Exchange rates and foreign direct investment: theoretical models and empirical evidence *

Abstract

Over the past decades, growth in foreign direct investment (FDI) has stimulated significant attempts at developing theories that explain this trend. One line of this research explores the relationship between exchange rates and FDI. There is no consensus about the nature of this relationship in either the theoretical or empirical work. In this article, we critically appraise this body of work, and find the theoretical studies to be making ground in exploring the complexities of FDI, but the empirical evidence to be constrained by data problems. Copyright 2008 The Authors. Journal compilation 2008 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishing Asia Pty Ltd.

Full text

Page 1

The Australian Journal of Agricultural and Resource Economics

, 52, pp. 505–525

© 2008 The Authors
Journal compilation © 2008 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishing Asia Pty Ltd
doi: 10.1111/j.1467-8489.2007.00431.x


Blackwell Publishing Ltd
Oxford, UKAJARAustralian Journal of Agricultural and Resource Economics1364-985X 1467-8489© 2008 The AuthorsJournal Compilation © 2008 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishers LtdXXX
ORIGINAL ARTICLE
Exchange rates and foreign direct investmentS. Phillips and F.Z. Ahmadi-Esfahani
Exchange rates and foreign direct investment:
theoretical models and empirical evidence*



Shauna Phillips and Fredoun Z. Ahmadi-Esfahani

†

Over the past decades, growth in foreign direct investment (FDI) has stimulated
significant attempts at developing theories that explain this trend. One line of this
research explores the relationship between exchange rates and FDI. There is no
consensus about the nature of this relationship in either the theoretical or empirical
work. In this article, we critically appraise this body of work, and find the theoretical
studies to be making ground in exploring the complexities of FDI, but the empirical
evidence to be constrained by data problems.

Key words:

exchange rate, foreign direct investment.

1. Introduction

Over the past decades, a striking feature of increased international economic
integration has been the growth in foreign direct investment (FDI). During
2005, for example, world FDI inflows grew 28.9 per cent compared to a
growth rate of 12.9 per cent for world exports (UNCTAD 2006). Growth in
FDI has been accompanied by growth of theories that explain this trend.
One line of research explores the relationship between exchange rates and
FDI. This line emerged in part from the prospect of European monetary
union, and in part from the US experience in the 1980s of a major inflow of
FDI, at the same time that the US dollar experienced a sustained period of
depreciation. It was considered that more traditional theories could not
explain the facts of large short-term swings in FDI.
Australia has a long history of inflows of FDI and the beneficial contribution
of these flows is evident. As can be seen in Figure 1, Australia experienced a
depreciation of the exchange rate and an associated FDI inflow during the
mid- to late-1980s similar to that of the USA. Inspection suggests that
a relationship existed for a time, but may have dissipated.
FDI is complex and heterogeneous in nature. FDI decisions are made in
the context of national customs, beliefs, social institutions and attitudes, all
of which change over time. Two broad strands have been identified in the

* An earlier version of this paper was presented at the AARES 50 th Annual Conference in
Manly, 8–10 February, 2006.
† Miss Shauna Phillips (email: s.phillips@usyd.edu.a) is an Associate Lecturer and PhD Candi-
date, and Fredoun Z. Ahmadi-Esfahani is an Associate Professor, both in Agricultural and
Resource Economics, University of Sydney, NSW, 2006, Australia. The authors gratefully
acknowledge the insightful comments and suggestions from an anonymous Journal referee.

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506S. Phillips and F.Z. Ahmadi-Esfahani

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Journal compilation © 2008 Australian Agricultural and Resource Economics Society Inc. and Blackwell Publishing Asia Pty Ltd

theoretical literature: the real options, and risk aversion approaches
(Goldberg and Kolstad 1995). These strands are now joined by emerging
work that considers heterogeneity of firm motives, firm productivity,
exchange rate endogeneity and multilateral resistance. Some recent models
make an important contribution in that they encompass existing alternative
models, opening up the possibility of distinguishing between theoretical
alternatives empirically. However, given the nature of FDI, it is likely that
there will never be a single model that can integrate all its complexities. Indeed
the sign on the predicted relationship between exchange rates and FDI varies
across theoretical models and some models predict ambiguous outcomes.
Taking into consideration the entire body of theoretical work, we are left
with ambiguous predictions, and therefore it remains the task of empirical
work to determine what, if any, the nature of the relationship may be.
Ambiguity at the theoretical level is clearly reflected in the empirical work.
There is some consensus on the relationship between exchange rate levels and
FDI flows, but none on volatility. Part of the explanation for the mixed evi-
dence may lie in the heterogeneity of the empirical work itself, reflecting the
theoretical ambiguity. Another part of the explanation may lie in the fact
that the empirical work appears to be impaired by data constraints and spec-
ification problems. It is because of these problems that estimates of the rela-
tionship between exchange rates and FDI must be viewed with some
suspicion.
The purpose of this article is to provide a comprehensive and critical
appraisal of the literature, and to make an assessment of the conclusions that
can be drawn from this work. The article proceeds as follows. In Section 2, a
brief overview of theoretical arguments is provided. In Section 3, the empirical
findings are considered, and developments in research are presented and discussed
in the context of model specification. Section 4 concludes the analysis.
Figure 1
Source: REER-International Financial Statistics (IFS), FDI-UNCTAD.
Australia’s real effective exchange rate and IFDI.

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2. Theoretical considerations

Theories about FDI-exchange rates linkages emerged in the 1970s and 1980s
(for example, Kohlhagen 1977; Cushman 1985). Two theories that have been
highly influential are Blonigen (1997) and Froot and Stein (1991). Froot and
Stein used an imperfect capital markets approach to argue that exchange
rates operate on wealth to affect FDI. Because of the assumption of imperfect
capital markets, external sources for borrowing are more expensive than a
firm’s internal cost of capital. As a result, a host currency depreciation is
predicted to have a positive effect on inbound FDI (IFDI), as it automatically
increases the wealth of foreigners, allowing them to make higher bids for
assets. Blonigen (1997) focuses on acquisitions FDI: a special case for
exchange rate effects as the acquisition of a foreign target firm can provide
firm specific assets. This theory assumes goods market segmentation, and
postulates that foreign and domestic firms have the same opportunity to buy,
but different opportunities to generate returns on assets in foreign markets.
The profitability of all branches of a multinational firm may be increased
after the acquisition of a foreign firm. For this reason, currency movements
may affect relative asset valuations, and a depreciation of the host’s currency
increases IFDI.
Beyond these models, the real options and risk aversion approaches are
joined by emerging work that explores the effects of heterogeneity in FDI
motive (Lin
et

al
. 2006), firms with heterogeneous productivity along with
endogenous exchange rates (Russ 2007a), and the notion of complex FDI
with multilateral resistance. These theories provide different predictions for
the response of FDI to exchange rate levels and volatility, and are discussed
in more detail below.





2.1 Real options

This approach is based on that of Dixit and Pindyck (1994) who considered
the effects of uncertainty on investment when decisions are irreversible. A
firm can have an option to invest overseas, with exchange rate uncertainty
potentially influencing the expected return on the option. Exchange rate
uncertainty may increase the value of holding onto the option by not investing,
whereas changes in exchange rate levels affect the price of the option. Examples
can be found in Campa (1993), Darby
(1996). Darby
et

al
. (1999) present a model where the response of FDI is
ambiguous. A different definition of option value is used in Aizenman (1992)
and Sung and Lapan (2000). This is referred to as the ‘production flexibility’
approach in Goldberg and Kolstad (1995). Here, having plants in different
countries creates the option to shift production among facilities in response
to exchange rate movements. Aizenman (1992) allows for exchange rate
endogeneity, and shows that a fixed exchange rate regime is more conducive
to FDI. Sung and Lapan (2000) suggest that investment will change to the

et



al

. (1999) and Kogut and Chang

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lowest cost location after an exchange rate movement, and the value of the
option is positively related to uncertainty. They show that, with adequate
exchange rate uncertainty, it is profitable for a multinational enterprise
(MNE) to open plants at home and abroad, postponing production decisions
until after an exchange rate shock. Kogut and Kulatilaka (1994) provide
another variant of a real options model that predicts exchange rate volatility
increases FDI.
The strength of this approach is that it highlights the effect that exchange
rate movements may have on the timing of FDI, because a firm’s decisions
are to invest, wait, or to not invest, whereas under the risk aversion approach
firms either invest or they do not. Hazard models are often used in empirical
applications, and they fit neatly into the theoretical framework, describing
the timing between appearance of an investment opportunity and the
investment decision. Although the empirical models express the underlying
theory more closely than those of the risk aversion approach, the counterpart
to this is the unappealing behavioural assumption that firms adjust factors
after the realisation of exchange rate shocks. Some researchers have argued
that this may be a reasonable long-run assumption. However, focus in empirical
work is more on short-run volatility, not long-run misalignment. It has been
criticised by Jeanneret (2005) on the grounds that fluctuations in employment
and capital expenditures are not large relative to exchange rate variability,
and that it seems unrealistic to expect producers to keep some capacity idle.

2.2 Risk aversion

Under this approach, exchange rate risk arises due to the timing differences
between investment and profits. Firms invest abroad when the expected
returns equal the cost plus payment for the degree of risk introduced by
exchange rate volatility. The most frequently cited models are those of
Kohlhagen (1977), Itagaki (1981), Cushman (1985) and Goldberg and
Kolstad (1995). Cushman (1985) argues that a risk adjusted expected real
exchange rate appreciation lowers the foreign cost of capital, encouraging
FDI. This positive effect may be offset by effects on inputs costs, or changes
in output prices, making the exchange rate-FDI link indeterminate.
Extensions of Cushman’s work include Goldberg and Kolstad (1995), Qin
(2000), and Bénassy-Quéré
et

al
. (2001). Goldberg and Kolstad incorporate
the effect of a link between exchange rate shocks and foreign demand shocks.
They argue that an increase in the foreign money supply increases demand,
while raising foreign prices, which leads to a short-term real appreciation of
foreign currency. As both shocks are positive, the covariance is positive. In
this case, firms minimise the variance of expected profits and increase expected
utility by higher foreign investment.
Bénassy-Quéré
et

al
. (2001) examine the case of FDI to re-export. Risk-
averse firms consider alternative locations for FDI, and try to reduce the
effect of uncertainty on profits by exploiting exchange rate correlations between

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locations. The authors identify channels through which the exchange rate
affects FDI. For a host currency appreciation these are through increased
purchasing power of locals, and a reduced ability to compete due to higher
local production costs. The appeal of this model is that it recognises that a
decision to invest abroad in a particular country is not independent of
conditions in alternative locations. In the spirit of Bénassy-Quéré
(2001), Barrell
et

al
. (2004) present a model of FDI but introduce firms with
market power.
Most of these models have more intuitive appeal than the real options
work, but the empirical work is not as well-aligned with theoretical ideas.
Typically, FDI flows are regressed on exchange rates, a volatility proxy, and
various control variables, the choice of which is not well-guided by theory.
Further research is clearly required to address this issue, and Chakrabarti
(2003) provides such an attempt. He presents a model of spatial determinants
of FDI, where the main aim is to provide an encompassing theoretical
framework for empirical testing.

et



al

.





2.3 Recent contributions

More recently, theoretical contributions have been made that consider the
effects of heterogeneity in FDI motive (Lin
endogeneity (Russ 2007a), and multilateral resistance (Egger
Contributions have also been made that synthesise earlier theoretical
explanations into unified testable models (Buch and Kleinert 2006; Lin
2006). These represent a welcome development as they provide a potential
means by which previous work can be reconciled.
Russ (2007a) presents a general equilibrium model that allows for
exchange rate endogeneity. The analysis indicates that an MNE’s response to
exchange rate volatility will differ depending on the source of the shocks. A
positive shock to the host’s money supply depreciates the host’s currency,
simultaneously increasing income, and sales by both domestic firms and
MNEs in the host’s market. Conversely, a contractionary monetary policy in
the host generates a better exchange rate to convert profits, but reduces local
sales. In comparison, a contractionary monetary shock in the foreign economy
can adversely affect the value of the host currency without a counteracting
effect on overseas sales. A companion paper, Russ (2007b), examines effects
on first-time and veteran investors when exchange rate variation can be
sourced to either foreign or domestic interest rate volatility. The implication
of these for empirical work is that no prediction can be made about the
correlation between FDI and exchange rate volatility, unless account is taken
of the origin of the volatility. Employing a general equilibrium framework
Contessi (2006) presents a model with firm heterogeneity, and endogenous
exports and FDI. Among several analytical results from this model is the
prediction that the pricing policy of MNEs can increase the volatility of the
exchange rate. This, along with related findings Shrikhande (2002), Lubik

et



al

. 2006), exchange rate
et




al

. 2007).

et



al

.