Exchange Rates and Foreign Direct Investment: A Note

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 444

April 1993

EXCHANGE RATES AND FOREIGN DIRECT INVESTMENT: A NOTE

Guy V.G. Stevens

NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an

acknowledgment that the writer has had access to unpublished material) should be cleared with the authors.

ABSTRACT

In "Exchange Rates and Direct Investment: An Imperfect Capital Markets Approach," Kenneth Froot and Jeremy Stein [1991] develop a new finance-based theory to answer an old question -- the relationship, if any, between the flow of foreign direct investment and the exchange rate. Their theory, based on the possibility that a foreign firm’s borrowing opportunities for financing a U.S. acquisition may be a function of its net worth in dollars, implies a negative relationship between a dollar appreciation and direct investment inflows into the United States. Empirically, the authors find statistically significant evidence of the implied negative relationship for quarterly and annual time series regressions, over the period 1973-88.

The major purpose of this note is to show that this empirical support for the theory is weak. The authors’ regressions show evidence of serious instability, and the significant negative relationship between direct investment inflows and the value of the dollar disappears for

important subperiods of the 1973-88 period and for the sample period

extended through 1991.

EXCHANGE RATES AND FOREIGN DIRECT INVESTMENT: A NOTE

Guy V.G. Stevens*

I. INTRODUCTION

In "Exchange Rates and Direct Investment: An Imperfect Capital Markets Approach," Kenneth Froot and Jeremy Stein [1991] develop a new finance-based theory to answer an old question -- the relationship, if any, between the flow of foreign direct investment and the exchange rate. Their theory, based on the possibility that a foreign firm's borrowing opportunities for financing a U.S. acquisition may be a function of its net worth in dollars, implies a negative relationship between a dollar appreciation and direct investment inflows into the United States. Empirically, the authors find statistically significant evidence of the implied negative relationship for quarterly and annual time series regressions, over the period 1973-1988.

The major purpose of this note is to show that, irrespective of whether this evidence serves to distinguish their theory from its competitors, the empirical support for the theory is weak. The quarterly aggregate regressions show evidence of serious instability inside and outside the 1973-88 sample period, and the significant negative relationship between direct investment inflows and the value of the dollar holds for only part of it. Moreover, when the sample period for the quarterly regression is extended through 1991, the estimated

coefficient on the exchange rate again becomes insignificant. A similar

‘* The author is a senior economist in the Division of International Finance, Federal Reserve Board. His thanks go to Michael Adler and Robert E. Lipsey for helpful comments, to Kenneth Froot and Jeremy Stein for sharing their data, and to Vlad Gutin and Dara Akbarian for skillful research assistance. This paper represents the views of the author and should not be interpreted as reflecting those of the Board of Governors oc members of its staff.

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show that a regression using annual aggregate data leads to the same conclusion (equation 7).

However, equations 2, 3 and 8 in the table illustrate that their key finding is not robust for subsamples within their chosen sample period. For more than half of the initial quarterly sample period, 1973:1 through 1981:4, the value of the dollar is insignificantly related to the direct investment ratio (equation 2); this is also the case for many subsamples ending before 1980, for example 1973:1 to 1977:4 (equation 3). Equation 8 shows a similar picture for the annual data.

The Froot-Stein result is absent, not only for large parts of their original quarterly and annual sample periods, but also for recent history -- 1988:2 through 1991:2 for the quarterly data, and 1988-1991 for the annual. The regression for the quarterly subsample (equation 4) shows a positive, although statistically insignificant, coefficient for the MERM index.“ When the original sample is extended to 1991, the coefficient for the value of the dollar is insignificant for both quarterly and annual regressions (equations 5 and 9). It might be added that this failure of the exchange-rate variable is not the result of seasonal factors or the autocorrelation of the residuals (p) that seems present in equation 5. In fact, standard attempts to correct for these factors in equation 6 further reduce the explanatory power of the exchange rate (insignificant seasonals not reported).

As might be inferred from the above results, formal Chow tests for the most part reject the hypothesis of structural stability for the Frooz-Stein equation for subsamples of the original sample period and for the sample period extended through 1991. In the table, all Chow tests

are based on Froot and Stein's original sample period, quarterly or

4. The annual regression for 1988-91 also shows a positive coefficient, but is not reported here because it only has one degree of freedom.

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[1989] supports the hypothesis of a negative sign. However, the

instability and ambiguity of the regression results in Table I, along

with other contradictory findings, Suggest, it seems to me, that the

issue is still open.

7. See also the results of Catherine Mann [1993] for Japanese direct investment into the United States; she finds no significant exchange rate effect for the period 1976-87.

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FDI/ GNP FDI LN (MERM) 1971 0.3326 367.4 4.8175 1972 0.7809 949.0 4.7433 1973 2.0563 2800.0 4.6570 1974 3.2303 4760.2 4.6792 1975 1.6288 2603.0 4.6694 1976 2.4362 4346.5 4.7189 1977 1.8691 3728.2 4.7143 1978 3.5026 7896.5 4.6247 1979 4.7115 11876.7 4.6027 1980 6.1697 16918.0 4.6052 1981 8.2238 25196.0 4.7236 1982 4.3374 13792.0 4.8343 1983 3.4786 11947.0 4.8905 1984 6.6708 25359.0 4.9670 1985 4.6926 19022.0 5.0062 1986 7.9695 34091.0 4.8072 1987 12.7889 58119.0 4.6808 1988 12.1071 59424.0 4.6211 1989 13.4429 70551.0 4.6634 1990 6.7360 37213.0 4.5961 1991 3.8977 22197.0 4.5921

SOURCES: FDI data, quarterly, 1984:1-1990:4, and annual, 1973-1990: Russell B. Scholl, "The International Investment Position of the United States in 1990," Survey of Current Business (June 1991), Table 1, line 57, pp. 44-49. For quarterly data before 1984:1, earlier issues of the June Survey of Current Business; for quarterly and annual data for 1991 (see also footnote 2, above), Christopher L. Bach, "U.S. International Transactions, Fourth Quarter and Year 1991," Survey of Current Business (March, 1992), Table 1, p.75.

MERM exchange rate data: International Monetary Fund, International Financial Statistics (February 1992 and earlier issues), line amx for United States (series discontinued after February 1992).

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IFDP NUMBER

431

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International Finance Discussion Papers TITLES

1992

The Power of Cointegration Tests

The Adequacy of the Data on U.S. International Financial Transactions: A Federal Reserve Perspective

Whom can we trust to run the Fed? Theoretical support for the founders views

Stochastic Behavior of the World Economy under Alternative Policy Regimes

Real Exchange Rates: Measurement and Implications for Predicting U.S. External Imbalances

Central Banks’ Use in East Asia of Money Market Instruments in the Conduct of Monetary Policy

Purchasing Power Parity and Uncovered Interest Rate Parity: The United States 1974 - 1990

Fiscal Implications of the Transition from Planned to Market Economy

Does World Investment Demand Determine U.S. Exports?

The Autonomy of Trade Elasticities: Choice and Consequences

German Unification and the European Monetary

System: A Quantitative Analysis

Taxation and Inflation: A New Explanation for Current Account Balances

AUTHOR(s)

Jeroen J.M. Kremers Neil R. Ericsson Juan J. Dolado

Lois E. Stekler Edwin M. Truman Jon Faust

Joseph E. Gagnon Ralph W. Tryon

Jaime Marquez

Robert F. Emery

Hali J. Edison William R. Melick

R. Sean Craig Catherine L. Mann

Andrew M. Warner

Jaime Marquez

Gwyn Adams Lewis Alexander Joseph Gagnon

Tamim Bayoumi Joseph Gagnon