The impact of exchange rate movements on foreign direct investment : market-oriented versus cost-oriented

Abstract

This paper examines the impact of exchange rate movements on foreign direct investment (FDI). We first employ a real options model to show that while the depreciation of a host country`s currency tends to stimulate FDI activity of cost-oriented firms, the depreciation tends to deter FDI activity for market-oriented firms. With industry panel data on Taiwan`s outward FDI into China over the period 1991–2002, our empirical findings indicate that the exchange rate level and its volatility in addition to the relative wage rate have had a significant impact on Taiwanese firms’ outward FDI into China. In general, the empirical results are consistent with the prediction of the theory. Our results reveal that the relationship between exchange rates and FDI is crucially dependent on the motives of the investing firms. Without considering this fact in an empirical model, the testing results might suffer from aggregations bias.