The case for Foreign Direct Investments (FDI) is particularly compelling in transition economies. The need for extensive enterprise restructuring and modernization in view of limited domestic resources creates an environment where the potential benefits of FDI are especially valuable. Furthermore, transition economies are well suited to benefit from inflow of technology and knowledge associated with FDI: they are relatively developed and have a highly educated labour force.
As a result, attracting FDI has become a prominent goal on the policy agenda, especially in transition economies, and research on the determinants of FDI has been expanding rapidly. While the literature has addressed many aspects of the determinants of foreign direct investment, it does not consider the role of the exchange rate and the role of Euro as anchor currency.
The role of the Euro as anchor currency is rapidly increasing. This is mainly due to the monetary integration process involving many European countries, but also to the increased tendency toward a more widespread monetary integration process characterizing many countries and areas in the world (Furceri, 2007).
Whether the growing role of the euro as an anchor currency is beneficial to foster FDI or not, is a question that has to be empirically addressed. In fact, from a theoretical point of view there is no clear consensus about which exchange rate strategy performs better in emerging economies for attracting FDI. In fact, proponents of flexible exchange rates have emphasized the importance of macroeconomic flexibility in case of real asymmetric shocks (Meade 1951, Friedman 1953) and thus the possibility to create a more stable and favourable environment to attract investments. In contrast, proponents of fixed exchange rates have stressed the (microeconomic) benefits of low transaction costs for international trade (Rose 2000, Frankel and Rose 2002), and for capital flows (Bacchetta and van Wincoop, 1998). In particular, for countries in the economic catching-up process where capital markets remain underdeveloped and macroeconomic instability tends to be high, also due to a high level of openness, fixed exchange rates are an important anchor for macroeconomic policies and private expectations, and can thus be an important element to foster capital inflows.
The purpose of the paper is to analyze the role exchange rate volatility plays in explaining the evolution of FDI inflows in the EMU neighbourhood countries. This study will undertake a thorough analysis of this issue, ignored so far by the literature, examining the question in the framework of an empirical model that considers the major macroeconomic determinants of FDI pointed out by the literature.
The rest of the paper is organized as follows. The next section presents some stylized facts regarding the exchange rate strategies and the FDI inflows in the EMU neighborhood countries. Section 3 discusses the data and the empirical strategy used to construct our measure of exchange rate volatility. Section 4 presents the empirical specification to test the effect of exchange rate volatility on FDI. Section 5 reports the results. Finally, section 6 summarizes the main findings.
Download
PDF Ebook Foreign Direct Investments and Exchange Rate Volatility in the EMU Neighbourhood Countries
