The Asymmetric Effect of Political Risk and Exchange Rate Fluctuations on Foreign Direct Investment Inflows in South Africa

Abstract

Most developing countries rely heavily on foreign direct investment (FDI) inflows for economic growth and stability. However, political risk and the foreign exchange rate could direly affect FDI inflows as investors seek stable markets. The most recent example of political risk interactions, the exchange rate and FDI has been the trade war between the United States (US) and China, where the US increased tariffs on Chinese goods worth over $16 billion. A crucial debate is needed regarding the importance of FDI inflows in developing countries, such as South Africa. FDI is observed as a crucial component in providing resources, and it is critical in facilitating globalisation and providing financial assistance to countries in need, especially developing countries such as South Africa. This study aimed to examine the long- and short-run effects of political risk ratings and foreign exchange rate fluctuations on FDI inflows in South Africa. The literature review provided evidence of long- and short-term relationships between political risk ratings, the real effective exchange rate, and the GDP's balancing variable on the dependent FDI inflows. The study utilised both the autoregressive distributed lag (ARDL) and non-linear autoregressive distributed lag (NARDL) models to analyse quarterly data from 1995 to 2020. The Variables included in the study were political risk, the real effective exchange rate, FDI inflows and GDP. The study revealed that political risk ratings and the real effective exchange rate have long-run effects on FDI inflows. The real effective exchange rate has an asymmetric long-run effect. It was also found that FDI inflows respond more to real effective exchange depreciations than real effective exchange rate appreciations, implying that the exchange rate is an important economic factor in explaining the investment inflows. Consequently, the study recommends that policymakers deploy responsive policy measures to deal with currency fluctuations and political instability. In South Africa, the negative effect of political risk affects FDI and impacts the overall country risk ratings and the country's ability to borrow. The study also recommends that further research be employed to understand other impacts on FDI inflows and the interaction of political risk and the real effective exchange rate on other critical economic factors.