Exchange rate strategies in the competition for attracting FDI
The financial crises of 1997-1998 have highlighted the destabilizing impact of short run capital flows to emerging countries. By contrast, foreign direct investment (FDI) is widely viewed as a stable source of financing for developing countries. However, the debate on the way to re-orient capital flows towards long term financing (through microeconomic reforms or capital controls) does not generally include the choice of an exchange-rate regime. Here the choice of an exchange-rate regime is re-considered by integrating the determinants of multinational firms locations. We consider the case of a risk-adverse multinational firm which contemplates relocating two alternative foreign locations in order to re-export. We explicit the trade-off between price competitiveness and a stable nominal exchange rate. We also show that the firm will consider both locations as substitutes or as complements depending on whether the two exchange rates against the investing country's currency are positively or negatively correlated. The theoretical model is estimated on a panel of 42 developing countries receiving FDI from 17 OECD countries, over 1984-1996. The results confirm the importance of the exchange-rate regime. Specifically, nominal exchange rate instability is detrimental to foreign direct investment, and its impact compares with that of misalignments. In addition, from the perspective of the host country, the correlation between its bilateral exchange rate against the origin country and the one of alternative locations has a sizable impact on inward FDI.
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