Foreign direct investment and inflation.

• Author: Sayek, Selin

1. Introduction

   In recent years interest in understanding the determinants of foreign direct investment (FDI) has intensified hand in hand with an increasing volume of FDI flows. From 1990 to 2005, the total worldwide FDI inflows increased from $203 billion to $974 billion. Almost all developing countries are competing to attract a major share of these inflows. In fact, the share of net FDI inflows in the gross domestic product (GDP) of middle income countries has risen from 0.74% in the 1970s to 1.08% between 1985 and 1994, and to 2.85% between 1995 and 2005. (1) The intensified competition to attract more FDI has led to changes in the regulatory frameworks provided by almost all countries. According to the recent World Investment Report (UNCTAD 2003), during the period 1991-2002, around 95% of the changes in worldwide laws governing FDI have been favorable to multinational firm activity. Establishment of investment promotion agencies as well as provision of fiscal incentives have accompanied these improvements in local regulatory environments. Given the objectives of host countries to attract high-quality investments and to ensure benefits from such foreign activity, it is important to fully understand the factors influencing the FDI flows.

   This article primarily studies the role of inflation among the factors that drive FDI. Inflation rates have increased from around 5 to 10% on average in developing countries during the 1970s, followed by an increase of 49% on average among developing countries between 1985 and 1994. This trend of increasing inflation rates has been reversed in the late 1990s; the inflation rates in developing countries have on average declined to 9.2% during 1995-2004, a period during which the net FDI inflows as a share of GDP have more than doubled in the middle income countries. Given the focus among developing countries to attract more FDI, it is interesting to analyze whether the increasing inflation rates in the 1970s and 1980s might have been a deterrent for FDI inflows and whether their reversal in the 1990s might have contributed to the increase in FDI inflows to these economies. Despite not providing conclusive evidence, the coincidences of high inflation and low FDI versus the low inflation and high FDI inflows into these developing countries motivates investigation of the possible links between the two variables.

   Therefore the broad objective of this framework is to study the effects of inflation on the investment decision of multinational enterprises (MNEs). Changes in inflation rates of the domestic or foreign country are anticipated to alter the net returns and optimal investment decisions of the MNE. In studying the explicit role of inflation in determining the investment pattern of MNEs across domestic and foreign locations, I use a model that is in fact discussing an investment-smoothing behavior of the MNE that faces domestic and foreign nominal shocks. In this framework the act of investment smoothing captures a shift of investments across locations and not across time. My argument is in line with Aizenman (1992), who notes that the goal of diversifying exposure to country-specific shocks induces producers to become multinationals. This investment-smoothing behavior can further be thought of as a production flexibility approach, where the MNE can shift production (and trade decisions) depending on the relative favorability of conditions in the two countries as discussed in Sung and Lapan (2000). Parallel to these two papers, the current model shows that the existence of FDI opportunities is tantamount to increased hedging possibilities against inflation taxes even if no explicit hedging instrument is modeled. In fact, MNEs minimize the negative effects of policy changes, in this case expected changes in the inflation rate, via a shift in the location of production across home and host countries. The model shows that the ability of a multinational to invest in two alternative economies does reduce the real effects of nominal shocks.

   There are models in the literature that have studied the investment decisions of MNEs in general equilibrium models with monetary shocks. However, a majority of these studies have focused on the exchange rate shocks, not inflation shocks as I do in this article. Three such articles are Aizenman (1992), Devereux and Engel (1999), and Russ (2007), which all focus on the effects of exchange rate-related policies on FDI decisions. Aizenman (1992) models the production flexibility approach into an option value model to discuss the role of exchange rate uncertainty in FDI decisions, finding that volatility under flexible exchange rates can in fact deter FDI. Devereux and Engel (1999), on the other hand, show that if the MNEs are serving the host market, then exchange rate volatility can be loosely associated with higher MNE activity. Both models are relevant to the current study, not in their focus on the link between exchange rate uncertainty and FDI, but in their simultaneous incorporation of MNE activity and monetary phenomena in the same model. (2) Furthermore, these papers tend to discuss the effects of these shocks on foreign investment decisions without considering the investment-smoothing effects made possible by the tandem decision of domestic and foreign investment by the MNE. The current model considers the effects of inflation on the domestic and foreign investment alternatives simultaneously, incorporating the fact that the FDI decision is not independent of the domestic investment decision of the firm. As such, the article contributes to the literature that studies the relationship between monetary processes and FDI without explicitly controlling for the possibility of investment smoothing by the MNE.

   Besides, although there are models in the literature that incorporate MNEs into general equilibrium models with money, the differential role of domestic inflation and foreign inflation on vertical and horizontal FDI have not been discussed explicitly in any of these models. The current analysis incorporates monetary phenomena into the model, with a focus on the links with both vertical and horizontal FDI. As such, my model is similar in spirit to Aizenman and Marion (2004), who discuss the association between several uncertainties and vertical as well as horizontal FDI. Their results emphasize that uncertainty's effect is larger on vertical FDI than on horizontal FDI. The current study's results echo this by finding that the investment smoothing of MNEs, upon changes in monetary processes' of the home and host countries, differs between vertical and horizontal FDI. This is an important finding, pointing to the importance of differentiating across initial motives of FDI in modeling MNE behavior and studying the determinants of FDI.

   Another important characteristic of the model is that it allows for the financing of the FDI activity to occur through both domestic and foreign sources. Several studies in the literature have provided evidence that MNEs not only use finances from the home country sources but that they also use foreign country financing. For example, Feldstein (1994) shows that, with the goal of minimizing the tax burden, U.S. foreign affiliates raise a significant amount of financial resources in their host country markets. This access to host country financial markets is furthermore a means of hedging against fluctuations in future local currency earnings. This is a point further emphasized by Lehmann, Sayek, and Kang (2004), who find that there is an association between the extent of exposure to local currency revenues and contribution of host country finances to total financing, generating a relationship between FDI and the financial market development of the host country. Taking a cue from these studies, my model allows for financing from both domestic (home) country sources and foreign (host) country sources, where not only does FDI become a hedging instrument, but a shift between alternative means of financing also does. (3) Allowing for differential financing sources to the MNE in a framework of investment smoothing is one of the novelties of this article.

   In summary, the current analysis of investment-smoothing behavior is done in a comprehensive way to allow not only for the characteristic of the FDI to differ (being vertical or horizontal) but also its financing composition (between domestic and foreign resources) to be a choice variable of the MNE. This is, to the best of my knowledge, the first model to formalize the role of inflation and how the investment smoothing made possible by FDI reduces the real effects of the inflation tax. The main finding of my article is that firms benefit from having the opportunity to invest abroad and the ability to finance their foreign investment activity through different financial markets. In other words, the option of diversifying the investment decision across countries and across financing means reduces the negative effect of inflation on physical investment fluctuations. The MNE could mitigate the loss in net benefit caused by higher domestic (foreign) inflation by increasing foreign source-financed FDI (domestic investment) and limiting the response of domestic (foreign) investment to the inflation tax. A detailed analysis suggests that the extent of reduction in the FDI financed through alternative financial markets depends on the motivation for FDI. In the case of vertical FDI, results show that both the quantitative and qualitative effects of a higher domestic inflation tax on the domestically financed portion of FDI depends on the substitutability of the factors of production. The lower the degree of substitutability between the factors of production, the higher the possibility that domestically financed FDI also decreases in response to domestic inflation. Finally, the results suggest that the response of the composition of the financing of FDI also...