Foreign direct investment, exchange rate volatility and political risk

This paper investigates the effect of exchange rate and institutional instability on the level of Foreign Direct Investment flows between developed and developing countries by presenting an empirical investigation on a panel of countries over two decades, both with cross country and cross sector data, justified by a partial equilibrium model of foreign entry. The issue is first presented with a partial equilibrium model of FDI in an oligopolistic industry , where n identical foreign firms have to decide whether to enter a host market characterized by exchange rate volatility and political risk. The results are that both exchange rate variability and political risk have a dampening effect on FDI flows, and that the interaction term is negative, indicating that the two effects reinforce each other. The econometric analysis confirms and verifies these results. The sectoral evidence points in the direction of specific industry effects, especially with respect to the role of interest rates and wages. The general conclusion regarding the role of exchange rate instability and institutional risk are confirmed, with some qualifications for the primary, financial, depository, trade and service sectors