Foreign Direct Investment And Exchange Rate

An unusual and growing role to global businesses plays Foreign Direct Investment (FDI). In developing countries most of the companies were socialist or publicly owned enterprises. During the transition period, privatization took place in those countries and state owned enterprises become private. With changes in eastern European countries, fall of communism switched the system to capitalistic democracies; therefore, we see foreign direct investment as a process where rich and developed countries participate in some other country’s economy through management skills, technology investments or joint cooperation’s, etc. The most classic situation of FDI is when a foreign investor privatizes an enterprise and he or she becomes the only proprietor by owning 100% of shares of the given company. However, this is not a situation that is always applicable. A more attractive and beneficiary technique is when a foreign investor participates by a certain percentage in some business and the rest of the business is owned by some local entrepreneur. This is done by investing in technology, equipment and machinery, or even providing trainings and increasing workers professional development.

Foreign Direct Investment plays a crucial role on internationalizing a given company. This is as a result that the final goods produced by that company will be identified at least in the country where the investment is coming from. It is important to mention that FDI is not present only in countries with weak economies! According to United States Bureau of Economic Analysis, US received over 260 billion US Dollars within a 5 year period of time (between 2003 and 2008). This proves that not only developing countries benefit from FDI.

FDI produces different outcome or result, depending in the monetary value that was invested in the hosting country, type of industry that was invested and of course the economic situation or development level of that country. Some countries have introduced even a restriction scheme for FDI’s in some sectors. This is mainly present in countries that have low income and FDI can have negative impact in specific fields. For example, according to Reserve Bank of India, FDI is prohibited in Retail businesses; lottery and gambling, or even in the agriculture sector. Those restrictions are followed by a list of other specific sectors that are prohibited completely or partly. The table below presents most of the sectors that are partially or totally prohibited.

Sector

Held by Gov of India

Subject to FDI

Completely prohibited and Gov of India has total control over those sectors

Banking

74%

26%

Retail Trading

Insurance

26%

74%

Atomic Energy

Telecommunications

74%

26%

Lottery, Gambling and Betting

Coal & lignite

74%

26%

Trading in Transferable Development Rights (TDRs)

Trading

51%

40%

Business of Chit Fund

Mining

74%

26%

Nidhi Company

Airports

74%

26%

Gambling and Betting

Domestic airlines

49%

51%

Agricultural or plantation activities

Print media

26%

74%

Housing and Real Estate business

However, the level of FDI is also determined by the exchange rate between the two parties.

Exchange Rate (Denion Galimuna)

To look at the exchange rate, we should look at the price of a currency in terms of the amount of another currency we want to obtain. For example, how much of Euro should we give, to receive an amount of 1 dollar in return? Economies operate under two types of exchange rates; the fixed exchange rate and the flexible exchange rate. Countries that fix their currency to a currency of another country, is called the fixed exchange rate. This regime is not preferred by economists because it prevents domestic central banks to set monetary policy; however, there are advantages to this regime, which we will discuss later (Fixed Exchange Rate, par.1-2). On the other hand, countries that leave the value of their currency to change in terms of other currencies, is called the flexible exchange rate.

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In the long run, exchange rate is said to be determined by the monetary model, which is related to money supply, output level of countries, as well as market expectations for future exchange rates. When these features are combined, we will get the current exchange rate. Monetary model suggests that the exchange rate is determined by the relative price levels of two countries, which vary based on the demand and supply of money. If one kilogram of apples costs twice as much in Germany, then 2 Euro would buy 1 kilogram of apples in dollars. Ceteris paribus, if the money supply in Germany increases, on average, prices will tend to increase in Germany. However, because the price level in the US remains unchanged, more Euros will be needed to buy 1 dollar. Furthermore, the Euro price of dollars will increase, which in turn makes the Euro to depreciate and make it worth less in terms of the dollar (Hopper, 1997).

In the short run, however, the real exchange rate is said to be the determinant; it is the balance of a country’s trade and payments. For example, when foreign currency is very plentiful like in Figure 1 (large exports, capital inflows, or remittances), the market sets a low real price on foreign exchange.

Exchange Rate

Quantity

D

S1

S2

Price

or

Depreciation

Figure 1

Figure 2 shows the opposite. When a country has low exports or should repay big debts, the market sets a high real price for foreign exchange.

Exchange Rate

Quantity

D1

S1

Price

or

Appreciation

S2

Figure 2

When examining the real exchange rate as the balance of a given country’s trade and payments, we should consider all inflows of foreign currency, as well as all outflows (Harberger, 2008). The same holds for the demand of a foreign currency. If demand increases, the currency will appreciate (Figure 3).

Exchange Rate

Quantity

D1

D2

S

Appreciation

Figure 3

If demand decreases, however, the currency will depreciate (Figure 4).

Exchange Rate

Quantity

D1

D2

S

Depreciation

Figure 4

Exchange Rate and Foreign Direct Investment (Muamer Niksic)

As we have mentioned earlier, a fixed exchange rate regime has some advantages, especially when we deal with foreign direct investments (FDI). FDI under fixed exchange rate regime are risk averse. It makes foreign investment safer with expected returns, because the domestic currency will be fixed to the foreign currency. In the fixed exchange rate the number of units of domestic currency needed to acquire foreign currency stays the same over the longer period of time, so investors can easily predict the amount of income they will receive after a given period ends.

However, depreciation of the foreign currency in terms of domestic currency under the flexible exchange rate regime will also make a certain market desirable for the potential foreign investors (Exchange Rates and Foreign Direct Investment, p. 1). This is caused by cheaper acquisition of production capacities internationally than on the local market. Such an investment will most likely bring higher profits. This is true only for the short run, while in the long run such a prediction may be incorrect and cause losses to the investors, because under the flexible exchange rate, currency may appreciate over time. Exchange rate uncertainty will affect the decision as to where and how an investing company will start to operate abroad; this is also valid for the company’s decision where it will sell its products (Hongmo and Lapan, 2000). Selling goods in another market with different a currency should also count for differences in exchange rate.

We can say that there is a clear economic relationship between exchange rates and FDI because when a certain company invests in another country it should consider exchange rates in order to properly calculate return on investment. The effect of the exchange rate may be positive or negative, depending on appreciation or depreciation of the currency, as well as where the destination country sells its goods or products.