Essay About Determinant Of Fdi And Exchange Rate

Exchange Rate as a Determinant of Fdi: Does It Really Matter?
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Exchange Rate as a Determinant of Foreign Direct Investment: Does it Really Matter?
Isabel Cristina Ruiz*
* Abstract. This paper re-examines the role of exchange rates as determinant
of FDI. It extends the analysis to include the issue of how exchange rates determine
the decision of invest in one country depending on whether the firm is deciding to
invest on the country to service the local market or to invest on the country in order
to re-export. This paper offers a broad literature review of the state of the empirical
research in order to draw conclusions of the real importance of the exchange rate
as a determinant of FDI. Details of FDI current behavior in Latin American are
described and I propose a model of FDI to be applied for these countries. Data
sources are given.
Key words: FDI, Exchange Rate, Exchange Rate Variability.
JEL Classification: F21, F23,F31, F41.
* Candidata a Doctorado del Department of Economics, Western Michigan University E-mail: [email protected]
Ecos de Economía No. 21 Medellín, octubre 2005
Exchange Rate as a Determinant of
Foreign Direct Investment:
Does it Really Matter?
Theoretical Aspects, Literature Review
and Applied Proposal.
Isabel Cristina Ruiz
1. Introduction
There are several determinants of foreign direct investment (FDI). Empirical
economists have been dedicated to study the reasons of why multinational firms
(MNCs) or transnational corporations (TNCs) invest in one country or another.
Much of this research has been dedicated to the analysis of location specific
determinants. Others have worried about institutional factors and market reforms.
In general, one question to answer has been, why does FDI flows more to some
countries than to others?
According to Trevino, et all (2002), empirical studies of FDI stem either from
a micro or a macro perspective. The idea of many of these studies is to establish
the reasons of why companies choose one country over another to invest and in
general, they point out that the two major reasons that MNCs and TNCs look at is
their perceptions of comparative opportunity and risk. According to Trevino (2002),
opportunity is referred to either gain markets or to acquire resources; risk is related
to political, monetary or competitive factors. Because companies motives
competencies, perceptions, and tolerance for risk may differ substantially, what
may be very attractive country for one company may be simultaneously unattractive
for another.
This paper deals with the second issue; the risk generated by a particular
location specific determinant: the exchange rate (ER). It has often been argued that
Isabel Cristina Ruiz/Exchange Rate as a Determinant of Foreign Direct Investment
the level of ER affects the decision to invest in one country depending on whether
the host country currency is overvalued or not in comparison with the investing
country. Others have argued that is not the level but its variability what matters in
terms of FDI flows. Much research has been done on the relations -FDI and ER-
, -trade and ER- but in general, it has often been inconclusive. Thus this paper raises
some questions that have not been clearly answered in the literature: does ER really
matters as a determining motive of FDI? If it does, does the investor see it from a
microeconomic (as in Dixit (1994)) or just as another macroeconomic determinant
(as in Goldberg and Klein (1997) and Campa (2000)? And finally, can it be
incorporated in the literature instead as financial variable?
This paper attempts to contribute to this kind of literature by doing an
extensive literature review of the empirical evidence of the role of ER
determining FDI. Furthermore, it attempts to uncover what the empirics have
shown about how it, and how it might alter the relationship between FDI and
trade (this is, is a company using ER as a strategy to re-export or is just simply
serving the local market). Therefore, analysis of ER on trade is also conducted.
It is important to note that the main emphasis is on the evidence that has been
presented for Latin American countries (LACs). Therefore, the second
section of this paper proposes a model that can be applied to these countries.
This topic is still relevant since FDI is viewed as a stable source of financing
and growth for developing countries and any type of research trying to
establish determinant motives of attracting FDI is relevant for a country
strategic economic policy.
2. Literature review
This section, discusses the