Literature review of the effects of exchange rate on FDI

Theoretical foretelling about the effects of exchange rate on FDI are somewhat mixed across the literature. A number of studies indicate that exchange rate slump

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encourages the foreign direct investment by decreasing the cost of international investment and by increasing returns to foreign investment relative to exports.

Empirical study by Froot and Stein (1991) shows that in the 1970s and 1980s the U.S. experienced large inwards foreign direct investment due to weak dollar. The study found that because of weak home currency the foreign direct investment had increased in this time and multinational firms came in U.S. for investment.

Cushman (1985, 1988) obtains similar result examining two-sided foreign direct investment flows between the United State and five industrialized countries.

Blonigen (1997) furthermore presents how a real currency depression in the host country can increase skill FDI in this country which help it to boost the currency and empower the exports to compete in the world market. Campa (1993), predicts a negative relationship between real home country currency valuation and FDI transactions to the host country.

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There s another variable other then exchange rate which also effects the investment procedure. A positive affects of exchange rate volatility on FDI is presented in studies by Cushman (1985, 1988), Goldberg and Kolstad (1995), found similar results that exchange rate positively effects foreign direct investment. It pushes the economic growth in the right direction which stimulate the national income. Later on MacDermott, Raymond (2008), used a panel data of 55 countries from 1980s to1997s and found that FDI is positively affected with exchange rate uncertainty.

Every country felt the significant impact of FDI because in most countries the currency was too low so it was golden bird for every investor. Investment from outside benefitted both the host and the investors because investors mustered the profit and the host got the recognition in the world market. Exports were qualified up to the standard to compete with the other countries products. Currency power was restored and recognized.

Campa (1993), predicted a negative relation between exchange rate volatility and FDI. He found the greater exchange rate volatility decreased the foreign direct investment in the host country. Benassy-Quere, et al (2001), found the similar result that exchange rate volatility has negatively affected FDI, Gorg and Wakelin (2002), found no strong and substantial relationship between real exchange rate uncertainty and FDI.

Yabuuchi, Shigemi(1999) had concentrated on impact of foreign direct investment on welfare and unemployment in urban sector. The analysis has used hybrid of the Ricardo-Viner and Heckscher-Ohlin models. The study has analyzed the welfare implications of the establishment or expansion of export processing districts through foreign direct investment.

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The study concludes that foreign investment is kind of panacea for the developing countries that increases employment levels , empower the exports and currency. If foreign capital is also used in domestic manufacturing sector and emerging economies need to focus on duty free zones to attract more foreign investment.

Agrawal(2000 had analyzed the affects of foreign direct investment inflows on GDP growth. The study had time series cross section analysis of panel data from five

South Asian countries, which included India, Pakistan, Bangladesh, Sri Lanka and Nepal. The results had indicated that foreign direct investments in these countries are linked with national investors and existence of reciprocity between the two was also confirmed.

The results had also indicated negative impact of foreign direct investment inflows on GDP growth rate before 1980 but the study indicated positive impact after 1980. The study suggested, since foreign direct investment had contributed more to GDP growth then foreign borrowing in South Asia so foreign direct investment should be preferred over foreign borrowing.

Saeed (2001) had elaborated Pakistan’s economic performance since incorporated with the global economy and stated that Pakistan’s economy was characterized by increase in GDP growth rates, decline in import duties, and an increase in FDI during the post 1988 decade. The sharp increase in integration had headed to a deteriorating balance of payments situation with continued high levels of poverty and unemployment. It was so because less labor power had induced the economy to decompose and that had a severe overall affect on the country s reputation.

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Due to globalization Pakistan experienced an increase in the wages of production sector and services sector till 1990. As for as education is concerned, literacy rate increased as well as the number of universities, colleges and schools. During that era Pakistan’s economy boosted and reached the top of developing countries. There s a quote of a scholar who said that if Pakistan headed on at this speed the day is not far away when it will be recognized as the most successful nation.

The paper had emphasized on the recognition of the importance of examining the interactions between globalization, economic development and social progress. In social progress the key role of trade and investment liberalization should be admitted in creating new business opportunities and raising living standards.

Aqeel and Nishat (2004) had emphasized on the determinants of growth in foreign direct investment (FDI) in Pakistan over the period 1961 to 2003. The study had focused on the impacts of different variables reflecting trade, fiscal and financial sector liberalization on Foreign Direct Investment in Pakistan. The study had used the Co-integration and error-correction techniques to identify the impacts of variables on the Foreign Direct Investment in Pakistan.

The variables included tariff rate, exchange rate, tax rate, credit to private sector and index of general share price, wages and per capita GDP. All variables showed correct signs and are found statistically significant except the wage rate and share price index. These policy variables played a key role in attracting foreign direct investment in Pakistan. The reforms also had positive impacts on foreign direct investment in Pakistan.

Haider Mullick (2004) emphasized GDP growth of Pakistan using economic and socio-economic indicators after the terrorist attacks of September 11, 2001. The sample was compromises of time series data from the years 1980 to 2003. The dependent variable was the percentage change in real GDP and the independent variables included economic aid from the US (US-FAID), total investment, foreign reserves, unemployment rate, stock exchange index etc. Log-Log Ordinary Least Squares analysis of the sample suggested that the dependent variable was positively affected by economic factors, such as US-FAID and development expenditure, while some socio-economic indicators showed little bearing on GDP growth.

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The data also illustrated that the economic cost of becoming a pioneer in the war against terrorism had exceeded the benefits indicating that more financial compensation in the form of economic aid is vital from the US to ignite higher economic growth in Pakistan. This study had also suggested that supporting Pakistan’s economic growth was in the best interest for both countries.

Humayon A.Dar, John R.Presley and Shahid H. Malik (2004) examined the effects of three major macro economic and socio political determinants on Foreign Direct Investment inflows to Pakistan. The study appeared to be a macro one and had not taken into account foreign direct investment with respect to region and industry. The study considered economic growth, exchange rate, level of interest rates, unemployment, and political instability as determinants of the level of FDI inflows for Pakistan over the period 1970 to 2003.

The study estimated an error correction model (ECM) by ordinary least squares, based on co-integrating VAR (2). The results of the test of co-integration showed the causality relationship between FDI, macro economic and socio political factors of Pakistan. The results supported the theoretical contention and the hypothesis that FDI inflows to Pakistanis dependent on the major macro economic factors along with the

most important socio political determinant known as PRI of the country like Pakistan with such changing political environment internally and externally in the region.

Ghatak and Halicioglu(2006) emphasized on foreign direct investment and economic growth across the world for the period of 1991-2001. This article produced fresh empirical evidence on the relation between foreign direct investment and economic growth obtained from single-equation and simultaneous equation estimated for 140 countries using macro economic variables. The results indicated that a positive and statistically significant estimate of coefficient of FDI is obtained from single equation ordinary least squares method for real per-capita GDP regressions in all but one case. There existed a positive and statistically significant relation between the real per-capita GDP and FDI in the case of many countries but correlation coefficient between exports-

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GDP ratio and percentage FDI is found to be insignificant. Country risk rating and the telecommunications variables are significant in all the relevant regressions and correlation estimates. In the cross-country data for one hundred and forty countries the study find a positive and significant impact of inward foreign direct investment in stock on real per-capita GDP in the OLS single-equation estimate.

Aamir and Shehbaz (2008) analyzed Modern technique has been used in finding the order of integration for running actors. ARDL bounds approach is for long run association among said macroeconomic variables, which had never been employed in literature regarding mentioned issue. Relationship between dependent and independent variables for short run is discussed through Error Correction Method (ECM). The results revealed that increased Foreign Direct Investment in Pakistan worsened income distribution because it is focused towards capital intensive industrial and a services sector which focuses urban localities and the fruits of foreign direct investment are reaped by the elite class.

Economic growth and raising unemployment also adds to unequal income distribution. Government size and inequality had same direction indicating positive and significant relationship. Besides all this, improvement in agriculture activity declined income inequality as it improved the incomes of rural class. Policy recommendations include training of unskilled labor.

Drabek and Payne (1999) analyzed that non-transparency leads to reduction in Foreign Direct Investment inflows. Bribery, corruption and unstable economic policies

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lead to non-transparency. The study took foreign direct investment, transparency, inflation, exchange rate, interest rate, opens of trade regime and economic growth as variables. The study used both ordinary least square method (OLS) and two-stage-least-squares method (TSLS). The results showed that the degree of non-transparency is an important factor in a country’s attractiveness to foreign investors.

High levels of non-transparency can be harmful for foreign investment. The study concluded that a nation should increase its transparency level in order to attract higher levels of foreign direct investment and this increased level of foreign direct investment would add to welfare and prosperity.