Chapter

IV. Foreign Direct Investment and the Exchange Rate

Author(s):
Takatoshi Ito, Tamim Bayoumi, Peter Isard, and Steven Symansky
Published Date:
December 1996
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Foreign direct investment (FDI) represents the acquisition by foreign residents of a controlling claim on firms (through equity) or on real estate, or further investment in an enterprise so controlled.1 It is the word “controlling” that distinguishes FDI from foreign portfolio investment, the other subcategory of private foreign investment.2 The System of National Accounts3 considers that a foreign investor controls a corporation or other asset if it owns 10 percent or more of the particular enterprise, rather lower than the 51 percent that is usually associated with the definition of a controlling interest.4 FDI itself is often divided into two further categories: mergers and acquisitions, in which an existing concern is bought; and “greenfield” investment, in which the enterprise is started from scratch.

Among the different components of FDI, acquisition of existing assets has been the predominant mechanism for making direct investments in industrial countries in recent decades (comprising, for instance, 80 percent of FDI in the United States). Even Japanese firms, which have historically displayed an inclination toward greenfield investment and joint ventures, have increasingly sought to expand through acquisitions in recent years (Kester, 1991; Froot, 1991; and Harris and Ravenscraft, 1991).

In either case, FDI includes a variety of transactions, such as the purchase of stock, the creation of production facilities or of distribution networks, and the acquisition of land for commercial or residential use. Because of the growing importance of these transactions, FDI is becoming an increasingly important economic link among countries. During the past two decades, the growth of FDI worldwide has been more rapid than that of world output and, more strikingly, of world trade. Several of the APEC nations have been among the fastest-growing hosts of worldwide FDI.5

Figure 4-1 shows annual inflows and outflows of FDI for most APEC economies, measured as a ratio to GDP, and Table 4-1 reports average levels of such inflows over time. In Figure 4-1, negative values represent a withdrawal of foreign investment. Experiences in the region are varied. In many of the developing economies there has been a clear underlying increase in inward flows of direct investment over time. Examples include China, Malaysia, Mexico, and Thailand. Such trends presumably reflect a number of factors, including high potential returns caused by long-term shifts in productivity, policies of capital account liberalization, and long-term movements in real exchange rates. By contrast, industrial countries such as Canada, Australia, and New Zealand show no clear trend, presumably reflecting their long tradition of foreign ownership and open capital accounts associated with exploitation of their natural resources.

Figure 4-1.Ratio of Foreign Direct Investment (FDI) to GDP

(In percent)
(In percent)

Source: IMF, International Financial Statistics (Washington, various issues).

Table 4-1.Ratios of Inward Foreign Direct Investment (FDI) to GDP(In percent)
APEC Member1971–801981–901991–93
Australia1.31.91.4
Canada0.60.70.8
Chile–0.12.21.7
Indonesia0.70.51.3
Japan
Korea0.30.30.2
Mexico0.81.41.4
Malaysia3.13.48.5
New Zealand1.81.4n.a.
Philippines0.30.91.0
Singapore6.410.613.2
Thailand0.61.21.8
United States0.30.80.3

Flows of FDI can also be compared with portfolio capital flows.6Table 4-2 reports data on total flows of net direct investment and portfolio investment during 1990–93 for a number of less developed countries in the APEC region.7 China was the most important destination for net FDI over this period, followed by Malaysia, Mexico, and Singapore, while Korea and Taiwan Province of China had net outflows. Over the same period, Korea, Mexico, and Thailand were major recipients of portfolio inflows, while Taiwan Province of China experienced a large net outflow. This diversity in experience with respect to different types of capital flows illustrates the disparate nature of the factors underlying alternative types of international capital flows.

Table 4-2.Composition of Net Capital Inflows for Selected APEC Economies, 1990–93(In billions of U.S. dollars)
APEC MemberNet FDINet Portfolio Investment
Chile1.65.0
China36.63.0
Indonesia6.32.7
Korea–1.420.4
Malaysia11.5
Mexico16.223.3
Philippines1.78.6
Singapore15.44.7
Thailand6.431.0
Taiwan Province of China–7.0–22.3
Source: IMF, World Economic Outlook (various issues).
Source: IMF, World Economic Outlook (various issues).

Figure 4-1 also shows that there is significant year-to-year variability of FDI inflows around their underlying trends. Inflows to the United States, for example, rose significantly in the mid-to late 1980s but fell in the early 1990s. FDI outflows show a similar level of variability. In the case of Japan, for example, there was a pronounced rise and fall in out-flows in the late 1980s and early 1990s.

It is also of interest to look at bilateral outflows of FDI from the United States and Japan, the two most important sources of such investment for the APEC region, to other economies.8Figure 4-2 shows these outflows during 1985–94 to six regional groupings, five within APEC plus aggregate non-APEC flows. The APEC regions are the newly industrializing economies (NIEs);9 other Asian economies;10 Pacific;11 other Americas;12 and Japan or the United States. Table 4-3 reports the associated cumulated direct investment flows for these regions.

Figure 4-2.U.S. and Japanese FDI Outflows by Region

(In millions of U.S. dollars)

Sources: United States, Department of Commerce, Survey of Current Business; and Japanese Ministry of Finance, Monthly Review, various issues.

Note: NIEs comprise Taiwan Province of China, Korea, Hong Kong, and Singapore. “Other Asia” comprises Thailand, Malaysia, Indonesia, China, the Philippines, and Brunei Darussalam. “Oceania” comprises Australia, New Zealand, and Papua New Guinea. “Other America” comprises Canada, Mexico, and Chile.

Table 4-3.Cumulated Outflows of FDI from the United States and Japan, 1985–92
United StatesJapan
In billions of U.S. dollarsIn percentof totalIn billions of U.S. dollarsIn percent of total
Total336.4100.0392.2100.0
APEC92.827.7262.066.8
Newly industrializing economies118.55.525.86.6
Other Asia29.12.731.38.0
Pacific312.83.821.95.6
Other America443.512.98.52.2
United States174.544.5
Japan9.32.8
Sources: United States, U.S. Department of Commerce, Survey of Current Business (various issues); and Japan, Ministry of Finance, Monthly Finance Review (various issues).

NIEs: Hong Kong, Korea, Singapore, and Taiwan Province of China.

Brunei Darussalam, China, Indonesia, Malaysia, Philippines, and Thailand.

Australia, New Zealand, and Papua New Guinea.

Canada, Chile, and Mexico.

Sources: United States, U.S. Department of Commerce, Survey of Current Business (various issues); and Japan, Ministry of Finance, Monthly Finance Review (various issues).

NIEs: Hong Kong, Korea, Singapore, and Taiwan Province of China.

Brunei Darussalam, China, Indonesia, Malaysia, Philippines, and Thailand.

Australia, New Zealand, and Papua New Guinea.

Canada, Chile, and Mexico.

The United States and Japan provided broadly similar aggregate quantities of FDI during the period, with $336 billion coming from the United States and $392 billion from Japan. However, only about one-fourth of aggregate U.S. FDI flows went to other members of APEC, compared with two-thirds in the case of Japan.13 This largely reflects very different direct bilateral flows between the United States and Japan. Although almost half of the Japanese FDI outflows went to the United States, Japan received only about 3 percent of U.S. out-flows. Excluding these direct bilateral connections, cumulated outflows from the United States and Japan to the remaining members of APEC were broadly similar, with the United States investing more in the Americas and Japan holding the edge in Asia and the Pacific.

The dynamic paths of FDI also differ between the United States and Japan. Japanese outflows of FDI to all destinations rose sharply in the late 1980s and then fell equally rapidly in the early 1990s. The rise was stimulated by large current account surpluses, the appreciating yen, and the “bubble economy” in the domestic market, during which the relative abundance of domestic credit combined with the appreciating yen encouraged Japanese firms to invest abroad. As these conditions disappeared in the early 1990s, the earlier upward trend in FDI was reversed. The behavior of U.S. FDI is less easy to characterize, since it is considerably more variable across regions than that of Japan (although some of this may reflect differences in the definition of the data). Direct investment from the United States to APEC as a whole was relatively volatile, with local peaks in 1987, 1990, and 1994.

This points to the need to explore the role of cyclical factors—including temporary exchange rate changes—as determinants of FDI in addition to underlying factors such as productivity trends. Before addressing the issue of how exchange rates affect FDI, however, one must first consider the determinants of FDI more generally. From this viewpoint, the main task to be tackled is to explain why investors need to acquire a controlling interest in a foreign country, rather than simply holding a passive claim (a noncontrolling portfolio share) on that country’s output or supplying the market through international trade.

Why FDI Instead of Portfolio Investment?

FDI has two faces: as a method of pursuing higher returns than can be obtained from domestic instruments and as a substitute for or complement to exports and imports.

In trade theory, foreign investment occurs because one country that is relatively short of capital, with abundant labor, would import capital from another country that is relatively abundant in capital. Foreign investment will occur until the returns to capital in different countries are equalized. However, this does not explain why the investment has to be “direct” and take a controlling interest in firms. Obtaining securities—that is, portfolio investment—would suffice to gain access to high-return markets. Major reasons for investment in order to take controlling interest may be that domestic private (capital) markets are inefficient in transforming capital inflows into productive resources, or that managerial know-how is hard to transplant in a different country.

On the other extreme, if market infrastructure (such as the capital markets) or managerial skills are deficient in the host countries, why not export (or import) the products instead of producing goods in the host country? There are several reasons why FDI is favored over trade. Usual explanations include building factories in a country with lower wages when labor mobility is limited, and building assembly lines for products where tariffs and quotas limit imports. In the following paragraphs, these explanations will be elaborated.14

The early literature on FDI focused on market size and on the desire to access new markets to extend monopolistic power, to penetrate tightly oligopolistic foreign markets, and to retaliate or preempt foreign competitors’ entry (see, for instance, Kindle-berger, 1969, andCaves, 1971). The focus of many multinational firms on the acquisition of leading brands, particularly in the food and consumer product industries, is consistent with this theory. Subsequent research has focused more on firm-specific advantages attributable to greater cost efficiency or product superiority, deriving from economies of scale, multiplant economies, advanced technology and product cycles, or marketing (Vernon, 1974; Dunning, 1974; and Porter, 1986). According to this view, multinationals find it cheaper to expand directly in a foreign country because many of their cost and product advantages rely on internal, indivisible assets, such as organizational and technological know-how. The large share of FDI in industries where research and development and knowledge play a crucial role, such as pharmaceutical and electronics, is consistent with the predictions of this theory. Finally, the need for vertical integration to ensure quality control of production has also received attention.

The recent literature has also considered economies of scale arising from the need to incur marketing costs to promote exports, emphasizing the symbiotic character of FDI and trade (see, for instance, Baldwin and Krugman, 1989, and Dixit, 1989). In the Japanese context, Kojima (1978; see also Kojima and Ozawa, 1984) observed that FDI was “trade-oriented.” He hypothesized that Japan invested in countries and sectors that complemented its trading positions. For example, as some exporting industries of Japan lost competitive advantage because of rising wages, the industries invested abroad. He has also argued that U.S. FDI operated in a rather different manner, acting as a substitute rather than a complement to trade, although this conclusion is not universally shared.15 These issues are clearly relevant for the APEC region, where Japan and the United States are major contributors of FDI. Others (see, for instance, Errunza and Senbet, 1981) have noted that international operations allow wealth diversification when individual investors are constrained by legal and informational barriers. Related research has emphasized the role of multinational operations in reducing the probability of bankruptcy (Shaked, 1986), and the role of internal liquidity in determining FDI.

Distortions induced by government policies are another major explanation for FDI. Tariffs, quotas, and other import-substituting policies (such as taxes and subsidies) can create conditions under which it is more profitable to produce in—rather than export to—a foreign country (a motivation for FDI often labeled “tariff-jumping”). Preferential tax treatment of foreign investors, specific regulations aimed at favoring foreign investment in specific industries, the use of foreign plants for transfer pricing, and other policy-induced distortions may also contribute to increasing after-tax returns to FDI and, hence, to raising the level of FDI itself. Thus, observed trends in FDI may reflect changes in these regulations, including changes in the rules on the repatriation of earnings, legal reforms that provide a clearer definition of property rights, political changes that alter the likelihood of nationalization, labor market reforms, and fiscal developments that foster changes in the taxation of capital. Political instability may also be an important factor in certain cases. Again, these factors are clearly relevant for the APEC region.

The host countries generally receive benefits from FDI. In addition to employment opportunities for workers, factories managed by foreign firms are often sources for the learning of managerial skills and the transfer of technology. Many countries prefer foreign companies producing on their soil to imports of the same products. FDI is also generally preferred to portfolio investment by host countries, since direct investment is regarded as a long-run commitment rather than “hot money” that can be withdrawn quickly, often leaving the country’s capital market in crisis.

It is also true, however, that host countries often limit possibilities of FDI by banning it altogether in certain industries or capping the share of foreign interest in firms of certain industries. Developing countries often fear, rightly or wrongly, that foreign capital will take over key sectors of the country. Sometimes, restrictions on FDI are also motivated by protection of domestic vested interests. In general, APEC developing countries have become increasingly favorable toward FDI, as can be seen from the upward trend in such investment evident in many countries (see Figure 4-1).

Empirical evidence in support of the determinants of FDI listed above is ample, particularly in support of the link between FDI and economies of scale owing to the ownership of knowledge capital and policy-induced distortions (see Harris and Ravenscraft, 1992, and Klein and Rosengren, 1994, for reviews). These theories are not very helpful, however, in explaining the behavior of FDI over shorter horizons and across countries that exhibit similar characteristics. For instance, foreign acquisitions in the United States fell by 60 percent in 1983, more than doubled between 1986 and 1988, and then fell by 30 percent by 1990 (Harris and Ravenscraft, 1992). The cyclical volatility of FDI is simply too large to be explained by slow-moving structural factors such as those discussed above. To explain the movement of FDI in relation to its historical trend, it is necessary to consider cyclical factors that affect costs and returns to investment. Exchange rates, as main determinants of the relative price of domestic and foreign goods and production factors, are prime candidates for this task.

Effect of Exchange Rates on FDI

Much of the traditional and modern analysis of the effects of exchange rates on FDI reflects a partial equilibrium perspective, based on the effects of exogenous shifts in real exchange rates on FDI flows. As discussed below, different types of disturbances may produce different links between FDI and exchange rates.

Among the suggested links between the real exchange rate and FDI, the effect of exchange rate changes on asset prices and costs of domestic labor and capital has received the greatest attention. An exchange rate depreciation contributes to FDI by lowering the cost of domestic assets to foreign investors. If the depreciation is perceived to be temporary in real terms (as may be the case for a nominal depreciation that is expected to feed rapidly into local factor and output prices), FDI is likely to include a greater fraction of acquisitions of land and of other existing assets, as foreigners take advantage of bargain prices. Depreciations that are regarded as more permanent in real terms are likely to increase the weight of greenfield investment, through their effect on factor costs, as foreign capital, for instance, seeks to combine with cheaper domestic labor.

A depreciation of the real exchange rate can also lead to an increase in direct investment inflows through its effect on relative wealth across countries (see, for instance, Froot and Stein, 1991, and Klein and Rosengren, 1994). By increasing the relative wealth of foreign firms, a change in the exchange rate can make it relatively easier for those firms to use internal financing, thereby lowering the relative cost of investing. Thus, an exchange rate depreciation would increase foreign firms’ wealth relative to domestic firms and spur an FDI inflow.

When one considers the effect of exchange rate changes on FDI coming through its effects on government policy, an opposite effect to that outlined above may be envisioned. To the extent that exchange rate depreciations improve a country’s trade balance, they may soften protectionist policies and, with it, reduce the incentive for tariff jumping. Further ambiguities arise when one goes beyond the examination of the effects on FDI of exogenous shocks that cause exchange rates to fall below their long-run trend. Indeed, one must recognize that exchange rates are themselves endogenous variables that respond to a variety of shocks. Depending on the effects of these underlying shocks on the long-run equilibrium exchange rate itself, empirical analysis may uncover quite different linkages between exchange rate changes and FDI flows.

Despite these sources of potential ambiguity, several studies looking largely at industrial countries have provided empirical evidence of a link between exchange rate depreciations and increased FDI inflows—including Cushman (1985, 1987), Caves and Mehra (1986), Culem (1988), Froot and Stein (1991), and Klein and Rosengren (1994). In addition, Harris and Ravenscraft (1991) showed that buyers from strong-currency countries were willing to pay significantly higher premiums than domestic buyers for the acquisition of U.S. assets during 1970–87.

Attention has also been devoted in the literature to the effects of greater exchange rate volatility on FDI. Reasons for greater exchange rate volatility to both stimulate and hinder FDI have been pointed out in the literature. Some authors (for example, Caves and Mehra, 1986) have emphasized the first possibility, based on the view that FDI provides insurance against exchange rate changes by allowing a firm to shift production across countries. From this viewpoint, greater exchange rate uncertainty is likely to cause more FDI (see also Aizenman, 1994, for a discussion of these issues). In contrast, the view that exchange rate volatility may reduce FDI has been emphasized by those noting the irreversible nature of FDI (see Dixit, 1989), which causes investors to be wary of potential exchange rate reversals when undertaking a foreign investment project that involves an unrecoverable outlay. This particular channel is more likely to apply when investment is of a green-field nature, or with certain types of investment undertaken in support of trade (for example, the cost of setting up a foreign plant, of developing a distribution network, or of establishing brand recognition). It has also been noted that some of the diversification motives applying to portfolio investment may extend to FDI (see Black, 1977). Exchange rate volatility should reduce portfolio investment and, by similarity (or if FDI remains in broadly constant proportion to portfolio investment), also FDI. This presumption is subject to qualifications, however. Countries whose exchange rates are negatively correlated with global returns to capital (for instance, oil-exporting countries), may actually benefit from their role as portfolio hedges. An increase in these countries’ exchange rate volatility may actually raise their FDI inflows on diversification grounds.

Empirical evidence on the link between exchange rate volatility and FDI is limited but tends to favor a positive link between exchange rate volatility and FDI inflows (see, for instance, Cushman, 1985, and Caves and Mehra, 1986). In response to greater exchange rate risk, multinationals appear to reduce exports to a foreign country but to offset this somewhat by increasing capital inputs and production in the country.

Empirical Evidence for the APEC Region

To investigate the links between FDI inflows and medium-term changes in the real exchange rate, we present regression results using annual data drawn from the APEC economies.16 The starting date of this empirical study is 1974, which marked the beginning of the current flexible exchange rate regime. It is well documented that this change in the nominal exchange rate regime also led to a significant change in the behavior of real exchange rates. The dependent variable in these regressions is the ratio of direct investment inflows (the sum of lines 45, 46, and 47 in the IMF’s Balance of Payments Statistics Year-book) to host-country GDR Data on investment out-flows were not used because they were not available for all economies.

The preceding discussion implies that the relationship between changes in the real exchange rate and direct investment inflows is ambiguous. A real depreciation may stimulate such flows by increasing the relative wealth of potential investors and by lowering costs in the host country. An appreciation of the exchange rate can be associated with increased FDI if the appreciation reflects a general surge in capital flows or if it increases protectionist pressures. The regression results will only be able to identify the general relationship between FDI and changes in the exchange rate. More disaggregated data on direct investment and other factors would be needed to help further distinguish among these potential channels.

The regressions relate the ratio of inflows of FDI to the level of the real exchange rate. To isolate the effect of the real exchange rate from some other possible factors that might be correlated with direct investment, two other independent variables were included in the initial regressions. The first was the growth of real output in the host country (measured as the change in the logarithm of real GDP from the previous year to the current year). The second was a time trend, so as to control for secular changes in inward FDI relative to GDP. Because the trend was found to be insignificant in most regressions, it was only included in the final specification when it was statistically significant.

Two specifications of the regressions are reported, and they differ according to the type of real exchange rate variable used. The regressions in Table 4-4 use the multilateral effective real exchange rate for each country. This variable has the advantage of representing the real exchange rate of the host country with respect to a broad range of other countries. The shortcoming of the multilateral effective real exchange rate is that the weights used to construct it are based on trade flows rather than on capital flows. Therefore, in Table 4-5 results are presented that used two separate bilateral real exchange rates, those against the United States and Japan, the major sources of direct investment for other APEC economies. Estimation was generally by ordinary least squares; however, in those cases where the residuals appeared to be significantly serially correlated, an autocorrelation adjustment was used, as indicated in the final columns of the tables. Finally, a panel regression was run in which the data from all of the available countries were included in a single specification (without an autocorrelation adjustment or a time trend). The results from these regressions can be thought of as representing evidence on the average behavior across the whole sample of countries.

Table 4-4.Results from FDI Regressions Using Real Effective Exchange Rates

(FDI/GDP)t=α+βΔlog(Yt)+Ψlog(Et)

APEC MemberGrowth in GDPReal Effective Exchange RateR2Adjusted for Autocorrelation
Panel of all countries0.061*–0.024**0.79No
Australia–0.087–0.0130.17Yes
Canada0.064–0.0210.13Yes
Chile–0.026–0.042**0.58No
Indonesia–0.041–0.0060.10Yes
Japan–0.004–0.001*0.15No
Korea0.014–0.0030.43Yes
Mexico–0.022–0.0090.61Yes
Malaysia0.034–0.0300.20Yes
Philippines0.047*–0.032**0.62No
Singapore0.323–0.0300.61Yes
Thailand0.1010.0270.19Yes
United States0.023–0.0090.10Yes
Note: One and two asterisks indicate that the coefficient is significant at the 5 and 1 percent levels, respectively. Time trends were included in the regressions for Japan, Mexico, and Singapore.
Note: One and two asterisks indicate that the coefficient is significant at the 5 and 1 percent levels, respectively. Time trends were included in the regressions for Japan, Mexico, and Singapore.
Table 4-5.Results from FDI Regressions Using Real Bilateral Exchange Rates

(FDI/GDP)t=α+βΔlog(yt)+Ψ1log(EUSt)+Ψ2log(EJAt)

APEC MemberGrowth of Real GDPU.S. Real Exchange RateJapanese Real Exchange RateR2Adjusted for Autocorrelation
Panel of all countries0.0510.007–0.023**0.80No
Australia–0.0710.016–0.019**0.34No
Canada0.0990.023–0.018**0.35No
Chile–0.0570.010–0.0450.42Yes
Indonesia0.0580.009–0.0110.13Yes
Japan–0.005–0.0000.15No
Korea0.013–0.002–0.0010.41Yes
Mexico–0.0340.003–0.010**0.67No
Malaysia0.040–0.0590.0120.21Yes
Philippines0.068*–0.016–0.0110.63No
Singapore0.3460.028–0.0110.68No
Thailand0.1590.0150.0170.45Yes
United States0.014–0.0060.11Yes
Note: One and two asterisks indicate that the coefficient is significant at the 5 and 1 percent level, respectively. Time trends were included in the regressions for Singapore and Thailand.
Note: One and two asterisks indicate that the coefficient is significant at the 5 and 1 percent level, respectively. Time trends were included in the regressions for Singapore and Thailand.

The regression results in Table 4-4 indicate that depreciations of the multilateral real exchange rate are generally associated with an increase in inward direct investment relative to GDP (all real exchange rate variables were defined such that an increase represents an appreciation). The coefficient on the real effective exchange rate is negative in the panel regression and in 11 of the 12 regressions for individual economies, although it is significant at conventional levels only in the panel regression and in 3 of the individual regressions. The coefficient of –0.024 in the panel regression indicates that for every 1 percent appreciation in the real effective exchange rate, FDI is lowered by 0.024 percentage point of GDP. Although this may appear small, it has to be gauged against both the relatively large movements in real effective exchange rates across economies and the low ratios of investment inflows as a percentage of output. For example, a 10 percent appreciation in the real effective exchange rate would lower FDI by almost ¼ of 1 percent of GDP, which is a significant proportion of the underlying inflows into many APEC economies (see Table 4-1).

The exchange rate coefficients for individual economies are generally similar in magnitude to the panel results, except in the case of Japan, where the coefficient is significantly lower. This presumably reflects the relatively low ratio of inward FDI in Japan. The coefficients for income growth are generally small, insignificant, and of variable sign, implying a weak link between growth and FDI (although the panel regression has a significant positive coefficient).17

Table 4-5 presents results from the same basic regression, but where the real effective exchange rate for each host country was replaced by two bilateral real exchange rates, those with respect to the United States and with respect to Japan. (The regressions for Japan and the United States, of course, include only one bilateral real exchange rate.) The results from these regressions confirm many of those found in the previous regressions using effective exchange rates. The coefficients on the growth of real GDP are generally insignificant, while there appears to be a significant negative relationship between real exchange rates and FDI. This negative relationship is clear in the case of the real exchange rate with respect to Japan, where both the panel regression and all but one of the individual regressions have negative coefficients, and the coefficient estimate in the panel regression is highly significant. The results for bilateral rates with respect to the United States, however, show little pattern. None of the regression coefficients is significantly different from zero, and many of them, including that in the panel regression, are positively signed.

This last result suggests a potential difference in the behavior of FDI from the United States and from Japan with respect to the exchange rate. To investigate this possibility further, data on bilateral flows of FDI from the United States and Japan to eight developing countries in the APEC region (Chile, Korea, Indonesia, Mexico, Malaysia, Philippines, Singapore, and Thailand) were collected.18 Unfortunately, the longest period for which consistent data could be obtained was 1980–93, which is rather too short for reliable estimation of regressions for individual economies. Instead, panel regressions were estimated, as reported below, relating the ratio of the bilateral flow of U.S. (Japanese) FDI to the GDP of the recipient country to the growth of real GDP in the host country (ΔY), and to the bilateral real exchange rate (E) for the U.S. dollar (yen):19

These regressions also indicate a difference in behavior between FDI coming from Japan and the United States. The coefficient on the real bilateral exchange rate in the panel regression for FDI from Japan was –0.004 and significant at the 5 percent level (although somewhat smaller than the corresponding coefficient on the corresponding real exchange rate in the panel regression reported in Table 4-5), while that on the bilateral real exchange rate in the panel regression for FDI from the United States was 0.002 and insignificant. Another contrast is that real GDP growth in the recipient country appears to matter for U.S. FDI flows but not for their Japanese counterpart.

Concluding Perspectives

Most of the factors affecting FDI flows are secular, as befits an activity that is long term by nature. This does not mean, however, that short-term factors have no influence in such decisions. In particular, a depreciation of the real exchange rate may stimulate inflows of direct investment by increasing the relative wealth of the investor and reducing the costs of domestic assets and factors of production. In contrast, an appreciation of the real exchange rate could also be associated with increased FDI if the appreciation reflects the impact of a general surge in capital flows or if it decreases protectionist pressures.

Earlier empirical work has found that capital inflows are generally associated with exchange rate depreciations, which is consistent with the idea that the wealth and cost channels predominate. The empirical work reported here for countries in the APEC region confirms this finding. There is, however, some evidence that foreign investment flows from the two largest economies in the region behave somewhat differently in this regard, with investment from the United States being less dependent on changes in the real exchange rate than the corresponding flows from Japan.20 This difference might indicate that the factors driving U.S. and Japanese FDI are rather different, although more work would be required to sustain such a conclusion.

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1

This section follows the normal practice of using the term FDI to denote the change, in a flow sense, in the stock of host-country assets owned by foreigners. The same term is also sometimes used, however, to describe the stock of FDI in a host country at a given time.

2

See Khan and Reinhart (1995) for a discussion of overall capital flows in the APEC region. This section focuses specifically on flows of FDI.

4

Other kinds of data with different definitions are available to measure FDI outflows for some countries because the definition of what constitutes FDI is not standardized across countries. The analysis here (in common with most of the literature) largely uses the standardized SNA measure of FDI in the empirical work, thereby ignoring the discrepancy between the underlying economic and statistical concepts.

5

Ahmad, Roa, and Barnes (1996) contains a detailed discussion of FDI flows in the APEC region.

6

A fuller discussion of these issues is contained in International Monetary Fund (1995). Khan and Reinhart (1995) have discussed capital flows in the APEC region in more detail, while Bercuson and Koenig (1993) have provided a detailed account of such flows for three members of APEC.

7

Because these figures refer to net capital inflows, they are not comparable with the data on gross inflows reported in Table 4-1.

8

The definitions of these bilateral outflows of FDI for the United States and Japan, which come from national sources, are not fully comparable. For example, the data for the United States include currency revaluations and reinvestment, and those for Japan do not.

9

Hong Kong, Korea, Singapore, and Taiwan Province of China.

10

Brunei Darussalam, China, Indonesia, Malaysia, the Philippines, and Thailand.

11

Australia, New Zealand, and Papua New Guinea.

12

Canada, Chile, and Mexico.

13

In the case of the United States, the other big recipients were Europe and non-APEC South America.

14

See Lizondo (1990), Harris and Ravenscraft (1992), Graham and Krugman (1991), and Graham (1995) for reviews of the literature.

15

See Lizondo (1990), Section IV.4, for a discussion; see also Ahmad and others (1996).

16

More general empirical analyses of FDI in Asia, and of its relationship to trade and growth, are contained in Eaton and Tamura (1994, 1996).

17

Because the dependent variable is measured as a ratio to nominal GDP, which includes real GDP as one of its components, the level of real GDP is also implicitly included in the regression.

18

These data came from OECD sources and, hence, are not necessarily compatible with the multilateral IMF data used in the previous regressions.

19

Note that the lagged exchange rate was used in these regressions because it appeared to work better than the contemporaneous value.

20

This may be due in part to the nature of the data. In particular, some of the FDI inflows from the United States in the past two decades may reflect reinvestment of income earned on, or appreciation in the value of, investments undertaken in the 1950s and 1960s; such reinvestment or appreciation is counted as FDI in-flows. By contrast, Japanese investments in the regions are newer, and the timing of the initial investment may have been more sensitive to exchange rate fluctuations. At this point, however, this observation remains a conjecture.

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