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The effect of temporary

devaluation on foreign

investment: A trade-theoretic

analysis and an application to

Mexico

Mriduchhanda Paul

& Sajal Lahiri

Department of Economics, Rutgers, The State

University of New Jersey, New Brunswick, USA

Department of Economics, Southern Illinois

University at Carbondale, USA

Available online: 06 May 2008

To cite this article: Mriduchhanda Paul & Sajal Lahiri (2008): The effect of temporary

devaluation on foreign investment: A trade-theoretic analysis and an application to

Mexico, The Journal of International Trade & Economic Development, 17:2, 243-255

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Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 The e ect of temporary devaluation on

foreign investment:

A trade-theoretic analysis and an application to Mexico

Mriduchhanda Paul

and Sajal Lahiri

Department of Economics, Rutgers, The State University of New Jersey, New

Brunswick, USA;

Department of Economics, Southern Illinois University at

Carbondale, USA

(Received October 2005; nal version received July 2007)

We develop a two-period model with foreign investment and international borrowing and lending. We

nd that temporary devaluation has

no e ect on contemporaneous foreign investment, but the e ect on future

foreign investment is positive via the working of the credit market. These

ndings are then tested for Mexico with regression analysis.

Keywords: devaluation; foreign investment; borrowing; lending; interest

rate

Introduction

A time-honored research question in macroeconomics is whether monetary

polices can have real-side e ects (see, for example, Romer and Romer 1994).

A second question is whether temporary policy interventions monetary or

otherwise can have permanent e ects (see for example, Djajic 1987;

Blanchard and Summers 1988; Lin and Tseng 1993). This paper attempts to

address both these questions.

There are of course many monetary policy instruments and many realside variables. In this paper we

focus on one monetary policy and one realside variable, namely we shall examine the e ect of

temporary devaluation

on the in ow of foreign investment.

The level of foreign investment depends on many di erent factors.

One of

them is the value of currency, i.e. the exchange rate.

There are many studies

that look at the relationship between devaluation though not temporary

and the in ow of foreign investment. Researchers have looked at several

channels via which devaluation could a ect the in ow of foreign investment.

Some of the channels give rise to a positive relationship, and some negative.

For example, Froot and Stein (1991) suggest that an appreciation of the

source country s currency increases its relative wealth, which in turn increases

the out ow of capital from that country. Cushman (1985), on the other hand,

*Corresponding author. Email: lahiri@siu.edu

The Journal of International Trade & Economic Development

Vol. 17, No. 2, June 2008, 243 255

ISSN 0963-8199 print/ISSN 1469-9559 online

2008 Taylor & Francis

DOI: 10.1080/09638190701872723

http://www.informaworld.com

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 points out that an appreciation of the host

country s currency lowers foreign

capital cost, and this stimulates further foreign investment. According to

Cushman (1987), a depreciation of the host country s currency can also trigger

an in ow of foreign investment into that country by lowering the relative cost

of inputs in there. Expected future appreciation or depreciation of the

currency of a host country is also thought to be an important determinant of

current level of foreign investment in that country by, for example, Klein and

Rosengren (1994), Cushman (1988), Blonigen (1997), and Dewenter (1995).

Agarwal (1997) nds real exchange rate to be one of the positive

determinants of foreign investment in six Asian countries. According to Hau

and Rey (2006), net equity ows into foreign market are associated with

foreign currency appreciation for 17 OECD countries during the period

1990 2001. Real exchange rate is found by Jeon and Rhee (2003) to have a

signi cant association with incoming US foreign investment in South Korea

during the period 1980 2001. Similarly, Caves (1989), Goldberg (1993),

Swenson (1994), Klein and Rosengren (1994) have also found a relationship

between dollar depreciation and incoming foreign investment to USA.

In this paper, we examine the issue of temporary devaluation and in ow of

foreign investment by identifying a new channel via which the mechanism

works. In particular, we rst develop a two-period, two-country tradetheoretic model in which the

countries are not only linked by the ow of

physical capital in the form of foreign investment, they are also linked via

movements of nancial capital in the form of international borrowing and

lending. The presence of borrowing and lending provides us with a new

channel for temporary devaluation of currency in a country to have a

permanent e ect on the ow of international physical capital. In this framework we nd that a

temporary devaluation has no e ect on contemporaneous

foreign investment, but it increases future foreign investment via movements in

the inter-temporal terms of trade. Thus, whereas the existing literature has

analysed the possibility of current foreign investment depending on current or

future (expected) value of a currency, this paper examines the possibility of

current devaluation a ecting future foreign investment.

Having developed and analysed the theoretical model, we also test the

predictions of our theoretical analysis for Mexico, and nd strong support

for our hypotheses.

The structure of the paper is as follows. The following section sets up the

theoretical framework. The section after that examines the e ect of temporary

devaluation on foreign investment. Econometric analysis for Mexico is then

carried out. Finally, some conclusions are drawn in the last section.

The model

We consider two countries: one developed and one developing. There are

two periods: period 1 and 2. There are two goods produced and consumed in

244 M. Paul and S. Lahiri

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 the two countries in both periods. They are

produced using a number of

factors, but only one of them, namely capital, varies in our model. First of

all, we assume capital to be perfectly mobile between the two countries in

both periods. The developed country which we also call the source

country is a net exporter of capital, i.e. private investors in the developed

country make foreign investment in the developing country which is

referred to as the host country in both periods. The second capital stock in

the source country is also augmented by domestic investment made in period

1. Furthermore, we assume that the source country consumers give loans to

their counterparts in the host country in period 1 and this is repaid with

interest in period 2.

The domestic prices of the two goods in the source country are denoted by

P1 and P2. We shall consider a temporary devaluation of currency in the host

country and so we shall denote by e the exchange rate between the two

countries so that the domestic prices in the host country in period 1 are eP1

and eP2. We shall take the rst good in period 1 to be the numeraire one, i.e.

P1 1. The prices of the two goods in period 2 in both countries are denoted

by P3

and P4

. We assume the two countries to be small open economies in the

goods markets so that the goods prices are exogenously given.

The production sides of the economy in the host country in the two

periods are represented by the two revenue functions R

e;eP2; K f1

and R

P3; P4; K f2 respectively, where K is the endowment of capital

stock owned by investors in that country, and f1 and f2 are levels of

foreign investments in the two periods. Similarly, r

1; P2; k f1 and

P3; P4; k f2 I are the revenue functions in the source country where I

is the level of domestic investment in period 1.

4,5

The inter-temporal expenditure functions in the host country and

the source country are E (e, eP2, P3/(1 r), P4/(1 r),U) and e(1, P2, P3/

(1 r), P4/(1 r), u) respectively where u and U are the inter-temporal

utility levels of a representative consumer in the two countries and r is the

discount or interest rate.

The equilibrium can be represented by the following equations:

Ir

1r

f1

f2

1r

e;eP2; K f1

1r

e;eP2; K f1f1

f2

1r

f1 e1 P2e2 I E1 P2E2 R

1; P2; K f1

1; P2; K f1f1 b

The Journal of International Trade & Economic Development 245

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 r

1 r 4

er

e;eP2; K f1; r

The rst two equations are the inter-temporal budget constraints of the

source country and the host country respectively. Equation (1) states that

the total discounted present value of expenditure on consumption and

investment in the source country is equal to the total discounted income

plus income including repatriated income on foreign investments in the

two periods. Equation (2) is similarly explained. Equation (3) states that

the demand for loans in the host country denoted by b equals the

supply by the source country. The rst-order condition for the determination of the level of domestic

investment in the source country (@u/@I 0)

is given in equation (4). The rates of returns in terms of the host country s

currency in the two countries in the two periods are equalized in equations

(5) for the determination of the levels of foreign investments in the two

periods. We assume that the levels of foreign investments in the two

periods, f1

and f2

, are positive. That is, the ow of capital is from the

source country to the host country. Implicitly, we are assuming that

without the international mobility of capital, the rate of return on capital

would be higher in the host country than in the source country in both

periods.

This completes the description of the model, which has six equations in

six unknowns in u, U, I, f1, f2 and r. We complete this section by stating

some assumptions. All goods are considered to be normal in both periods

and in both countries, and that they are substitutes both intra- and intertemporally. Formally, see the

following assumption.

Assumption 1

ei5 4 0, Ei5 4 0 (i 1, 2, 3, 4), and eij 4 0, Eij 4 0 (i 6 j 1, 2, 3, 4).

Analysis of the model

The model developed in the preceding section describes an equilibrium. In

particular, equation (3) states that total lending by the source country in

period 1 is equal to total borrowing by the host country in the same period.

Moreover, equations (1) and (2) can also be rewritten to show that the

intertemporal balance of payment is also in equilibrium in the two countries.

However, the assumption that net borrowing by the host country in

period 1 (b in equation (3)) is positive implies that the host country has a

trade de cit in period 1. Thus, if the government of the host country is

shortsighted or myopic it may attempt to devalue its currency temporarily in

order to deal with period-one balance of payment de cit.

246 M. Paul and S. Lahiri

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 In this section we will examine the e ect of

a temporary devaluation of

currency in the host country, i.e. de 4 0, on the levels of foreign investments

in the two periods f1

and f2

First, from the rst of the two equations in equation (5), we get

33

33

df1 r

31

P2R

32

de 6

There are just two opposite e ects of a change in e on f1. First, a

devaluation reduces the return to foreign investment for the source country

in terms of its own currency. This would reduce the supply of f1

. Second, an

increase in the domestic prices in the host country in terms of its own

currency increases the demand for capital and thus the rate of returns

to capital. This would increase the supply of foreign investment.

However, since R

is linear homogeneous in output prices, we have

=e R

31

 P2R

32

and thus using equations (5) and (6) we get df1/de 0.

That is, the two opposite e ects cancel each other out. It is to be noted that

the two opposite e ects are precisely the two e ects discussed in the

literature as mentioned at the outset of this paper. Formally, see the

following Proposition.

Proposition 1

A devaluation of currency in rst period in the host country has no e ect the

level of foreign investment into that country in that period.

Turning now to f2

, di erentiation of the second part of equation (5)

gives:

33

33

df2 r

33

dI 7

That is, an increase in domestic investment has a positive impact on foreign

investment in period 2. This is because an increase in I reduces the rate of

return on capital in the source country because of diminishing marginal rate

of return on factors, and this induces more ow of capital out of the source

country and into the host country.

As for the e ect on domestic investment, di erentiating equation (4)

we get

33

dI dr r

33

df2 8

An increase in the interest rate r raises the cost of investment and this

reduces I. This is given by the rst term on the right-hand side of equation

(8). An increase in f2

reduces the rate of return on capital. Thus, in order for

the rate of return on capital to remain constant, for a given level of r,

domestic investment has to increase. This e ect is captured by the second

The Journal of International Trade & Economic Development 247

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 term on the right-hand side of equation (8).

Substituting dI from equation

(8) in equation (7) we get:

33

df2 dr 9

i.e. an increase in the rate of interest decreases the amount of foreign

investment in period 2. Thus, what remains for us to ascertain is the e ect of

a change in e on r in order to derive the e ect of devaluation on f2. This is

what we now turn to.

Di erentiation of equations (1) (3) gives:

e5du

1r

dr

f2r

33

1r

dI f1r

33

df1

f2r

33

1r

df2 10

E5dU

eb

1r

dr bde f1R

33

df1

f2

1r

33

df2 11

D1 eD2

1r

dr e15 P2e25du E15 P2P25dU

f1 R

33

33

df1 D2de dI

12

where D1 e11 2P2e12 P

e22 < 0; D2 E11 2P2E12 P

E22 < 0.

The rst terms in equations (10) and (11) are the inter-temporal terms-oftrade e ects in the two

countries: an increase in the interest rate r makes the

borrower worse o and the lender better o . An increase in I reduces utility in

the source country by reducing the rental rate of return on capital in period 2

and thus its repatriated income. A devaluation (de 4 0), ceteris paribus,

reduced welfare in the host country by increasing the value of a loan in terms of

its domestic currency. An increase in Ireduces the rental rate of capital and thus

welfare in the source country.

10

A rise in either f1 or f2 increases welfare in both

countries via changes in repatriated pro ts. The rst two terms in equation (12)

give income e ects. An increase in inter-temporal real income in either country

increases the demand for loans and thus the interest rate. An increased ow of

foreign investment in period 1 increases income in period 1 in both countries

and this reduces the demand for loans and therefore the interest rate.

Substituting equations (8), (10) and (11) into equation (12) we get:

Ddr bb D2de 13

where

ac

P2c

;bC

P2C

1 > a > 0; 1 > b > 0

e15

e5

;c

e25

e5

;C

E15

E5

;C

E25

E5

1r

D1 eD2 ab bbe f2a b

33

R2

33

248 M. Paul and S. Lahiri

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 c

and C

are the marginal propensity to consume good i (i 1, 2) in period

1 by the consumers in the source country and the host country respectively.

D is the slope of the uncompensated excess demand for loan function and it

must be negative for the Walrasian stability of the credit market.

A devaluation in the currency of the host country has a negative e ect on

the interest rate. It then follows from equation (9) that an increase in e

unambiguously increases foreign investment in period 2. This is given

formally in Proposition 2.

Proposition 2

A devaluation of currency in the host country in period 1 increases the level

of foreign investment into that country in period 2.

Intuitively, a temporary devaluation increases the domestic prices of the

goods in the host country in period 1 relative to those in period 2. This leads

to an inter-temporal substitution in consumption away from period 1 to

period 2. This reduces expenditure in period 1 and thus the demand for a

loan, reducing the equilibrium value of the interest rate. A reduction in the

interest rate in turn stimulates domestic investment in the source country,

reducing the rate of return of capital there. This reduction in the rate of

return leads to an out ow of capital from that country.

In terms of empirical support for Proposition 2, there is a study by Love

and Lage-Hidalgo (2000) in which, based on an error correction model, they

found that depreciation of the peso increased US direct investment in Mexico

with a one-period lag. Although this study is speci cally about foreign direct

investment and not foreign investment in general, we believe that it lends

prima facie support to Proposition 2 above. In the following section, we shall

test the validity of our theoretical predictions for the case of Mexico.

Empirical analysis

To test the theoretical ndings of the study empirically, we consider

Mexico as the host country. Quarterly data obtained from the CD-ROM

of the International Monetary Fund s International Financial Statistics

are taken to test the hypothesis. The sample period is 1981(Q1) to

2005(Q4).

Since the main mechanism in our theoretical analysis works via induced

changes in the interest rate or the inter-temporal terms of trade, we estimate

a two-equation system as follows:

r a1 a2 r1 a3 e a4 p

er

14

FI b1 b2

r b3

e b4

FI1 b4

gY1 b5

ps ef

15

The Journal of International Trade & Economic Development 249

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 where er and ef are the error terms in the

two equations, and the other

variables are de ned in Table 1 with (71) indicating a one-period lag in the

variable. The data on the bankers acceptance rate is taken as interest rate

(r). The portfolio investment coming into Mexico is taken as the foreign

investment (FI). National currency (peso) per SDR is taken as exchange rate

(e) an increase in the value of it denotes a devaluation of the Mexican

currency peso.

The purpose of equation (14) is to test equation (13), i.e. to examine

how the exchange rate a ects the interest rate. We have added a lagged

endogenous variable in both equations to deal with problem of

autocorrelation. Equation (15) tests two of our hypotheses: (i) the

exchange rate does not have a direct e ect on foreign investment,

and (ii) it a ects foreign investment via its e ect on the interest rate.

We have added a number of control variables in the two equations.

For example, following Berument and Malatyali (2001), we take the

Table 1. Summary statistics and de nition of variables.

Variable De nition Mean

Std.

Dev. Max. Min.

Foreign

Investment

(FI)

Portfolio

Investment into

Mexico (IFS

code

78BGDZF)

1095.74 2856.42 9290.00 77355.11

Exchange

Rate (e)

Domestic

Currency

In terms of

SDR (IFS code

WA ZF)

6.76 5.80 17.49 0.03

Interest Rate

(r)

Bank Acceptance

Rate (IFS code

60B ZF)

35.66 26.56 130.76 5.10

Growth Rate

of Income

(gY)

% Change in Real

GDP Index

(IFS code 99

BVRZF)

0.0076 0.045 0.094 70.077

Expected

In ation

Rate (p

e1

Treasury Rate

(IFS code 60

ZF)

33.16 26.55 134.47 4.58

Expected

In ation

Rate (p

e2

Previous Quarter s

In ation Rate

(IFS code

64 ZF)

0.073 0.075 0.389 0.0045

Share Price

(ps

Share Price Index

(IFS code 62

ZF)

48.67 57.45 257.79 0.01

250 M. Paul and S. Lahiri

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 expected in ation rate as control variables

in equation (14). We

consider two proxies for expected in ation: the lagged treasury rate

e1

and, following Pelaez (1989), the previous quarter s in ation

rate p

e2

Since there are no endogenous variables on the right-hand side of

equation (14), it is estimated using the Ordinary Least Square (OLS)

method. The results are shown in Table 2. Regression 1 does not use the

control variable p

, which is included in regressions 2 and 3. As predicted in

our theoretical analysis, a devaluation given by an increase in e has a

signi cant negative e ect on the interest rate in both regressions. The value

of the coe cient of p

is also signi cant and of the expected sign when the

lagged treasury rate is used as a proxy, but insigni cant when the previous

period s in ation is used as a proxy.

Equation (15) is estimated using OLS as well as Instrumental Variable

(IV) methods, since one of the explanatory variables r is endogenous.

The instruments used are all the explanatory variables except r plus

r(71). The results of both OLS and IV regressions are presented in

Table 3. As predicted by our theoretical analysis, interest rate r

uniformly has a negative and signi cant e ect on foreign investment,

and the direct e ect of the exchange rate on foreign investment is always

insigni cant. Thus, the two equations together con rm that devaluation

a ects the in ow of foreign investment only via its e ect on the

interest rate.

Table 2. OLS estimates of interest rate equation. Dependent Variable: Interest rate

(r). No. of observations: 98 (1981(Q3) 2005(Q4)).

Eqn. 1 2 3

C 11.0762* 11.98* 10.94*

(2.78) (3.03) (2.73)

r(71) 0.8070* 0.28 0.845*

(13.35) (1.04) (7.77)

e 70.6044** 70.55** 70.61**

(2.15) (2.00) (2.18)

e1

0.50**

(1.91)

e2

715.63

(0.43)

0.79 0.79 0.79

DW 2.12 2.00 2.13

S.E. 12.27 12.09 12.32

F 182.14 117.43 120.44

Notes: The gures in parentheses are t-statistics values. *Statistically signi cant at 99%

con dence level. **Statistically signi cant at 95% con dence level.

The Journal of International Trade & Economic Development 251

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 Conclusion

The importance of foreign investment in today s highly integrated world

economy cannot be overstated. Most countries nowadays bend over

backwards to attract foreign investment. One instrument for attracting

foreign investment by a host country is the devaluation of its currency. The

literature is however divided on the e cacy of such a policy. In this paper,

we developed a two-period, two-country model with borrowing and lending

to examine the e ect of temporary devaluation on contemporaneous and

future levels of foreign investment. We nd that whereas such a devaluation

has no net impact on the current level of foreign investment, it increases

future foreign investment by reducing the interest rate. Our empirical

analysis for the case of Mexico provides strong support for our theoretical

predictions. Thus, a monetary policy in the form of a devaluation does

have real-side e ects, albeit indirectly, and only via changes in the interest

rate.

Acknowledgements

The authors are grateful to an anonymous referee for very helpful suggestions and

comments.

Notes

1. For an analysis of the e ect of temporary devaluation on other variables see, for

example, Fender (1986); Lin and Tseng (1993). There is also somewhat related

Table 3. Estimates of foreign investment equation. Dependent Variable: Foreign

Investment (FI). No. of observations: 98 (1981(Q3) 2005(Q4)).

Eqn. 1(OLS) 1(IV) 2(OLS) 2(IV) 3(OLS) 3(IV)

C 2632.91* 3246.54* 2573.22* 3079.11* 2574.95* 3240.23*

(2.80) (2.80) (2.76) 2.64 (2.75) (2.76)

r 735.12* 744.74* 734.98* 742.02* 734.67* 744.41*

(2.48) (2.50) (2.50) (2.36) (2.43) (2.44)

e 783.02 7113.66 785.48 7112.75 796.12 7128.21

(1.36) (1.64) (1.42) (1.61) (0.95) (1.21)

FI(71) 0.315* 0.28* 0.32* 0.29 0.31 0.28*

(3.14) (2.66) (3.22) (2.77) (3.17) (2.66)

gY(71) 10397.08** 10624.47** 10400.57** 10631.56**

(1.81) (1.83) (1.81) (1.82)

ps 1.30 0.94

(1.31) (0.09)

0.23 0.23 0.26 0.26 0.26 0.26

DW 2.00 1.95 1.97 1.933 1.96 1.91

S.E. 2594.75 2609.71 2564.19 2583.89 2577.698 2599.78

F 9.640 9.55 8.22 7.91 6.513 6.41

Notes: The gures in parentheses are t-statistics values. *Statistically signi cant at 99%

con dence level. **Statistically signi cant at 90% con dence level.

252 M. Paul and S. Lahiri

Downloaded by [INASP - Pakistan ] at 00:21 03 January 2012 literature on exchange rate pass-through,

which examines the e ect of exchange

rates on relative goods prices (see, for example, Dixit 1989; Devereaux et al.

2004).

2. See, for example, Ru n (1984) for a survey of the literature.

3. There is also some debate about whether the volatility of exchange rate a ects

foreign investment. See, for example, Cushman (1988), Goldberg and Kolstad

(1995), and Gorg and Wakelin (2002).

4. A revenue function is the maximum value of total output that can be achieved

for given commodity prices, technology and endowments. The partial derivative

of a revenue function with respect to the price of a good gives the supply function

for that good. Moreover, the matrix of second-order partial derivatives with

respect to the prices of an revenue function is positive semi-de nite. For this and

other properties of expenditure and revenue function see, for example, Dixit and

Norman (1980). Since the endowments of factors other than capital do not vary

in our analysis, they are omitted from the arguments of the revenue functions.

5. For simplicity, we assume that there is no domestic investment in the host

country and that there is no depreciation of capital.

6. The expenditure function represents the minimum level of expenditure that can

possibly attain a given level of utility. The partial derivative of an expenditure

function with respect to the price of a good gives the Hicksian demand for that

good. Moreover, the matrix of second-order partial derivatives with respect to

the prices of an expenditure function is negative semi-de nite.

7. The subscript i to a function represents the partial derivative of that function

with respect to its ith argument.

8. For example, since the expenditure and revenue functions are homogeneous of

degree 1 in prices, using the well-known Euler s theorem, equation (1) can be

rewritten as

e1 r

P2 e2 r

Ir

f1

e3 r

P2 e4 r

f2

1r

which states that the present value of the total cost of net imports for the source

country should be zero. Similarly, equation (2) can be rewritten make the same

point for the host country.

9. Since e1

and e2

are homogeneous of degree zero in all four prices, we can write

(1 r) D1 7[P3e13 P4e14 P2(P3e23 P4e24)], and since we assume the

goods to be substitutes (see Assumption 1), we have D1 5 0. Similarly, we can

show that D2 5 0.

10. Other e ects of a change in I disappear due to the envelope property.

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