Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach

This 1991 Quarterly Journal of Economics paper by Kenneth Froot and Jeremy Stein explains the empirical correlation between dollar depreciation and foreign direct investment (FDI) inflows into the United States through informational imperfections in capital markets rather than through the standard view that exchange rates are irrelevant to the location of investment once capital is internationally mobile. In a model where an asset’s profits are privately observed by its owner-manager and verifiable to outside financiers only at a monitoring cost (Townsend’s costly-state-verification framework), external finance is more expensive than internal finance, so an entrepreneur’s own wealth determines how aggressively he can bid for an information-intensive asset; because a depreciation of the dollar raises the dollar value of a foreign entrepreneur’s wealth one-for-one while a credit-constrained domestic entrepreneur’s wealth and hence maximum bid rise less than proportionately, dollar depreciation shifts the balance of bidding power toward foreign buyers specifically for assets subject to this informational friction. Regressions on U.S. Balance-of-Payments and International Trade Administration data from 1973-1987/88 confirm that FDI inflows – but not passive portfolio investment in U.S. Treasury securities or corporate stocks and bonds – are significantly, negatively correlated with the real value of the dollar, with the relationship strongest for industry categories (such as mergers and acquisitions and chemicals manufacturing) plausibly most subject to informational asymmetries, and largely absent for capacity-expansion investment, evidence the authors argue favors their informational mechanism over competing tax-timing, portfolio-diversification, sticky-price, tariff-jumping, and brand-loyalty explanations.

Kenneth A. Froot | Macro Paper Warehouse

Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach