Dynamic Relationships between Exchange Rates and Foreign Direct Investment: Empirical Evidence from Korea

• Date: 01 March 2015
• Published date: 01 March 2015
• DOI: http://doi.org/10.1111/asej.12048
• Author: Jung Wan Lee

Dynamic Relationships between Exchange

Rates and Foreign Direct Investment:

Empirical Evidence from Korea*

Jung Wan Lee

This paper examines the short-run and long-run dynamic relationships between

exchange rates and foreign direct investment (FDI) in Korea. Monthly data

retrieved from the Bank of Korea from January 1999 to March 2012 are examined.

A cointegration test, a vector error correction model, the Wald test and impulse

responses techniques are applied to analyze the data. The present study finds that,

first, long-run causation between exchange rates and FDI flows exists, which

implies that a change in exchange rates negatively affects FDI flows in the long run.

Second, short-run causation between exchange rates and FDI flows exists, which

confirms that there is reciprocal feedback between the two variables. Finally, the

study finds evidence of a structural break from the global financial crisis of

2007–2009 shock to FDI flows in Korea. An external shock affects changes in the

endogenous variables and, thus, causes instability in the cointegrating vector in

the system.

Keywords: cointegration, exchange rates, foreign direct investment, impulse

responses, Korea, vector error correction model.

JEL classification codes: F21, F31, G11, G18, O24.

doi: 10.1111/asej.12048

I. Introduction

International investors would be prudent to evaluate multiple factors when they

make foreign direct investment (FDI) decisions. Those factors include, but are not

limited to, trade policies, taxes, interest rates, country credit ratings as well as

economic issues such as earnings repatriation and exchange rates. Currency risk

and fluctuations, sovereign financial debt and austerity measures have been on the

forefront of economic discussions for many years. Currency strength seems to

play a role as companies want to invest when the domestic currency is stronger.

Companies obtain more value, goods or services in other countries where the

currency is weaker and, therefore, exchange rate risks can affect foreign invest-

ment decisions.

Devaluation in the currencies of FDI recipient countries could induce a reduc-

tion in local production cost in terms of foreign currencies, raising the profit of

export-oriented foreign investors accordingly. Higher return on profit attracts

more FDI inflows. From the perspective of foreign investors having capital

* Lee: Administrative Sciences Department, Metropolitan College, Boston University, 808

Commonwealth Avenue, Boston, MA 02215, USA. Email: jwlee119@bu.edu.

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measured in foreign currencies, production inputs, including labor, land and

machines, in FDI recipient countries become cheaper after a devaluation, encour-

aging foreign investors to acquire more of the domestic assets. The exchange rate

is determined by a country’s current account balance or trade balance, and,

therefore, to an extent, exchange rate fluctuation affects international competi-

tiveness and the trade balance. Consequently, the fluctuation affects real income

and multinational corporations’ financial position. For example, local currency

depreciation would lead to greater competitiveness of domestic firms, given that

their exports will be competitive in international trade. The model infers that the

weaker currency of FDI recipient countries will lead to more FDI inflows. Xing

and Wan (2006) argue that exchange rates have significant influence on the

competition among FDI recipient countries. A recipient country with a relative

currency appreciation can lose its FDI inflows and divert investments to its rival

country.

The relationship between exchange rates and FDI has significant implications,

especially from the viewpoint of recent large cross-border movement of funds and

investments (e.g. ECB, 2012; Fratzscher and Imbs, 2009; IMF, 2010). Hence, it

is worthwhile for policy-makers to understand the impact of exchange rates on

FDI in order to attract a steady flow of FDI. Accordingly, the dynamic relation-

ship between exchange rates and FDI is of interest to policy-makers, international

business managers and researchers. To widen our intellectual horizons and

knowledge base on the dynamic relationship between exchange rates and FDI, the

present paper aims to provide further evidence explaining the short-run and

long-run dynamic relationships between exchange rates and FDI in Korea.

II. Literature Review and Hypotheses

The mechanism through which exchange rates affect FDI has been modeled in a

few previous studies (e.g. Froot and Stein, 1991). These studies generally show

that depreciation in the recipient country’s exchange rate induces more FDI

inflows. In the published literature, both the level and volatility of exchange rates

are heavily discussed, because exchange rate movements significantly distort

relative wealth and costs for multinational corporations while higher exchange

rate volatility poses additional risks to foreign investors.

In regards to the impact of the level of exchange rates on FDI, two relationships

can be observed. First, if the investor aims at serving a local market, an appre-

ciation of the local currency in real terms can encourage inward FDI toward

the local market. Alternatively, if the output from FDI is to be re-exported, an

appreciation of the local currency can discourage inward FDI, because it

lowers the relative wealth of foreign investors. Goldberg and Kolstad (1995)

provide supportive evidence for the location choices of risk-averse firms facing

exchange rate variability, which affects the location of firms and, hence, the

degree of specialization of countries. Buch and Kleinert (2008) present supportive

evidence that exchange rate changes affect the foreign investment behavior of

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