Exchange rates and foreign direct investment: Exchange Rate Volatility
In addition to levels of exchange rates, volatility of exchange rates also matters for FDI activity. Theoretical arguments for volatility effects are broadly divided into ‘‘production flexibility’’ arguments and ‘‘risk aversion’’ arguments. To understand the production flexibility arguments, consider the implications of having a production structure whereby producers need to commit investment capital to domestic and foreign capacity before they know the exact production costs and exact amounts of goods that will be ordered from them in the future. When exchange rates and demand conditions are realized, the producer commits to actual levels of employment and the location of production. As Aizenman (1992) demonstrated, the extent to which exchange rate variability influences foreign investment hinges on the sunk costs in capacity (i.e., the extent of investment irreversibilities), on the competitive structure of the industry, and overall on the convexity of the profit function in prices. In the production flexibility arguments, the important presumption is that producers can adjust their use of a variable factor following the realization of a stochastic input into profits. Without this variable factor that is, under a productive structure with fixed instead of variable factors the potentially desirable effects of price variability on profits are diminished. By the production flexibility arguments, more volatility is associated with more FDI ex ante, andmorepotentialforexcess capacityandproduction shifting ex post, after exchange rates are observed.
An alternative approach linking exchange-rate variability and investment relies on risk aversion arguments. The logic is that investors require compensation for risks, and that exchange rate movements introduce additional risk into the returns on investment. Higher exchange-rate variability lowers the certainty equivalent expected exchange-rate level, as in Cushman (1985, 1988). Since certainty equivalent levels are used in the expected profit functions of firms that make investment decisions today in order to realize profits in future periods, if exchange rates are highly volatile, the expected values of investment projects are reduced, and FDI is reduced accordingly. These two arguments, based on ‘‘production flexibility’’ versus ‘‘risk aversion,’’ provide different directional predictions of exchange rate volatility implications for FDI.
The argument that producers engage in international investment diversification in order to achieve ex post production flexibility and higher profits in response to shocks is relevant to the extent that ex post production flexibility is possible within the window of time before the realization of the shocks. This distinction suggests that the production flexibility argument is less likely to pertain to short-term volatility in exchange rates than to realignments over longer intervals.
When considering the existence and form of real effects of exchange rate variability, a clear distinction must be made between short-term exchange rate volatility and longer-term misalignments of exchange rates. For sufficiently short horizons, ex ante commitments to capacity and to related factor costs are a more realistic assumption than introducing a model based on ex post variable factors of production. Hence, risk aversion arguments are more convincing than the production flexibility arguments posed in relation to the effects of short-termexchange rate variability. For variability assessed over longer time horizons, the production flexibility motive provides amore compelling rationale for linkingFDI flows to the variability of exchange rates.
As explained earlier, the exchange rate effects on FDI are viewed as exogenous, unanticipated, and independent shocks to economic activity.Of course, to the extent that exchange rates are best described as a random walk, this view is a reasonable treatment. Otherwise, it is inappropriate to take such an extreme partial equilibriumviewof theworld.Accounting for the comovements among exchange rates, monetary demand, and productivity realizations of countries is important. As Goldberg and Kolstad (1995) show, these correlations can modify the anticipated effects on expected profits and the full presumption of profits as decreasing in exchange rate variability. Empirically, exchange rate volatility tends to increase the share of a country’s productive capacity that is located abroad. Analysis of two-way bilateral FDI flows between the United States,Canada, Japan, and the United Kingdom showed that exchange rate volatility tended to stimulate the share of investment activity located on foreign soil. For these countries and the time period explored, exchange rate volatility did not have statistically different effects on investment shares when distinguished from periods where real or monetary shocks dominated exchange rate activity. Real depreciations of the source country currency were associated with reduced investment shares to foreign markets, but these results generally were statistically insignificant.
Although theoretical arguments conclude that the share of total investment located abroad may rise as exchange rate volatility increases, this logic does not imply that exchange rate volatilitydepresses domestic investment activity. In order to conclude that domestic aggregate investment declines, onemust show that the increase in domestic outflows is not offset by a rise in foreign inflows. In the aggregate U.S. economy, exchange rate volatility has not had a large contractionary effect on overall investment (Goldberg 1993).
Overall, the current state of knowledge is that exchange rate volatility can contribute to the internationalization of production activity without depressing economic activity in the home market. The actual movements of exchange rates can also influence FDI through relative wage channels, relative wealth channels, and imperfect capital market arguments.