Real Effective Exchange Rates and Foreign Direct Investment Inflows: Empirical Evidence from India’s Sub-National Economies

Abstract

This paper investigates the impact of real effective exchange rates (REER), both in terms of levels and volatility, on foreign direct investment (FDI) inflows for a panel of 35 Indian sub-national economies over the period 2000-2013. In light of the asymmetric distribution of FDI inflows within India, we focus on examining the nexus between FDI inflows at the sub-national level and India’s competitiveness captured by REER. Our empirical analysis reveals that movements in REER have a significant and negative impact on FDI inflows, while REER volatility is found to be inducing FDI. Our results are suggestive that FDI inflows into India are largely domestic market oriented in nature. Purpose: In light of the asymmetric distribution of FDI inflows within India, we focus on examining the nexus between foreign direct investment (FDI) inflows at the sub-national level and India’s competitiveness captured by real effective exchange rates (REER). This paper investigates the impact of REER, both in terms of levels and volatility, on FDI inflows to 35 Indian sub-national economies over the period 2000-2013. Research Methodology: To examine the impact of REER on FDI inflows, we compile a panel dataset for 35 sub-national economies covering the time period 2000 to 2013. We employ panel fixed effects models to explore our relationship of interest between REER and FDI, controlling for other characteristics specific to a sub-national economy.Findings: Our empirical analysis reveals that movements in REER have a significant and negative impact on FDI inflows, while REER volatility is found to be inducing FDI. Our results are suggestive that FDI inflows into India are largely domestic market-oriented in nature. Originality/Value: Considering that India’s FDI inflows exhibit significant concentration patterns among selected regions, we exploit this heterogeneity at the sub-national level to empirically understand the determinants of FDI, with a particular focus on cost competitiveness as captured by REER. The extant literature has not explicitly focused on testing the impact of REER both in terms of its levels and volatility on FDI inflows to India at the sub-national level, especially not at the sub-national level. While admittedly the exchange rate varies only at the national level, the value-addition comes from understanding its interaction with state-varying macroeconomic indicators.

Private ownership and management control decisions in infrastructure from the perspective of Transaction Cost Theory: Evidence from emerging economies

“…Private partners are less likely to engage in types of PPP with greater ownership and management control in an unstable macroeconomic environment, as shown by the respective coefficients of REER and CPI (e.g., in model 1: β 7 = 0.0562, p < .02; β 8 = −0.1155; p < .02). Our findings are consistent with Giap et al (2020) regarding the positive relationship between the appreciation of the exchange rate and the willingness of the sponsor to engage in greater control of the project. In addition, as suggested by Banerjee et al (2006), inflation negatively affects the NPV of the project and increases demand risk, and therefore lessens the engagement of private partners.…”

“…The impact of the fluctuations of exchange rates may not be as straightforward given that PPP projects are long-term projects and that the return from the assets, not only their costs, should be considered. Giap et al (2020) suggest that the differentiation between foreign firms investing in the host country to serve the domestic market and those using the host country as an export platform lift the ambiguity related to the impact of exchange risk on the attractiveness of foreign direct investments (FDI). The authors' results on a panel of 35 Indian subnational economies over the period 2000-2013 show that an increase in the real effective exchange rate (REER) will attract FDI when they are destined to serve the domestic market (Giap et al, 2020).…”

“…Giap et al (2020) suggest that the differentiation between foreign firms investing in the host country to serve the domestic market and those using the host country as an export platform lift the ambiguity related to the impact of exchange risk on the attractiveness of foreign direct investments (FDI). The authors' results on a panel of 35 Indian subnational economies over the period 2000-2013 show that an increase in the real effective exchange rate (REER) will attract FDI when they are destined to serve the domestic market (Giap et al, 2020). Besides, the findings of Boateng et al confirm that the appreciation of the host country's currency, in this case Norway, increases investment expectations of increased future profits (Boateng et al, 2015).…”

“…Moreover, if the private partner is a foreign investor, a depreciation of the host country currency reduces the relative production costs of local inputs such as labor, land, machines, and assets (Giap et al, 2020). If resources are imported, costs depend on the exchange rate of the country‐of‐origin currency (Burger et al, 2009).…”