An investigation of exchange rate, exchange rate volatility and FDI nexus in a gravity model approach

Abstract

ABSTRACT This study assesses the significance of exchange rate and exchange rate volatility in the bilateral inflows of FDI using a gravity model, based on a sample of 40 countries over the period 2001 to 2019. This analysis is also specifically concerned with the estimation challenges which revolve around the validity of the log-linear transformation of the gravity equation in the potential presence of heteroscedasticity and zero FDI observations. The various alternative estimation techniques, all validate the fact that exchange rate volatility has a negative impact on the bilateral inflows of FDI whereas exchange rate depreciation has a positive and significant coefficient. On the other hand, the variables GDP-host and GDP-Home are positive and significant justifying that the host and home countries’ economic sizes remain factual elements in attracting FDI. The models’ estimates also interestingly validate the fact that geographical distance and tax level have a sizeable negative influence on the bilateral inflow of FDI. Besides, the significance of the dummy variable common language confirms a negative causal effect of a communication barrier between the local workers and foreign investors.