Exchange Rate as a Determinant of Fdi: Does It Really Matter?

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: isabel.ruiz@wmich.edu

155

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

156

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