Media Briefings

EXCHANGE RATE VOLATILITY DOESN’T HARM INTERNATIONAL INVESTMENT FLOWS: Evidence from G-7 inflows and outflows

  • Published Date: April 2015

Volatile exchange rates have not discouraged international investments flowing to and from advanced nations in recent years, contrary to the common view. That is the key finding of research on key drivers of foreign direct investment (FDI) by Abdulkader Nahhas, to be presented at the Royal Economic Society’s 2015 annual conference.

As more countries encourage international trade by adopting a floating exchange rate system, there has been a growth in multinational companies seeking to invest worldwide. But it has been widely believed that since a floating currency can experience heavy fluctuations in exchange rates, the uncertainty will discourage FDI. This study looks at international investment in and by the G-7 countries between 1980 and 2011 and finds that:

• Increased exchange rate volatility led to higher foreign investment by Canada, Italy, Japan and the United States.
• Increased exchange rate volatility led to an increase in inflows of foreign investment to all G-7 nations except France, Italy and the United States.

The author comments:

‘FDI has desirable features that affect growth, acting as a conduit for technical knowledge, improving the capacity of host economies to benefit from firm-specific technological innovations. It might also reduce adverse shocks to the poor stemming from financial instability and improve corporate governance.

‘Empirical investigation of the relationship between exchange rate and FDI is critical for the formulation of FDI policies, because FDI brings benefits to both investing and recipient countries.’

More…

The latest trends in globalisation have led to both increased trade and large increases in foreign direct investment (FDI) around the world. This has been enhanced by among other things, the liberalisation of rules governing foreign direct investment via various World Trade Organization (WTO) negotiations. As international companies search for more profitable overseas production markets and facilities, the growth in overall FDI is expected to increase gradually.

FDI has possible desirable features that affect growth, acting as a conduit for technical knowledge, improving the capacity of host economies to benefit from firm-specific technological innovations. It might reduce adverse shocks to the poor stemming from financial instability and improve corporate governance. Moreover, FDI generates returns that may enhance safety net development for the poor.

A common claim in the international trade community is that exchange rate volatility is one of the most important factors in decisions regarding a firm’s FDI policies. For example, FDI is of growing interest among policy-makers, as the number of countries that are adopting the floating exchange rate system have increased. Empirical investigation of the relationship between exchange rates and FDI is critical for the formulation of FDI policies, because FDI brings benefits to both the investing and recipient countries.

Given that fluctuations in real exchange rates can lead to higher levels of uncertainly being faced by private investors, the real magnitude of the effect can only be determined empirically. This constitutes the main purpose of this research.

The impact of exchange rate volatility on the level of FDI in the G-7 countries is investigated over the period 1980 to 2011 In addition to the volatility of the exchange rate the study’s SUR approach makes it possible to control for several FDI determinants including openness (imports and exports of goods and services), R&D (technology cost) and other financial variables (equity return).

The results support the hypotheses that exchange rate volatility is a determinant of FDI decisions. This suggests that there is some merit in distinguishing between three cases.

The results do not confirm the relatively common view that there is a negative relationship. It is the case that for some countries an increase in volatility can encourage FDI. Nonetheless, this result in line with the earlier findings reported by some of the earlier studies indicate that volatility in the exchange rate decreases flows of FDI.

It is clear for outflows, the nominal exchange rate volatility has a significant positive impact for Canada, Italy, Japan and the United States. While exchange rate volatility has a negative impact on FDI inflows for France, Italy, and the United States, there is a positive impact for the other G7 countries’ FDI inflows. The results are also robust to the presence of other conditioning variables, such as openness, often viewed as important in determining FDI.

In this article it has also been pointed out that investors of these developed economies do value exchange rate volatility as an important factor in their decisions to engage in external investments in addition to other controlling variables. The impact of exchange rate shocks has a strong impact on dynamic models in the long run and the short run.

This contribution adds to previous literature in several ways. First, it analyses the most significant economies in the world, the G-7 countries. It also examines the relationship between the exchange rate volatility and FDI inflow. Second, the data include the 2008 banking crisis and the crisis in the euro zone. Finally, it is intended that the analysis contributes to the discussion on the link between exchange rate volatility and FDI inflow.

ENDS


‘Does Exchange Rate Volatility Affect Foreign Direct Investment? Evidence from the G-7 Countries’ by Abdulkader Nahhas, lecturer in economics and finance at Brunel University, London.

For further information: contact Abdulkader Nahhas on +44 7587 511835 (email: AbdulKader.Nahhas@brunel.ac.uk )