Exchange rates and foreign direct investment: Exchange Rate Levels
When a currency depreciates, meaning that its value declines relative to the value of another currency, this exchange rate movement has two potential implications for FDI. First, it reduces that country’s wages and production costs relative to those of its foreign counterparts. All else being equal, the country experiencing real currency depreciation has enhanced ‘‘locational advantage’’ or attractiveness as a location for receiving productive capacity investments. By this relative wage channel, the exchange rate depreciation improves the overall rate of return to foreigners contemplating an overseas investment project in this country.
The exchange rate level effects on FDI through this channel rely on a number of basic considerations. First, the exchange rate movement needs to be associated with a change in the relative production costs across countries, and thus should not be accompanied by an offsetting increase in the wages and production costs in the destination market. Second, the importance of the relative wage channel may be diminished if the exchange rate movements are anticipated. Anticipated exchange rate moves may be reflected in a higher cost of financing the investment project, since interest rate parity conditions equalize risk-adjusted expected rates of returns across countries. By this argument, stronger effects of exchange rate movements on FDI arise when unanticipated and not reflected in the expected costs of project finance for the FDI.
Some experts dismiss the empirical relevance of the interest-parity caveat. Instead, some argue that there are imperfect capital market considerations, leading the rate of return on investment projects to depend on the structure of capital markets across countries. For example, Froot and Stein (1991) argue that capitalmarkets are imperfect and lenders do not have perfect information about the results of their overseas investments. In this scenario, multinational companies that borrow or raise capital internationally to pay for their overseas projects will need to provide their lenders some extra compensation to cover the relatively high costs of monitoring their investments abroad. Multinationals would prefer to finance these projects out of internal capital if possible, since internal capital is less expensive than borrowed capital.
Consider what occurs when exchange ratesmove. A depreciation of the destination market currency raises the relativewealth of source country agents and can raise multinational acquisitions of certain destination market assets. To the extent that source country agents hold more of their wealth in own currency-denominated form, a depreciation of the destination currency increases the relative wealth position of source country investors. As the parent company’s wealth rises, more financing out of internal capital occurs. The reduced relative cost of capital allows these investors to bidmore aggressively for assets abroad. Empirical support for this channel is provided by Klein and Rosengren (1994), who show that the importance of this relative wealth channel exceeded the importance of the relativewage channel in explaining FDI inflows to the United States during the period from 1979 through 1991.
Blonigen (1997) makes a ‘‘firm-specific asset’’ argument to support a role for exchange rates movements in influencingFDI. Suppose that foreign and domestic firms have equal opportunity to purchase firm-specific assets in the domestic market but different opportunities to generate returns on these assets in foreign markets. In this case, currency movementsmay affect relative valuations of different assets. While domestic and foreign firms pay in the same currency, the firm-specific assets may generate returns in different currencies. The relative level of foreign firm acquisitions of these assets may be affected by exchange rate movements. In the simple stylized example, if a representative foreign firm and domestic firm bid for a foreign target firmwith firmspecific assets, real exchange rate depreciations of the foreign currency can plausibly increase domestic acquisitions of these target firms. Again, this channel predicts that foreign currency depreciation will lead to enhanced FDI in the foreign economy. Data on Japanese acquisitions in the United States support the hypothesis that real dollar depreciations make Japanese acquisitions more likely in U.S. industries with firm-specific assets.