Foreign Direct Investment and Exchange Rate in India

Abstract

The present article attempts to identify the causal nexus among real exchange rate (RER), its volatility and foreign direct investment (FDI) inflows in India using quarterly data from 1990:II to 2008:I. Generalized Auto Regressive Conditional Heteroscedasticity (GARCH) model is employed to obtain conditional variance of RER data series. Besides, Johansen’s cointegration technique followed by the vector error correction model (VECM) is employed to examine the objective. The analysis reveals a long run relationship among FDI, RER and the GARCH measure of exchange rate volatility, and also a short run causality flow from RER and its volatility to FDI. However, we find no discernible link from FDI to RER and its volatility in the short run. Thus, the study concludes that depreciation in exchange rate level leads to increase in inflow of FDI, and an increase in FDI is due to decreases in exchange rate uncertainty in the short run.

Keywords: Foreign Direct Investment, Exchange Rate, Volatility

JEL Classification: C32, F21, F31