Exchange rate uncertainty and foreign direct investment in Africa: Does financial development matter?

• Published date: 01 May 2022
• Author: Michael Effah Asamoah,Imhotep Paul Alagidede,Frank Adu
• Date: 01 May 2022
• DOI: http://doi.org/10.1111/rode.12858

878 

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     wileyonlinelibrary.com/journal/rode  Rev Dev Econ. 2022;26:878–898.

© 2022 John Wiley & Sons Ltd

Received: 17 April 2020 

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  Revised: 14 December 2021 

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  Accepted: 17 December 2021

DOI: 10.1111/rode.12858  

REGULAR ARTICLE

Exchange rate uncertainty and foreign

direct investment in Africa: Does financial

development matter?

Michael EffahAsamoah1

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Imhotep PaulAlagidede2

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FrankAdu3

Frank Adu is a Transformation Fellow.  

1Accounting Department, University of 

Ghana Business School, University of 

Ghana, Accra, Ghana

2Wits Business School, University of the 

Witwatersrand, Johannesburg, South 

Africa

3African Center for Economic 

Transformation, Accra, Ghana

Correspondence

Michael Effah Asamoah, Accounting 

Department, University of Ghana 

Business School, University of Ghana, 

Accra, Ghana.

Emails: measamoah@ug.edu.gh, 

iameffah@gmail.com

Abstract

The  orthodox  view  is  that  uncertainty  deters  invest-

ments and, by extension, private capital inflows. Paying 

specific  attention  to  the  volatility  of  the  domestic  ex-

change  rate,  foreign  direct  investment  (FDI),  and  fi-

nancial development  indicators, this  study investigates 

the  impact  of  exchange  rate  uncertainty  on  FDI  and 

whether  financial  development  matters  in  such  asso-

ciation. We  establish our  empirical relationship  with a 

system general  methods  of  moments  (GMM)  two- step 

robust estimator with orthogonal  deviations. We found 

evidence supporting a nonlinear U- shaped relationship 

between  uncertainty  and  FDI  and  that  the  impact  of 

uncertainty on FDI depends on varying levels of uncer-

tainty. We also  document  that  uncertainty  deters  FDI 

flows and that countries with a well- functioning finan-

cial development  can  transform  the  adverse impact of 

volatility on  FDI.  However,  curbing  the  adverse  effect 

depends  on  the  specific  indicator  and  the  threshold 

value of financial development (financial institutions or 

financial markets).

KEYWORDS

exchange rate, financial development, foreign direct investment, 

marginal effects, nonlinearity, systems GMM, uncertainty

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ASAMOAH et al.

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INTRODUCTION

The unpredictability of volatilities associated with capital flows adversely affects the quantum of 

inward capital flows to destination  countries. Macroeconomic uncertainties  can lead to sudden 

stops and reversal of capital flows resulting in a change in quantum and direction. Uncertainties 

can hinder the attraction of private capital, which can adversely impact the growth of  countries 

that hugely  depend on  them. Shocks  affecting capital  flows may  impede the  directional move-

ment of the flows. According to a UNDP  (2011) report, “A financial shock can result in the sud-

den reversal of  capital  flows and  also in  a sharp decline  in inflows”  (p. 86). The  report further 

admonished, “For this reason, policy  measures to build a  country's resilience to private capital- 

related shocks  should  focus  on  stabilizing  the  volatility  associated with  private  capital  flows” 

(UNDP,2011, p.  87).  Such  volatilities  could result  from  the  devaluation of   the exchange  rate, 

inflationary pressures, and growth volatility. Lensink and Morrissey  (2006) posit that countries 

deemed political and economically volatile attract few  foreign investors. Instabilities associated 

with capital flows could also lead to distortions in the economic progress of  countries (Forbes & 

Warnock,2012).

The theory  of  investment irreversibility  primarily influences  the  adverse impact  of  volatili-

ties on investment and, by extension,  capital flows. According  to the proponents  of investment 

irreversibility and the  “options to  wait,” future uncertainty leads  to a  postponement of  current 

investment as economic agents will hold onto additional investment until the level of uncertainty 

has been dispelled. Again, since the returns on investment are unpredictable during uncertainty, 

investors will curtail additional financing. The unpredictability of returns indicates an inverse re-

lationship between investments and uncertainty (Dixit et al., 1994; Nickell,1978; Pindyck,1993). 

In line with the aforementioned theoretical stance, some empirical studies have found a negative 

relationship between  uncertainty  and private capital  flows  (Asamoah et al., 2016;  Cavallari & 

d'Addona,2013; Jehan & Hamid,2017). However, the empirical conclusions on the uncertainty- 

investment dynamics do not support a vigorous one- sided conclusion of a negative relationship. 

Some  studies  have found  volatility  to  positively  affect  investment  and  capital  flows  (Corden, 

1990; Daly & Vo,2013). The positive  association results from the  theories of  risk neutrality and 

investment reversibility. Hartman (1972) and Abel (1983) posit that uncertainty causes the desire 

to increase current investment,  as the marginal  product of  capital and profits  is expected to  in-

crease with increasing uncertainty.

Considering these opposing  theories, we  contend that the  association between  capital flows 

and volatility  may not be  strictly  monotonic (positive  or  negative). With  a  prime focus  on  the 

domestic exchange  rate,  the  study  seeks to  reexamine  the  dynamics  between macroeconomic 

uncertainty and private capital flows in Africa by testing the two contrasting theories (investment 

irreversibility and  investment reversibility). Many existing studies take a linear  relationship as 

given, raising  doubt on  the validity  of  the conclusions from  such studies.  Therefore, the  study 

contends that there exists a U- shaped relationship between exchange rate  volatility and foreign 

direct investment (FDI), where both theories could exist at  extreme ends of the  curve. First, the 

study focuses on a more stringent nonlinear procedure proposed by Lind and Mehlum (2010) to 

examine the two opposing theories (i.e., investment irreversibility and risk neutrality) (Table A1).

JEL CLASSIFICATION

O2; O24