The Effect of Exchange Rate Volatility on Foreign Direct Investment: The Bayes Approach

Abstract

This research examined the effect of exchange rate volatility on foreign direct investment in a group of countries with soft pegged exchange rate regimes and a group of countries with floating exchange rate regimes. The study dataset covered 114 countries from 2000 to 2021. Bayesian “random-effects” model were used to estimate the empirical model and perform statistical inferences throughout the research. The impact of exchange rate volatility on foreign direct investment was mainly positive, with a high probability (94%-95%) in the group of countries with soft pegged exchange rate regimes. For countries with floating exchange rate regimes, the impact of exchange rate volatility on foreign direct investment was still positive but weaker than in the group of countries with soft pegged exchange rate regimes. The probability of a positive effect of exchange rate volatility ranged from 88% to 90%. Therefore, the production flexibility is more strongly supported than the risk aversion. The difference between the two exchange rate regimes is shown in the prevalence of the probability of a positive effect of exchange rate volatility.