variables, real GDP and real GDP per capita, reflect market size and prospective purchasing power in the host country, while the third, the growth rate of real GDP is a proxy for expectations of future growth. The signs on all three variables are expected to be positive. These factors should be important factors in explaining investment which will generate a high proportion of sales to the local market. The next variable is government expenditures as a share of GDP. A large share of government expenditures in GDP may indicate that excessive and unproductive government spending hinders economic growth and that future taxes increases may be expected. However, it may also indicate a willingness of the government: willingness to develop infrastructures that support private enterprises activities. Which effect dominates depends on the types of government expenditure predominating, the governments policy goals and its ability to manage the economy. Note that since our focus in this paper is on inflation and exchange rate policy, our purpose in including other independent variables is to avoid any possible omitted variable bias in our estimated in inflation and exchange rate coefficients. We have included several independent variable whose expected sign is indeterminant. We also include the budget deficit as a percent of GDP. Our expectation is that a larger budget deficit would be seen as reflecting poor economic management and a greater likelihood of future tax increases. Thus we would expect it to have a negative sign. A high debt service ratio is a sign that a country may have difficulty in servicing its foreign debt and may be vulnerable to adverse changes in its foreign trade or the level of international interest rates. If the debt service ratio is very high, capital movements may be restricted. In this case, it may be difficult for foreign investors to repatriate profits back to their home country. However, a high debt service ratio may also indicate the countrys high credit worthiness. That is, it has already attracted a great deal of foreign capital, and that is why its debt service payments are high. The overall effect of debt service ratios on capital flows is not clear. A high value of IMF credit indicates that the country has suffered balance of payments problems. Thus the level of IMF credit provided to a country may be considered a sign of economic uncertainty and of an increased likelihood of future capital controls. However, the procurement of IMF credit also shows that the country is following an IMF approved adjustment program. The IMFs seal of approval should have a positive effect on capital flows into the country. Thus the overall relationship between IMF credit and foreign direct investment is not clear. The effects of trade policy may also go in either direction. Protectionist trade policies may attract direct investment to service the local market. Where the host country is being used primarily as an export platform, liberal trade policies would be more attractive for foreign investors. In addition, trade liberalization may signal more liberal economic policies in general which could improve the overall investment climate. Thus the expected sign is unclear. Domestic political instability in a country, such as political demonstrations, strikes



and riots, may disrupt the economy. It may increase uncertainty about future economic policies and hence increase investment risk and reduce the expected future returns to capital. This would lower foreign capital inflows. 3. EMPIRICAL RESULTS Our statistical analysis considers direct investment flows to a set of twenty three developing countries over the years 1970-81. A longer time period could not be used because of the system-wide effects of the international debt crisis which emerged in the early 1980s and led to a virtual cessation of direct investment flows to most developing countries. 6 In the last few years substantial direct investment flows have resumed to a number of developing countries, but we do not yet have enough years of post debt crisis data for systematic statistical investigation. Tests indicated that the pre and post debt crisis data should not be pooled. We use a panel data approach which allows us to combine time series (1970-1981) and cross section (23 developing countries) data, giving us 276 observations. This reduces the collinearity among explanatory variables and improves the efficiency of econometric estimates. There are three basic models of pooled cross-section and time-series analysis; the ordinary least squares (OLS) model, the fixed effects model, and the random effects model. The OLS model assumes that the intercepts and slopes of the regression model are constant across countries and over time. The fixed effects model assumes that intercepts vary across countries (one intercept for one country) but over time. Instead of assuming a set of given (unknown) constants for each country, the random effects model assumes a single intercept and differences among countries is merged with the disturbance terms. The list of sample countries included and the definitions and data sources for the independent variables are given in the appendix. We used F- and Hausman-tests to determine the proper specification of the model. The F-test is used to compare the fixed effect model with the OLS model. The null hypothesis in this test is that the intercepts and slopes are constant and the alternative hypothesis is that intercepts vary and slopes are constant. If we do not accept the null hypothesis, this means that it is more appropriate to perform cross-section time-series analysis using the fixed effects model. The Hausman test determines whether the fixed effects model or the random effects model is the better choice.7
A reviewer suggested that it would be useful to investigate the period of the late 1980s and early 1990s to see to what extent the severity of industrial countries debt crisis experience influenced the resumption of capital flows and that it would also be interesting to see if overvaluation due to foreign borrowing would have the same effects on direct investment inflows due to other factors. We believe that both of these are important topic for future research. 7 The Hausman test compares two sets of estimates of the same parameters using the same data. The test is computed by differencing the two sets of parameter estimates and standardizing the vector of differences by the difference in the covariance matrices of the two



The results of the F-test indicate that the intercepts vary across countries and thus the OLS model is inappropriate. 8 Although slope coefficients were found to be homogeneous, the intercepts varied across countries. The Hausman-test was then employed to determine whether the fixed effects or the random effects model with different intercepts best fit the data. The fixed effects model was found to be a superior specification. Our empirical results are presented in Table 1. Because of the substantial amount of inflation over the period investigated, nominal dollar figures for direct investment flows were deflated by changes in an industrial country price index. A time trend was also tried to scale for real growth in the investing countries, but it was not significant and its inclusion did not have substantial effects on the other coefficients. We also investigated formulations of the dependent variable as a ratio of capital inflows to host country GDP in both nominal and real terms, but this resulted in a very substantial fall in the explanatory power of the equation.9 The results confirm our a priori expectations that the black market exchange rate variable is a better measure of disequilibrium than the level of the real exchange rate, suggesting that changes in equilibrium real exchange rates are important. The coefficient on the real exchange rate variable has the correct sign but is not significant, and its inclusion has little effect on the coefficient of inflation, which rises slightly from - 1.368 to - 1.409. On the other hand, the coefficient on the black market rate based overvaluation variable is highly significant and is virtually unchanged when the real exchange rate is included as well, rising from - 0.160 to 0.162. Importantly, when the overvaluation variable is included, the coefficient on the inflation variable drops by the same order of magnitude, from - 1.368 and - 1.409 to 1.153 and - 1.196. This suggests that while following a sensible exchange rate policy significantly reduces the costs of inflation in terms of its discouragement effects on direct investment inflows, high inflation remains quite costly even when its effects on exchange rate disequilibrium are effectively neutralized by appropriate exchange rate policy. The real GDP and real GDP capita variables are positive and significant as is the government expenditure variable. This suggests that in our country sample a good deal of government expenditure may be used to develop infrastructures that support private enterprises activities. This is consistent with recent work by political
sets of estimates. The quadratic form computed in this way is distributed asymptotically as a chi-square with degrees of freedom equal to the number of parameters being tested. 8 The test for overall homogeneity versus varying the intercepts and slopes for the complete set of independent variable could not be conducted effectively since the number of independent variables is greater than the number of observations. 9 As a part of longer project from which this paper is drawn, we have done a great deal of testing for sensitivity to the inclusion of various independent variables and the use of different formulation of several of the variables. Our findings for the effects of inflation and exchange rate policy were quite robust across these different formulations. See Seno Adji (1995) and Ahn (1997).



Table 1. Effects on Real Net Foreign Direct Investment (Fixed Effects Model)
Independent Variables Real GDP Real GDP per Capita Real GDP Growth Rate Ratio of Government Expenditure to GDP Ratio of Budget Deficit to GDP Debt Service Ratio IMF Credit Trade Policy Inflation Rate Real Exchange Rate Exchange Rate Overvaluation Political Instability Adjusted R2 F test of A,B = Ai B: F Statistics p value Hausman test: RE vs. FE Chi sq.(n) Statistics p value Equation (1) .037*** [3.801] .159** [1.870] 1.113 [.204] 16.216** [2.037] 7.473 [.786] 12.315*** [3.471] .106 [.944] 203.230*** [2.328] 1.368*** [2.786] 5.307** [2.198] .861 6.243 (.000) 22.085 (.015) (2) .039*** [3.916] .155** [1.829] .606 [.111] 16.560** [2.079] 7.515 [.790] 12.011*** [3.374] .120 [1.057] 174.623** [1.904] 1.409*** [2.861] .455 [1.020] 5.252** [2.175] .861 6.445 (.000) 27.789 (.000) (3) .035*** [3.647] .175** [2.109] 1.905 [.355] 15.390** [1.985] 10.493 [1.129] 13.709*** [3.946] .082 [.748] 194.405** [2.286] 1.153*** [2.396] .160*** [3.782] 4.277** [1.807] .868 9.386 (.000) 24.462 (.011) (4) .037*** [3.784] .171** [2.066] 2.474 [.460] 15.757** [2.032] 10.558 [1.136] 13.389*** [3.843] .097 [.875] 163.359** [1.829] 1.196*** [2.480] .493 [1.135] .162*** [3.809] 4.209** [1.779] .868 7.206 (.000) 31.151 (.002)

Notes: 1. Number of observations: 276 (annual data of 23 developing countries for the sample period 1970-1981). 2. F- and Hausman-tests for the best specification among panel data estimation methods indicate that the fixed effects model is the best choice of model. Thus, each country has its own constant term in all equations (not reported in the table). 3. RE is the random effects model and FE is the fixed effects model. 4. t-ratios are in parentheses under the estimates: *:statistically significant at the 10% level; **: statistically significant at the 5% level; and ***: statistically significant at the 1% level.



scientists which find that for developing countries the growth of government is on average associated with stronger political systems and improved economic performance (see Arbetman and Kugler (forthcoming) and Snider (forthcoming)). Somewhat surprisingly, the government deficit variable has a positive sign, although it is not significant. The economic growth and IMF credit variables are also not significant. As expected, we also find that political instability discourages investment over and above its tendency to generate higher rates of inflation.10 Interestly, we find that a high debt service ratio is associated with higher direct investment inflows. This may reflect favorable country characteristics not captured in the other independent variables which led to substantial capital inflows in the past and are continuing to do so in the present. Also of particular interest is the consistently positive and significant coefficient on the trade policy variable, suggesting that the effects of high trade barriers on the incentives for direct investment to serve the domestic market in the host country is more than offset by the discouraging effects on direct investment in export industries. The effect of trade liberalization in signaling more liberal economic policies in general may also be important in improving the overall investment climate. 4. CONCLUDING REMARKS We find that avoiding exchange rate overvaluation has a significant positive effect on direct investment inflows. Thus, for countries which do not succeed in reducing inflation to moderate levels, it is important that a realistic exchange rate policy be adopted which allows the exchange rate to depreciate roughly in line with inflation rate differential after adjustments for major changes in equilibrium real exchange rates. For many countries some form of crawling peg has been an attractive policy strategy. We also find, however, that neutralizing the effects of inflation on the real exchange rate through nominal exchange rate adjustments is not sufficient to eliminate the adverse effects of inflation on direct investment inflows. Our empirical work suggests that a substantial, albeit smaller, negative effect of inflation on capital inflows remains even when nominal exchange rate adjustments keep inflation from leading to exchange rate overvaluation. This may occur both from the direct effects of inflation on uncertainty and indirectly through judgments of investors that high rates of inflation reflect a lack of political strength and economic policy coherence of the host government and hence an increased probability not only of variable rates of inflation but also of government policy interventions such as higher taxes and controls which would adversely affect the expected profitability of international investments. Our results thus provide additional support for the view that higher rates of inflation will typically have adverse effects on economic growth.
10 On the effects of political instability on inflation, see Cukierman, Edwards, and Tabellini (1992) and Edwards and Tabellini (1991).



DATA APPENDIX The countries in the sample are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Mexico, Peru, Sri Lanka, Indonesia, Korea, Malaysia, Pakistan, Philippines, Thailand, Ghana, Kenya, Zambia, and Turkey (23 developing countries). Real direct investment flows are calculated by dividing net nominal flows in dollars by the consumer price index for developed countries. All data are annual and most data are from the International Monetary Funds International Financial Statistics and Government Finance Yearbook. The data on real gross domestic product are from Summers and Hestons The Penn World Table and data for the debt service ratios are from the World Banks World Debt Table. The real exchange rate variable is based on the host countrys nominal exchange rate against the US dollar adjusted by the consumer price indexes in the U.S. and the host country. Exchange rate overvaluation is measured by the difference between the black market and official exchange rates divided by the official exchange rate. Data on black market exchange rates are from International Currency Analysis, Inc., World Currency Yearbook (Brooklyn, N.Y.). The trade policy variable is derived from Greenaway and Nam (1988). They categorize trade policies in 42 developing countries as strongly outward oriented, moderately outward oriented, strongly inward oriented and moderately inward oriented. Based on the above categories, this study divides countries trade policies into two broader groups: outward oriented and inward oriented trade policies. A dummy variable is assigned a value of 1 if the county adopts on outward oriented trade policy and a value of 0 if the country adopts an inward oriented trade policy. Political instability is approximated by the total number of political demonstrations, strikes and riots, from Taylor and Jodice (1988). The data are available on magnetic tape provided by the Interuniversity Center of Political and Social Research, University of Michigan, Ann Arbor. REFERENCES Agenor, Pierre-Richard, Parallel Currency Markets in Developing Countries: Theory, Evidence, and Policy Implications, Essays in International Finance, No. 188, Princeton: Princeton University, 1992. Agenor, Pierre-Richard and Flood, Robert P., Unification of Foreign Exchange Markets, IMF Staff Papers, December 1992, 923-947. Ahn, Young Seok, The Determinants of Various Types of Capital Flows and the Degree of Capital Mobility in Developing Countries, Ph.D. Dissertation, Claremont Graduate School, California, 1997. Burdekin, Richard C. K., Salamun, Suyono and Willett, Thomas D., The High Costs of Monetary Instability, in Richard C. K. Burdekin, Richard J. Sweeney, and Clas Whilborg, eds., Establishing Monetary Stability in Emerging Market Economies,



Boulder: Westview Press, 1995. Cukierman, Alex, Edwards, Sebastian and Tabellini, Guido, Seiniorage and Political Instability, American Economic Review, June 1992, 537-555. Edwards, Sebastian, Capital Flows, Foreign Direct Investment and Debt Equity Swaps in Developing Countries, NBER Working Paper, No. 3497, 1991. Edwards, Sebastian and Tabellini, Guido, Explaining Fiscal Policies and Inflation in Developing Countries, Journal of International Money and Finance, March 1991, s16-s48. Fischer, Stanley, The Role of Macroeconomic Factors in Growth, Journal of Monetary Economics, December 1993, 485-512. Greenaway, David and Nam, Chong Hyun, Industrialization and Macroeconomic Performance in Developing Countries under Alternative Trade Strategies, Kyklos, 1988, 419-435. International Currency Analysis Inc., World Currency Yearbook (continues: Picks Currency Yearbook), Brooklyn, New York: International Currency Analysis Inc., various issues. Kamin, Steven B, Devaluation, Exchange Controls, and Black Markets for Foreign Exchange in Developing Countries, Journal of Development Economics, February 1993, 151-169. Schneider, Friedrich, and Frey, Bruno S., Economic and Political Determinants of Foreign Direct Investment, World Development, February 1985, 161-75. Seno Adji, Slamet, The Effects of Macroeconomic and Political Factors on Capital Flows to Developing Countries, Ph.D. Dissertation, Claremont Graduate School, California, 1995. Seno Adji, Slamet, Ahn, Young Seok, Holsey, Cheryl M. and Willett, Thomas D., Political Instability, Political Capacity, and Capital Flows to Developing Countries, in Marina Arbetman and Jacek Kugler, eds., Political Capacity and Economic Behavior, Boulder: Westview Press, 1996. Summers, Robert, and Heston, Alan, The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950-1988, Quarterly Journal of Economics, May 1991, 327-368. Taylor, Chales L. and Jodice, David A., World Handbook of Political and Social Indicators, New Heaven: Yale University Press, 1988.

Mailing Address: Research Associate, Dr. Young Seok Ahn, Korea Development Institute, P.O. Box 113, CheongRyang, Seoul 130-012, KOREA. Tel: 011-822-9584114, Fax: 011-822-958-4088, e-mail: Mailing Address: Dr. Slamet Seno Adji, Chief of Bureau for Project Preparation and Analysis, The National Development Planning Agency, Jakarta, INDONESIA Mailing Address: Dr. Horton Professor Thomas D. Willett, Department of Economics, Claremont Graduate School, Claremont, CA 91711, U.S.A. Tel: 1-909621-8787, Fax: 1-909-621-8390.