The nexus between exchange rate and long-term investment in Indian manufacturing industry

Abstract

PurposeThe purpose of this paper is to examine the impact of changes in the exchange rate on long-term investment decisions of Indian manufacturing firms at the sector level.Design/methodology/approachThe study is undertaken on a sample of 1,222 firms from six key manufacturing sectors of Indian economy during the period 2000-2016. The non-linear relationship between real exchange rate and long-term investment is studied using the two-step generalized model of moments estimator.FindingsThe study finds a concave (i.e. inverted U-shaped) relationship between the long-term investment and real exchange rate, particularly in case of chemical, construction, machinery and textile sector, in particular, and Indian manufacturing industry as a whole. It implies that investments in these sectors increase with depreciation of real exchange rate up to a point of inflection and subsequent to which it starts decreasing if exchange rate continues to depreciate further. But consumer goods and metal product sectors ensure a convex pattern, which demonstrates that investment is decreasing at the initial stage of depreciation of the exchange rate. The study moves one-step forward in validating this nexus between investment and exchange rate with respect to the price-cost margin and the extent of financial flexibility of firms. It is found that high price cost margin and financial flexibility moderates the adverse impact of exchange rate depreciation and immunizes the long-term investments in the scenario of a weak domestic currency and induce long-term investments.Research limitations/implicationsThe study measures the impact of exchange rate changes, but the impact of exchange rate volatility on investment has not been studied, which is absolutely different with different implications.Practical implicationsThe study provides a clear guideline to firm managers for using the exchange rate movements in a favorable manner. The findings can be used to ensure sustainable long-term investments with respect to the core competence of firms in terms of price cost margin and financial flexibility at sector level of Indian manufacturing firms.Originality/valueThe study analyzes the non-linear relationship between exchange rate changes and long-term investment behavior of manufacturing firms from six key sectors of India. Further, the study moves one step forward to analyze this nexus under different scenarios of financial flexibility and price cost margin using dynamic panel models.