Which exchange rates matter for FDI? Evidence for Japan.

• Author: Dennis, Benjamin N.
• Position: Company overview

1. Introduction

   Although the scope of its benefits is the subject of recent debate, foreign direct investment (FDI) has long been recognized as an important means for economic growth. Not only does FDI aid in capital accumulation, it also allows developing countries to raise total factor productivity through the introduction of new ideas, skills, and technology (De Mello 1997). The role of FDI as a source of growth in developing countries is increasing, with FDI to these countries rising by 50% from $156 billion in 2002 to $233 billion in 2004 (UNCTAD 2005); this occurred despite a 9% decline in total global FDI flows.

   Since exchange rate movements affect expected profits, they influence the attractiveness of FDI. The connection between FDI and exchange rates has been extensively studied from a theoretical perspective, including the impact on FDI of both the level of the exchange rate which influences the local cost of production--and its volatility--which determines the riskiness of the investment. Yet the diversity of ways to measure an appropriate real exchange rate has long served as an embarrassment of riches. Chinn (2006), for example, reviews the literature and determines that the selection of effective exchange rate measures depends on the economic issue being analyzed.

   This paper provides evidence that the choice of exchange rate measure is central to understanding FDI. We demonstrate that the most appropriate exchange rate measure depends on the type of FDI being considered, and that use of industry-level data on FDI is essential for this purpose. For example, if FDI is intended to break into domestic markets (which we term "domestic-oriented" FDI), profits will depend in part on the price of imports to the extent that imported inputs are required for production. Thus, an import-weighted exchange rate measure would appear to be the best exchange rate choice for this type of FDI. On the other hand, FDI intended to create export platforms to produce for sale in a third-country market (termed "export-oriented" FDI) may be more closely tied to other measures. Many studies that presume an export role for FDI concentrate on trade-weighted exchange rate measures. However, because countries compete to attract FDI, an exchange rate measure that accounts for the exchange rates of rival nations, even if they are not large trade partners, may be more appropriate. This may be particularly true for developing nations where South-South trade is relatively small.

   Studies that focus on aggregate FDI flows, for which data are more readily available, cannot distinguish between these variants of FDI, and this represents a clear shortcoming if each type of FDI is most influenced by a different exchange rate measure. In this paper, we focus on industry-level data that allow us to test this theory. By using disaggregated Japanese FDI data on flows between 1989 and 2003, we can differentiate between export- and domestic-oriented FDI. We then empirically investigate the relationship between different exchange rate indices and these two types of FDI. We construct a set of industry-specific trade-weighted real effective exchange rates. In addition, we create a measure of exchange rate competitiveness that uses the global export shares of competitors as weights.

   Our results shed new light on key competing theories of FDI, providing some support for those that suggest exchange rate volatility encourages export-oriented FDI, but not for those that suggest exchange rate volatility (as a trade barrier) should increase domestic-oriented FDI. Using disaggregated FDI data, we find that both the level and volatility of the exchange rate significantly affect the share of Japanese FDI received by the host country. Both depreciation of the local currency and lower exchange rate volatility encourage FDI, consistent with most theoretical predictions. However, we also find that this is more the case with industries oriented toward the domestic market as opposed to industries oriented toward exports. The difference is significant, with export-oriented FDI sometimes responding positively to certain kinds of exchange rate volatility. In addition, we find that the bilateral exchange rate between host and source matters, but that broader exchange rate measures contain additional information. In particular, volatility in exchange rates with competitors for FDI better explains how FDI is allocated than trade-based measures.

   After a brief literature review in section 2, section 3 presents the data and the empirical model. The main results are provided in section 4. Section 5 concludes.

2. Literature Review

   In general, the theoretical impact of exchange rate levels and volatility on FDI is ambiguous and depends significantly on the motives behind the investment (Cushman 1985). Lower exchange rate levels--implying that the host country's currency is relatively depreciated--mean lower costs of production and hence a more attractive investment location for export-oriented FDI. However, a lower exchange rate level may also imply lower dollar profits for domestic-oriented FDI once local revenues are converted into the source country's currency.

   The effect of exchange rate volatility also depends on the orientation of FDI, but with more exceptions. Since domestic-oriented FDI is a substitute for trade, high exchange rate volatility may foster increased FDI flows given that producing goods locally would reduce mismatches between local prices, costs, and revenues caused by exchange rate shocks. Alternatively, if the production from FDI is reexported back to the source country or to a third market, the variability of the exchange rate introduces additional risk in multinational cashflows leading to reduced FDI. However, the uncertainty created by this volatility gives rise to an options value of enhancing production flexibility by investing in several countries simultaneously and rotating production to whichever country provides the cheapest production platform (Aizenmann 1992, 2003; Sung and Lapan 2000). Yet uncertainty also creates an options value to wait and see (how uncertainty might be resolved) before committing to an investment, a prospect that leads to a negative relationship between volatility and FDI (Dixit 1989; Campa 1993).

   In light of the ambiguity found in the literature, it is not surprising that empirical studies using aggregate data display mixed results. For example, using country level FDI flows, Cushman (1985) and Goldberg and Kolstad (1995) find a positive relationship between exchange rate volatility and FDI. In seeming contradiction, Benassy-Quere, Fontagne, and Lahreche-Revil (2001), using data on FDI flows from OECD countries to developing countries, provide empirical evidence of a negative relationship between exchange rate volatility and FDI. With respect to Asia, where the empirical focus of this paper lies, Bayoumi and Lipworth (1997) and Goldberg and Klein (1998) examine the effect of exchange rate movements on Japan's outward FDI and the linkages between trade flows and FDI. They show that the exchange rate depreciation of the host country encourages FDI from Japan and Japanese FDI increases both the export and import linkages of Southeast Asia. However, the volatility of exchange rate is not considered in their studies.

   Baek and Okawa (2001) also use industry-level data (in combination with aggregate data) in their investigation of Japanese manufacturing FDI in Asia. They explore the impact of the behavior of various bilateral exchange rates and find that appreciation of the yen against the Asian currencies or against the dollar increases Japanese FDI to Asian countries significantly. Although a depreciation of the Asian currencies against the dollar had no significant impact on the FDI in aggregate manufacturing, it did increase FDI into the export-oriented electrical machinery sector. Industry-level differences matter.

   In our view, however, the common use of the bilateral real exchange rate between the source and host countries is flawed. Countries now engage with more international trade and investment partners than in previous decades. Because bilateral exchange rates may prove misleading, the U.S. Federal Reserve (Leahy 1998) and the IMF construct aggregate "effective" exchange rates from weighted averages of bilateral exchange rates. While these indices focus on economy-wide prices, Goldberg (2004) argues that the use of industry-specific indices is more effective. She shows that use of aggregate indices misses the empirical importance of the exchange rate on producer profits in specific industries.

   We therefore construct industry-specific trade-weighted exchange rates for five Asian countries for use in our empirical estimation, including one that focuses on competitors for third-country market share and not, as is traditional, on trade partners. We then test how well these various exchange rate measures explain FDI behavior at the industry level.

3. Data and Empirical Approach

   Our investigation uses Japanese FDI data by country disaggregated at the industry level. The panel data include FDI flows to China, Indonesia, Malaysia, the Philippines, and Thailand in 18 industries from 1989 to 2003. (1) Outside of the major industrialized countries, these were the prime recipients of Japanese FDI, with China alone receiving 25% of manufacturing investment over this period and another 42% going to the Southeast Asian countries. The industries examined in this study, data, and definitions are described in the data appendix and include nine manufacturing and nine nonmanufacturing categories. (2)

   There are significant advantages in focusing on Japanese FDI to this region. FDI is conceivably motivated by a variety of factors, including global shocks and events in the FDI source countries. By focusing on a single source country--Japan--during a period of significant FDI outflows and restricting our hosts to countries...