Foreign Direct Investment, Trade and Real Exchange Rate Linkages



Foreign Direct Investment, Trade and Real Exchange Rate Linkages

Question 1

The main result from the Pooled Ordinary Least Squares on FDI/K is that the rate of foreign investment depends most on the real exchange rate and population differences. We find a consistent positive effect from the real exchange rate variable, which supports the theoretical prediction of our model. This is in line with previous research on the relationship between exchange rates and foreign direct investment; for example, both Froot and Stein (1991) and Blonigen (1997) find that the real exchange rate movements significantly affect FDI flows into the United States. Note, however, that the real exchange rate variable could be significant for reasons other than q theory, namely simply cheaper production costs. Also, as the difference between the population in the host country and home country increases, the rate of FDI also increases. This suggests that FDI in the semiconductor industry is seeking lower cost labor, since higher population is associated with a larger labor force and lower wages. This finding is also consistent with the proximity hypothesis regarding FDI that firms locate closer to large markets.

The class of models that can be estimated using a pooled ordinary least squares estimator can be written as follows

Where is the dependent variable, are K regressors not including a constant term. The heterogeneity or individual effect is where contains a constant term and a set of individual or group specific variables, which may be observed or unobserved, all of which are taken to be constant over time t. Ordinary Least Squares (OLS) is often used to estimate the gravity model but does not permit to control the individual heterogeneity and hence may yield to biased results due to a correlation between some explanatory variables and some unobservable characteristics. If the Breusch Pagan LM test rejects the null hypothesis in favor of random effects, the OLS method is not adequate.

Random Effects (RE) and Fixed Effects (FE)

The purpose of the empirical investigation is to estimate the effects of Exchange rate on FDI and identify factors that enhance or inhibit the effects of Exchange rate on FDI. In particular, in this section, we examines whether exchange rate interacts with the FDI, the development of infrastructure, and other determinants of institutions and the investment climate measured among other things by the perception of corruption and risk in the host country.

All sectional correlation are based on a panel data of thirteen years (1982-1995), and are estimated using the weighted seemingly unrelated regressions (SUR) technique. The FE and the RE models are also tested but yielded much less better results than weighted SUR. The results of the effects of Exchange rate on FDI are reported in the Table 1.

There is substantial debate on the issue of the direction of the effect of devaluation on FDI in the existing literature. The traditional view is that exchange rate should not matter at all (see Blonigen (1997)). However Caves (1989), Froot and Stein (1991), ...