Interactive Effects between Exchange Rate Volatility and Financial Development on Foreign Direct Investment: The International Evidence

Abstract

The aim of this paper was to study the interactive influence between exchange rate volatility and financial development on foreign direct investment in different exchange rate regimes. The research dataset covered 114 countries from 2000 to 2021 and was classified into countries with a soft pegged exchange rate regime and countries with a floating exchange rate regime. The article utilized the Bayesian random-effect model to estimate the empirical models and make statistical inferences. In the group of countries with a soft pegged exchange rate regime, the interaction term could minimize the negative effect of exchange rate volatility, even reversing this effect on foreign direct investment, depending on financial development. The higher the financial development of a country, the greater the positive probability of the marginal impact of exchange rate volatility. In the group of countries with a floating exchange rate regime, the interaction term reduced the positive effect of exchange rate volatility on foreign direct investment. The higher a country's financial development, the lower its positive marginal effect. According to the posterior mean, the marginal effects of exchange rate volatility in both groups of countries were likely positive rather than negative. For the group of countries with a soft pegged exchange rate regime, countries need to strengthen strict control of exchange rate volatility and promote the development of financial markets and financial institutions. For the group of countries with a floating exchange rate regime, countries should loosen their exchange rate policies and focus on stabilizing their financial systems.