Exchange Rate Volatility on the Timing of Foreign Direct Investment: Marketseeking versus Exportsubs

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Exchange Rate Volatility on the Timing of Foreign
Direct Investment Market-seeking versus
Export-substituting

• Chia-Ching Lin
• Kun-Ming Chen
• Hsiu-Hua Rau
• March 18, 2006

Department of International Trade, National
Chengchi University, Taiwan
2
Stylized Facts

• The flows of FDI have been increasing
  dramatically and fluctuating sharply since the
  1970s.
• Since the breakdown of the Bretton Woods system
  in 1973, the exchange rates of many countries
  have been fluctuating considerably over time.

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Motivation

• How to explain the short-run movements of FDI.
• It has been suggested that the exchange rate
  changes may be a good explanation for it.
• However, there is no consensus either in theory
  or empirical studies.
• Few studies focus on the newly industrializing
  countries or the developing countries

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Literature Review Relationship between Exchange
Rate Uncertainty and FDI

• Cushman (1985) and Goldberg and Kolstad (1995)
• They emphasize the importance of considering the
  post-FDI changes in the exposure of a firms
  profits to exchange rate risk.
• If the investing firm can choose to serve foreign
  markets via exports or FDI, then an increase in
  exchange rate volatility might lead the firm to
  substitute FDI for exports.
• It is because FDI activity reduces the exposure
  of its profits to exchange rate risk.

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Literature Review Relationship between Exchange
Rate Uncertainty and FDI

• Dixit (1989a,b)
• A real options model.
• He indicates that the waiting value increases as
  the uncertainty rises even for a risk-neutral
  firm.
• Hence, an increase in exchange rate uncertainty
  will defer the FDI activity of the firm.

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Objective

• Using Real Options Approach with risk aversion,
  this paper investigate theoretically the effects
  of exchange rate uncertainty on the FDI activity
  under different motives of the firms.
• The relationship between exchange rate
  uncertainty and FDI varies with the extent of the
  exposure to exchange rate risk which is
  determined by investing motives.

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Objective (cont)

• Firm-level data on Taiwans outbound FDI in China
  over the period 1987-2002 are employed to test
  the validity of the theoretical results.
• Survival analysis is used to examine the
  relationship between the timing of FDI and
  covariates.

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A Real Options Model

• Assumptions
• The exchange rate R, expressed in units of home
  currency per foreign currency, follows an
  exogenously geometric Brownian motion.
• Risk aversion firms.
• A potential entrant stays in the market forever
  after entering the market.
• Perfect competition.

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A Real Options Model (cont)

• Mean-variance expected utility function
• ap is Arrow-Pratts absolute risk aversion
  coefficient

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Two Types of Firms

• Export-substituting Firm
• An exporting firm, originally producing at its
  home country and serving a foreign market via
  exports, relocates its whole production abroad to
  serve the foreign market.
• Profit flows pre-FDI
• Profit flows post-FDI

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Two Types of Firms (cont)

• Market-seeking Firm
• A domestic firm, originally not serving a foreign
  market via exports, chooses to set up a foreign
  subsidiary to produce and sell in a given foreign
  market.
• Profit flows pre-FDI
• Profit flows post-FDI

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Proposition 1

• In the case of export-substituting FDI, an
  increase in exchange rate volatility will
  stimulate FDI activity of a firm if the firm
  cannot delay its investment.
• The risk attitude is the only channel through
  which exchange rate uncertainty affects FDI.
• Substituting FDI for exports reduces the firms
  exposure to exchange rate risk, and this gain
  from risk reduction is larger if the exchange
  rate is more volatile.

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Proposition 2

• A risk-neutral export-substituting firm will
  delay its FDI activity when the exchange rate
  volatility rises.
• The option value of investment flexibility is the
  only channel through which exchange rate
  uncertainty affects FDI.
• An investment is like a call option whose value
  rises if the underlying uncertainty increases.

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Proposition 3

• In the case of export-substituting FDI, the
  effect of exchange rate volatility on the timing
  of FDI is ambiguous. However, there exists a
  threshold in the degree of risk aversion a such
  that this effect is positive (negative) if the
  firms risk-aversion coefficient is greater
  (smaller) than a.
• Given the negative effect on FDI activity from
  the option value of investment flexibility, if
  the positive effect resulting from the risk
  aversion as well as the change in the exposure to
  exchange risk resulting from the firms FDI
  becomes large enough, the net effect will be
  positive .

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Proposition 6

• In the case of market-seeking FDI, an increase in
  exchange rate volatility will delay the FDI
  activity of the firm.
• FDI activity will make the firms exposure to
  exchange rate risk increase.
• An increase in exchange rate volatility will
  increase the option value of delaying the
  investment so as to deter the FDI activity
  further.

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Expected signs of the determinants of FDI with
different motives
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Empirical Model Survival Analysis

• This paper focuses on the analysis of how
  exchange rate volatility affects the timing of
  foreign entry.
• One widely applied method to examine the issue
  about timing is to conduct survival analysis
  (event history analysis).
• The event is a firms entry into a foreign
  market.
• The waiting time for a firm to enter a foreign
  market can be treated as the survival time of the
  firm.
• The timing of entry can be treated as the timing
  of event occurrence.

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Survival Analysis (cont)Coxs proportional
hazard model

• Hazard function
• Partial likelihood function

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Empirical Equation
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Dependent Variable

• The dependent variable is defined as the duration
  from 1987 to the year when the firm invested in
  China.
• It is because Taiwanese firms were not permitted
  to invest in China until 1987.
• Sample period 1987-2002.
• Sample size 337 listed companies (4063
  observations).

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Independent Variables

• Rt-1 the one-period lagged real exchange rate.
• µt the trend of the real exchange rate.
• st the volatility of the real exchange rate.
• Waget-1 the one-period lagged relative real wage
  rates of China with respect to Taiwan.
• MKTi marketing intensity, a proxy variable of
  the sunk costs.

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Independent Variables (cont)

• Control variables
• Profits rate (PF)
• Source of funds (FUND) a dummy variable parent
  company (1) otherwise (0).
• RD intensity (RD)
• Firms size (SIZE) firms sales
• Capital-labor ratio (KL)
• High-tech industry dummy (HT) a dummy variable
  high technology industries (1) otherwise (0).

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Two measures for µt and st

• Unconditional measure Tasy (2002)- Modified
  average and modified standard deviation of the
  monthly change in the logarithm of exchange rate
• Conditional measure GARCH

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Independent Variables (cont)

• EXE Export-substituting firm dummy
• EXE 1, for a firm with export ratio greater than
  0.6 and the sales of its subsidiary account for
  more than 80 of the subsidiarys total sale in
  China .
• EXE 0, otherwise.

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Independent Variables (cont)

• EXM Market-seeking firm dummy
• EXM 1, for a firm with zero exports and the
  sales of the firms subsidiary account for more
  than 80 of its total sale in China.
• EXM 0, otherwise.

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Distribution of sample firms by industry
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Cox estimation of the Determinants of FDI
Notes t-statistics are in parentheses a , band
c denote t-statistics are significant at the 1
,5 and 10 confidence levels, respectively.
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Cox estimation Control Variables
Notes t-statistics are in parentheses a , band
c denote t-statistics are significant at the 1
,5 and 10 confidence levels, respectively.
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Conclusion

• Higher exchange rate volatility tends to delay
  Taiwans FDI into China of market-seeking firms,
  but accelerate that of export-seeking firms.
• A depreciation of RMB to NTD tends to stimulate
  the Taiwans FDI into China of export-substituting
  firms, but deter that of market-seeking firms.
• In general, the empirical results are consistent
  with the prediction of the theory.

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THE END

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