Exchange Rates and Foreign Direct Investment - Case Study Example

Full Full PART In conventional terms the concept of foreign direct investment is the movement of capital resources from one location to another often with the involvement of multinational corporations. There have been a dramatic rise in the flow of capital especially among the countries of the OECD of which Japan is a part. There are numerous factors that influence the flow of capital resources into host countries however within the current scope of this study emphasis will be placed on the specific influence that exchange rates with regards to the rise and fluctuations across the international capital market have on investment activities across the world. The behavior of exchange rates on the international capital market has a significant bearing on the quantity of capital resources that can be marshaled by multinational corporations to enable them carry out investments in the host countries. A country's currency is said to have undergone depreciation if there is a general fall in the value of the country's currency relative to the main value of another country's currency. Within the context of this essay, the Japanese Yen can undergo a depreciation against one of the leading currencies such as the US Dollar or the Euro if its value falls in relative terms to any of them. Suffice to cite a hypothetical illustration to buttress the foregoing point. Should the Japanese Yen fall against the United States Dollar by say 25 percentage points then the most likely impact is that cost of production by another hypothetical corporation will be significantly lower by 25%. The resulting low cost of the Yen can serve as an incentive for investment because a would be corporation will have to pay low cost for wages in addition to the prevailing low cost of production relative to what it will be in the United States. This phenomenon of attractiveness due to exchange rate differences among countries is known as the relative wage concept (Froot & Stein, 1991). However, this latter assertion ought to be treated with some level of caution taking note of the fact that in the most absolute sense for this to occur the changes in the exchange rate has to be in line with some preconditions of which include an associated parallel between the significant changes in the relative costs of production across both the United States and Japan and above all this should not in any way be altered by any overt or covert changes in either the cost of production or the wages in Japan where this investment will be taken place. In addition, the overall relevance of the relative wage factor will become negligible in the event of an advent of an anticipated movement in exchange rate. This has to do with either a direct or indirect rise in the cost of carrying out an investment in the host nation in this case which is Japan. The point that should be noted here is that in the most conventional form the factors that fulfill the interest rate parity are consistent with risk-adjusted rates of return in both the United States and Japan. Any shift in any of the above mentioned factors can change the entire course of a foreign direct investment stream. In a deeper sense the effects of changes on the foreign exchange market on investments are more profound on multinational corporations. Citing again the instance of a decline in the value of the currency of the host country relative to the investing source country, it is worth stating that should this situation of depreciation in the value of the host country's currency then the potential impact can be a significant rise in the wealth of the multinational corporation in relation to the host country. By this leverage the investing multinational corporation is better placed to engage in robust bidding for assets in the home country in view of the fact that it has relatively stronger capital base to engage in these activities. Of course saying this is an extension of illustrations presented in the preceding chapter with regards to wages and cost of production and how they both work together to present a motivation to would be investment source of multinational corporations. The field of international economics is hinged on the economic activities that take place in the economies of countries across the world. Indeed, these activities taking place within the economies of individual countries if viewed corporately creates the enabling platform for the foundational framework of international economics. It is also important to state that pioneering economic scholars like Adam Smith and David Ricardo in their monumental works that inform the understanding of contemporary economic thought to the effect that successful economic development cannot be achieved in isolation. Therefore, their call on nations to engage in vigorous international trade in their quest to achieve economic development; to say the least the timeless truth of these reputable scholars still holds true for our day and age. Thus, attracting foreign direct investment has become very crucial for most countries because of its perceived positive impact on economic growth and development. Many countries have undertaken structural and regulatory reforms such as privatization of state enterprises, liberalization of their foreign exchange markets and establishment of fiscal incentives like tax holidays in order to attract more foreign direct investments. The quest for increased foreign direct investment stems from the assumption that foreign direct investment leads to economic benefits within the host country, which assumptions are based on economic theory. In addition, there is existing empirical research that has further highlighted the benefits of foreign direct investment. According to World Bank, developing countries should endeavor to attract more foreign direct investment because: it encourages production improvements, contributes to advancement in technology, boosts employment opportunities, bolsters business sector competition and creates exports. In their article "Multinational Firms and the New Trade Theory" Markusen and Venables (1998) indicate that foreign direct investment through multinational enterprises is an influential and effective means to propagate technology from developed to developing countries. Fortanier and Maher further indicate that foreign direct investment is habitually the only source of innovative and new technologies. PART 2 The primary objective of this study is to establish a robust causal direction between foreign direct investments and exchange rate dynamism on the international capital market. Among other things the study will address the following concerns: To establish whether the increase in foreign direct investments in Japan is a direct consequence of activities on the international exchange rate market; To establish whether the behavioral trends of the Japanese Yen has resulted in to an increase in foreign direct investments; Eventually culminating into establish whether there is a bi-directional relationship between foreign direct investments by multinational corporations and the relative wage concept. Conventional economic theory and a number of empirical studies support the notion that there is a causal relationship between foreign direct investments and Exchange rate trends and that foreign direct investment inflows enhance growth in host countries. For example Markusen & Venables (1998) indicates that foreign direct investment is beneficial to host countries because it avails a consolidated package of quality control practices, management skills, human resource and marketing techniques and improved production procedures all of which place the host country's economy along the frontiers of best practice. Because of its presumed benefits to the host country economies, proponents of foreign direct investments such as the World Bank and International Monetary Fund strongly encourage countries to attract more foreign direct investments as a way of stimulating and increasing efficiency of resource allocation. Nonetheless, there are other theories and empirical studies which indicate that there is a reverse causation from economic growth to increased foreign direct investments. Some authors further caution that there are several risks and repercussions to host countries associated to foreign direct investment inflows such as "crowding out" - which is the apparent domination of the domestic economy by the foreign companies leading to decreased competition and in some instances monopoly of the domestic economy by the foreign firm(s). Other risks and negative impact could include; reduced investment as a result of financial and capital resource drains, hindrance of capital formation, increase in unemployment and the possibility of brain drain from the developing countries to developed countries. The existing empirical evidence on the causal relationship between foreign direct investment and exchange rate regimes and the associated benefits is very inconclusive. Most of the empirical research that has been undertaken in this area has used panel data for a number of countries to establish the causal relationships. This thus provides a major incentive for this study. Previous related studies such as Konings (2000) concentrated on establishing the influence of changes on the Japanese Yen and its likely impact on foreign direct investment inflows. http://209.85.129.132/search'q=cache:hIC24Q-bHjYJ:https://dspace.lib.cranfield.ac.uk/bitstream/1826/2094/1/Final%2520Oscar%2520Thesis%2520Report.pdf+as+a+result+of+financial+and+capital+resource+drains,+hindrance&hl=ru&ct=clnk&cd=3&gl=ua It is also known that the contemporary exchange rate volatility has a siginificant correlation between the host and source countries ignites a global expansion of production in absolute terms it however leaves economic progress in a steady path when it comes to the host country. Most importantly, the relative indices such as capital and wealth have an impact on how Japan can strategically place itself to take advantage of the trends because of the performance of the Yen on the global market with respect to other trading currencies. In summing up, the Japanese economy's attractiveness to foreign direct investment is in many ways connected to how its national currency the Yen fares with regards to other trading currencies. Of all these the exchange rate volatility is the most conspicuous indicator that has very reverberating effects on the subject in question. There should be a clear variation between the level of exchange rate volatility in the short term and also the long term trends. These are definitely entirely distinctive elements that have varying effects on foreign direct investment. It will therefore be erroneous to make superficial judgments to make decisions of investments based on nominal exchange rate structures. Looking at the Japanese economy, a very likely temptation is for investment decisions to be made based on sheer currency volatility. Much as this should not be completely discounted there is the need to create a kind of platform that will accommodate risk aversion concerns. By so doing, multinational corporations receive some form of guarantee against corrosive volatility that can unproductively impact investment returns. Investors are always aware of the fact that an upward adjustment in a high volatility context the projected value of investment suffers enormously eventually stifling foreign direct investment inflows. Reference: Froot, K., and J. Stein, "Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach", Quarterly Journal of Economics (1991) 1191-1217. Konings, J., "Effects of direct foreign investment on domestic firms: Evidence from firm level panel data in emerging economies", WDI working paper, no 344, 2000. Markusen, J. R., & Venables, A., "Multinational Firms and the New Trade Theory", Journal of International Economics 46(2), 1998. 133-200. Serven, L. (1998), 'Macroeconomic Uncertainty and Private Investment in LDCs: An Empirical Investigation', The World Bank, mimeo Read More