The Effect of Exchange Rate Volatility on International Trade and Foreign Direct Investment (FDI) in Developing Countries along “One Belt and One Road”

10/16/2018

|

Rashid Latief and Lin Lefen | International Journal of Financial Studies

Abstract:

The “One Belt and One Road” (OBOR) project was started by the Chinese government with the aim of achieving sustainable economic development and increasing cooperation with other countries. This project has five major objectives, which include (i) increasing trade flow, (ii) encouraging policy coordination, (iii) improving connectivity, (iv) obtaining financial integration, and (v) fortifying closeness between people. This paper aims to analyze the effect of exchange rate volatility on international trade and foreign direct investment (FDI) in developing countries along “One Belt and One Road”. We selected seven developing countries which are part of this project, namely Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka. We collected panel data for the period 1995 to 2016 from the U.S. Heritage Foundation, International Financial Statistics (IFS) (a database developed by the International Monetary Fund), and World Development Indicators (WDI) (a database developed by the World Bank). We applied Generalized Autoregressive Conditional Heteroscedasticity (GARCH) (1,1) and threshold-Generalized Autoregressive Conditional Heteroscedasticity (TGARCH) (1,1) models to measure the exchange rate volatility. Furthermore, we employed a fixed effect model to analyze the relationship of exchange rate volatility with international trade and FDI. The results of this paper revealed that exchange rate volatility affects both international trade and FDI significantly but negatively in OBOR-related countries, which correlates with the economic theory arguing that exchange rate volatility may hurt international trade and FDI. It can be concluded that exchange rate volatility can adversely affect international trade and FDI inflows in OBOR-related countries.

Introduction

The “One Belt and One Road” (OBOR) project was initiated by Chinese President Xi Jinping as a regional development strategy and focuses on the economic development and cooperation of China with other countries. The main purpose of this project is to promote the development of China, especially simultaneously in central and western regions, along with promoting economic development in Central Asia. The five key priorities of this project include (i) increasing trade flow, (ii) encouraging policy coordination, (iii) improving connectivity, (iv) obtaining financial integration, and (v) fortifying closeness between people (Latief and Lefen 2018). The countries along the OBOR have the potential to open new markets for China to improve trade and investment activities (Ding et al. 2017). As a result of this project, trade and investment activities in participating countries will be accelerated. However, these activities are associated with the variations in the exchange rate of those countries.

The relationship between exchange rate volatility and international trade is the central part of the discussion of alternative exchange rate regimes. Supporters of fixed exchange rates claim that exchange rate volatility acts as a weak factor for attaining prospective international trade flows. It is based on the view that exchange rates are majorly determined by fundamentals, where the volatility of an exchange rate may be dependent on changes in parity. The flexible exchange rate is based on the view of facilitating the adjustments of the balance of payments from external sources. Exchange rate volatility carries direct and indirect effects on trade flows through transmission mechanisms on the structure of employment, investment, and output. There is an old view that exchange rate volatility is an inborn risk factor. This depends on the assumption that the profitability of firms and variations in exchange rates have a fixed relationship with each other (Hwang and Lee 2005).

The relationship of exchange rate volatility with international trade has been extensively studied in the literature but there is no unanimity about this relationship. Literature can be divided into two groups: One group argues in favor of a positive relationship of exchange rate volatility with trade, while the other group is on the opposite side (Cheong et al. 2005). Theoretically, the negative and positive relationship between exchange rate volatility and international trade can be described in the subsequent ways. If the risk-averse traders face a higher transaction risk and higher cost due to exchange rate volatility, they will decrease the volume of trade. On the other side, if the anticipated cost of import expenditure decreases or the anticipated utility of export revenue increases, this leads to a rise in exchange rate volatility, which can ultimately increase the trading volume. There are also some studies which have highlighted the insignificant effect of exchange rate volatility on international trade (Kim 2017).

Imports and exports are part of the current account of the balance of payment (BOP), in the same way as FDI is part of the capital account. The formation of capital plays an important role in achieving sustainable economic development. Developing economies rely on foreign capital and construct policies to attract FDI (Comes et al. 2018). FDI has spillover effects on host economies through human capital, knowledge transfer and competitions in markets (Wang and Liu 2017; Wang et al. 2016) and ultimately increases capital stock and stimulates economic growth (Peng et al. 2016). FDI can also cause negative effects in spillovers in worse situations (Chou et al. 2014). FDI generally comprises two items: Equity and debt held by firms in association with foreign entities. The basic feature of FDI is corporate control, which is different from foreign portfolio investment. FDI is different from trade because of its different features. The inference from these observations is that FDI flows are sensitive to exchange rate considerations. In principle, the relationship of the exchange rate with FDI should be more parallel as compared to the relationship of the exchange rate with trade. FDI yields a return, which may translate into the flow of profit or loss (Crowley and Lee 2003).

In general, countries compete with each other to attract FDI. Multinational firms select a location for investment based on different factors (Wu et al. 2018). The exchange rate volatility can affect the investment decisions of multinational firms by creating unexpected profit in trade and non-trade sectors and also by the ambiguous cost of imported goods. In some previous decades, the exchange rate volatility badly affected the investment decisions and profits of firms. Exchange rate volatility can affect the FDI in different forms, subject to the place where goods are produced. If the investor desires to invest in a local market, trade and FDI could be used as substitutes. In that scenario, FDI inflow can be increased due to the appreciation of the domestic currency, which helps to increase the buying capacity of domestic consumers, while the devaluation in the exchange rate of the host economy helps to increase FDI by decreasing the cost of capital (Chowdhury and Wheeler 2008).

The OBOR initiative of the Chinese government can play an important role to promote trading and investment activities in the participating countries of this project. As a result of this project, the overall economies of these countries could be improved. Most of the countries along the OBOR have poor infrastructure and lack the latest technology. The Chinese government considers these countries as the effective outlets for promoting investment and trading activities. Before 2013, these countries were not the major destination of Chinese investment. After 2013, the Chinese government changed their investment policies and these countries became the hot destination of Chinese investment (Liu et al. 2017).

The empirical and theoretical literature shows conflicting opinions about the relationship of exchange rate volatility with international trade and FDI. This paper aims to reexamine the relationship between these variables in the context of developing countries along the “One Belt and One Road” project, which include Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka. We used the annual panel data for the period 1995 to 2016 and measured the exchange rate volatility by applying GARCH (1,1) and TGARCH (1,1) models. We estimated the effect of exchange rate volatility on international trade and FDI by applying a fixed effect model based on Hausman test results.

The rest of the paper is organized as follows. The next section reviews work completed by other authors on the relationship of exchange rate volatility with international trade and FDI. The third section details the sample selection, data collection, variables measurement, and econometric model. The fourth section provides results and discussion about the study. The last section gives the concluding remarks and policy implications.

ijfs-06-00086
  © 1996-2018 MDPI (Basel, Switzerland), All Rights Reserved. To see the original post, click here.