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IMPACT OF EXCHANGE RATE AND OIL PRICE ON FDI INFLOWS IN BRICs: DOES VOLATILITY MATTER?
Foo Lin Yie
Master of Science 2014
Pusat IVUQnlAI lvlaluumal iuwuruu" UN[VENSTTI MALAYSIA SARAWAK
IMPACT OF EXCHANGE RATE AND OIL PRICE ON FDI INFLOWS IN BRICs: DOES VOLATILITY MATTER?
FOO LIN YIE
A thesis submitted in fulfillment of the requirements for the degree of Master Science in Economics
Faculty of Economics and Business UNIVERSITI MALAYSIA SARAWAK
2014
Statement of Originality
The work described in this Thesis, entitled "Impact of Exchange Rate and Oil Price on FDI Inflows in BRICs:
Does Volatility Matter? ", is to that best of the author's knowledge that of the author except
where due reference is made.
Date submitted Foo Lin Yie 09021558
ABSTRACT
IMPACT OF EXCHANGE RATE AND OIL PRICE ON FDI INFLOWS IN
BRICs: DOES VOLATILITY MATTER?
By
Foo Lin Yie
(This study investigates the effects of exchange rate volatility and oil
price volatility on Foreign Direct Investment (FDI) inflows for BRICs
(Brazil, Russian Federation, India and China). The testing period for this
study ranges from year 1986 to 2009 for Brazil, India and China. As for
Russian Federation, the sample covers the 1992 to 2009 period because of
the breaking up of Union of Soviet Socialist Republics (USSR) in 1991') The
Phillips and Perron (PP) unit root test was used to identify the
integration order of the variables. The cointegration and causality
relationships between the variables were examined via the ARDL
(Autoregressive Distributed Lag) framework. From the empirical results,
exchange rate volatility and oil price volatility were found to have no
significant effects on FDI inflows for BRICs in the long-run. In the
short-run, India was the only country which provided evidence of causal
relationship running from exchange rate volatility to FDI inflows.
ABSTRAK
KESAN KADAR PERTUKARAN MATA WANG DAN HARGA MINYAK KE
ATAS ALIRAN MASUK PELABURAN LANGSUNG ASING BRIC: ADAKAH
VOLATILITI MEMBERI KESAN?
Oleh
Foo Lin Yie
Kajian ini dijalankan dengan tujuan untuk menganalisis impak perubahan kadar
pertukaran dan harga minyak terhadap pelaburan asing bagi negara BRICs (Brazil,
Russian Federation, India dan China). Tempoh ujian bagi negara Brazil, India dan
China dalam kajian ini bermula daripada tahun 1986 hingga tahun 2009. Manakala,
tempoh kajian bagi Russian Federation dalam kajian ini bermula pada tahun 1992
hingga 2009 atas kekangan pembubaran Union of Soviet Socialist Republics (USSR)
pada tahun 1991. Kaedah "Phillips and Perron" telah digunakan untuk megenalpasti
integrasi perintah bagi setiap pembolehubah dalam kajian ini. Cointegrasi dan sebab-
musabab pula dikaji melalui ARDL (Autoregressive Distributed Lag). Hasil empirikal
menunjukkan bahawa perubahan kadar pertukaran dan harga minyak tidak membawa
impak yang ketara terhadap pelaburan asing bagi negara BRICs pada jangka masa
panjang. Namun, perubahan kadar pertukaran bagi negara India didapati menjejaskan
pelaburan asing pada jangka masa pendek.
ACKNOWLEDGEMENT
Firstly, a great gratitude to my supervisor, Associate Professor Dr. Venus
Khim-Sen Liew who had given me so much advices and suggestions. He had devoted
his time to assist me in my research. His advices and ideas helped me a lot in
completing this research. I would like to thank my co-supervisor, Associate Professor
Dr. Puah Chin Hong for his suggestions and information that helped me in writing
this thesis as well.
In addition, I also thank the staff of CAIS, Universiti Malaysia Sarawak for
their help in providing resources for this study.
Lastly, I sincerely thank my beloved family members who had given me a lot
of encouragement and moral support to complete this research. Besides, I wish to
thank all my friends for their discussion and suggestion.
Pusat Khidmat M"mat Almdemik UMVERSTTI MALAYSIA SARAWAK
TABLE OF CONTENT
LIST OF TABLES
LIST OF FIGURES
CHAPTER ONE: INTRODUCTION
1.0 Introduction
1.1 Importance of FDI
1.2 Problem Statement
1.3 Objectives of Study
1.4 Significance of Study
1.5 Organisation of Study
CHAPTER TWO: BACKGROUND OF THE COUNTRIES
2.0 Introduction
2.1 Overview of Brazil
2.2 Overview of China
2.3 Overview of India
2.4 Overview of Russian Federation
CHAPTER THREE: LITERATURE REVIEW
3.0 Introduction
Page
V
vii
1
4
6
10
11
13
14
16
22
29
34
39
1
3.1 Theoretical Framework 39
3.1.1 Exchange Rate, Exchange Rate Volatility and FDI 39
3.1.2 Exchange Rate Volatility and FDI 40
3.1.3 Oil Price, Oil Price Volatility and FDI 41
3.2 Empirical Models 46
3.3 Testing Procedures 54
3.3.1 Unit Root Test 54
3.3.1.1 Augmented Dickey-Fuller (ADF) Test 54
3.3.1.2 Phillips-Perron (PP) Test 56
3.3.1.3 Kwiatkowski-Phillips-Schmidt-Shin (KPSS) Test 57
3.3.2 Cointegration Test 58
3.3.2.1 Engle and Granger (EG) Test (1987) 58
3.3.2.2 Johansen (1988) Test 59
3.3.2.3 Johansen and Juselius (1990) Test 61
3.3.2.4 Autoregressive Distributed Lag (ARDL) Cointegration 63
3.3.3 Causality Test 64
3.3.3.1 Vector Error-Correction Model (VECM) 64
3.3.3.2 Granger Causality Test 65
3.3.4 Estimation of Volatility 66
3.3.4.1 Autoregressive Conditional Heteroskedasticity (ARCH) 67
model
3.3.4.2 Generalized Autoregressive Conditional 68
Heteroskedasticity (GARCH) model
3.4 Empirical Evidences/Findings 70
3.4.1 Effects of Oil Price on Macroeconomics and Activities 70
ii
3.4.2 Effects of Oil Price on Exchange Rate
3.4.3 Effects of Exchange Rate on FDI
3.4.4 Effects of Exchange Rate Volatility on FDI
3.5 Conclusion
CHAPTER FOUR: METHODOLOGY
4.0 Introduction
4.1 Conceptual Model
4.2 Data Descriptions
4.3 Unit Root Test
4.3.1 Phillips and Perron Test
4.4 Cointegration Test
4.4.1 Autoregressive Distributed Lag (ARDL) Test
4.5 Causality Test
CHAPTER FIVE: EMPIRICAL RESULTS
5.0 Introduction
5.1 Unit Root Test
5.2 Cointegration Test
5.3 Causality Test
CHAPTER SIX: CONCLUSION
71
72
74
76
77
77
79
82
82
85
85
91
93
93
98
117
iii
6.0 Introduction
6.1 Discussions
6.2 Policy Implications
6.3 Limitation and Further Study
6.4 Conclusions
APPENDIX I
APPENDIX II
REFERENCE
121
122
129
132
134
135
163
168
iv
LIST OF TABLES
Table 1: Top World Oil Consumers 2008 9
Table 2: Oil Consumption for BRICs in thousand barrels daily 9
Table 3: Gross Domestic Product (GDP) China from 1978-2009 27
Table 4: Summary of the Data Descriptions 81
Table 5: PP Unit Root for Brazil 96
Table 6: PP Unit Root for China 96
Table 7: PP Unit Root for India 96
Table 8: PP Unit Root for the Russian Federation 97
Table 9: Results of bounds-test for Cointegration 106
Table 10: ARDL Estimations based on AIC with Heteroskedasticity 107 Autocorrelation Consistent Covariances (HACC)
Table 11: Diagnostic Tests for ARDL Estimations 108
Table 12: ARDL Long-run Coefficients 115
Table 13: Results of Error-Correction Representation for the selected ARDL 116
models
Table 14: Short-run Causality Test (Wald test F-statistic) for Brazil 119
Table 15: Short-run Causality Test (Wald test F-statistic) for China 119
Table 16: Short-run Causality Test (Wald test F-statistic) for India 119
Table 17: Short-run Causality Test (Wald test F-statistic) for Russian 120
Federation
Table 18: Short-run Causality Test (Wald test F-statistic) for Russian 120
FederationA
Table 19: Short-run Causality Test (Wald test F-statistic) for Russian 120
FederationB
V
Table 20: Joint Short-run Dynamics and ECT (Wald test F-statistic) 120
APPENDIX I
Table I: Summary of Literature Review for Theoretical Framework 135
Table II: Summary of Literature Review for Empirical Models 142
Table III: Summary of Literature Review for Testing Procedures 144
Table IV: Summary of Literature Review for Empirical Evidences/Findings 155
APPENDIX II
Table A: Results of bounds-test for Russian Federation Model A 165
Table B: Results of bounds-test for Russian Federation Model B 165
Table C: ARDL Estimations based on AIC without Heteroskedasticity 166
Autocorrelation Consistent Covariances (HACC)
Table D: Diagnostic Tests for ARDL Estimations without HACC 167
V1
LIST OF FIGURES
Figure 1: FDI net Inflows (in Billion US dollar) for Brazil from year 1980 to 21
2011
Figure 2: FDI net Inflows (in Billion US dollar) for China from year 1980 to 28
2010
Figure 3: FDI net Inflows (in Billion US dollar) for India from year 1980 to 33
2010
Figure 4: FDI net Inflows (in Billion US dollar) for Russian Federation from 38
year 1980 to 2011
Figure 5: The Dynamic Effects of an Increase in the Price of Oil 43
Figure 6: CUSUM and CUSUMSQ of Squares Tests for Brazil 109
Figure 7: CUSUM and CUSUMSQ of Squares Tests for China 110
Figure 8: CUSUM and CUSUMSQ of Squares Tests for India 111
Figure 9: CUSUM and CUSUMSQ of Squares Tests for Russian Federation 112
Figure 10: CUSUM and CUSUMSQ of Squares Tests for Russian FederationA 113
Figure 11: CUSUM and CUSUMSQ of Squares Tests for Russian FederationB 114
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CHAPTER ONE
INTRODUCTION
1.0 Introduction
The fluctuation of exchange rate in Brazil, Russian Federation, India and
especially China (BRICs) has become a popular focus across the globe mainly due to
the economic crisis in 2008. In 2011, China was urged to appreciate its currency,
Renminbi, such that it could help in recovering the economy of the European Union
which was in trouble. Hence, the increasing influences of BRICs in global economy
could not be denied. BRICs were seen as playing an important role in leading the
global economy since they would become an export-driven recovery to the advanced
economy. The increasing trend of domestic demand and productions in BRICs shows
that they were able to lead global and advanced economy to recovery. This is because
BRICs were not affected much by the US subprime crisis in 2008 as compared to
major developed countries (O'Neill & Stupnytska, 2009). In fact, Wilson and
Purushothaman (2003) predicted that the economy in BRICs was expected to exceed
the G6 (United States, Japan, Germany, France, Italy and United Kingdom)
economies in less than 40 years.
In addition, the most widely debated form of non-renewable energy--oil is an
interesting topic since the increasing oil price has increased the inflation of many
countries around the world. Oil consumption has been increasing for the past two
decades (BP Statistical Review of World Energy, 2010) while its price has been
fluctuating in the past few decades (Carollo, 2011). It is therefore reasonable to
I
believe that the fluctuation of exchange rate and oil price might have huge effects on
the economy of BRICs.
The allocation effect theory claims that the devaluation of a country might
attract foreign investors and increases FDI inflow for that country. The devaluation of
currency in the host country could lower the cost of productions, so that FDI inflows
might increase. In addition, relative labour cost theory is used as the underlying
principle for the study. Many foreign investors are looking for cheaper labour to lower
their cost of productions and maximise their profit. Thus, a country with huge and
cheaper human capital is an attraction for FDI inflows.
The dynamic effects are used in testing the oil price volatility to the FDI
inflows. In dynamic effects, as in the short-run, if oil price increases, a firm will
obviously increase the price, and this leads to the decrease in aggregate supply (AS)
output, and thus, aggregate demand (AD) for output decreases too. In the medium-run,
oil price increase will decrease the output and aggregate supply (AS) will decrease
higher than in the short-run. This causes the aggregate demand (AD) to decrease and
prices will increase higher than before. This causes investors to change their
investment plans and some might even cancel their investment plans.
The econometric methodology is used to test the effects of exchange rate
volatility and oil price volatility on FDI inflows. Phillips and Perron (PP) test is used
for stationarity test. Autoregressive Distributed Lag (ARDL) test which was first
developed by Pesaran and Shin (1995) is used for cointegration test while Wald F-
statistics is used to test the causal relation for variables to FDI inflows. From the
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empirical results, exchange rate volatility and oil price volatility were found to have
no significant effects on FDI inflows for BRICs in the long-run. In the short-run, India
is the only country which indicated that the exchange rate volatility has causal relation
to FDI inflows.
3
1.1 Importance of FDI
FDI could encourage economic growth through technology transfer and
technical know-how. FDI plays an important role in introducing improved products
and processes. Ahmad and Hamdani (2003) found that most of the growth literature
had highlighted the importance of FDI to a country. Thus, it is not surprising that
most of the countries are tremendously in search for ways to attract FDI.
According to Organisation for Economic Co-operation and Development
(OECD) (2002), FDI may help in reducing poverty and improve social conditions.
This may happen and have an effect if FDI is utilising in developing labour-intensive
industries. FDI found that higher incomes in developing countries normally could
help the poorest population in the country. This is because foreign investors are
always looking for cheaper labour in order to lower their cost of productions and
maximise their profits. As the theory of exchange rate and FDI call relative labour
cost.
Apart from that, it is widely believed that FDI may help in contributing to
factors such as productivity and income growth in host countries. Foreign investors
could help to increase the productivity and bring social and environmental benefits to
a host country. When foreign investors decided to invest abroad, they would
simultaneously bring in their technologies and knowledge to the host country
(Borensztein et al., 1998). Thus, through the allocation of good practices and
technologies within multinational enterprises (MNEs) and domestic enterprises, the
host country's economy would be improved through the innovation from FDI. Once
the society has been educated, they will benefit from it where income may increase
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Pusat Khidmat Makluuat Akademik UNIVERSTTi MALAYSIA SARAWAK
and improve their living standard. Foreign investors too are concerned on many
factors that could influence their investments such as the economy conditions,
political stability, performance of targeted industries in that particular country and
others.
Consequently, FDI is vital especially after the Global Financial Crisis (GFC).
FDI is seen as a tool for countries to boost their economic growth, however, when
crises arise, most of the countries will be affected. GFC hits most of the countries
around the world including the developed countries but BRIC was less affected and
had a rapid recovery (Banerjee & Vashisht, 2010). Poulsen and Hufbauer (2011)
stated that FDI remained as the stabiliser in the early stages of the crisis for emerging
economies. Few emerging economies handled the crisis better than the developed
countries and the distribution of global FDI flows is continuing especially with
countries like India and China which have accounted positive growth.
5
1.2 Problem Statement
Nowadays, many countries have adopted a floating exchange rate. Although a
floating exchange rate will influence the price stability, there are still a large numbers
of countries which have chosen to allow the currency in managing the floating
exchange rate. In the 1970s, most of the developing countries started to adopt the
floating exchange rate regime (Hossain & Chowdhury, 1996). Yet, the floating
exchange rate regime could make the foreign exchange market become more volatile,
causing high inflation and influencing the economy. In general, the volatility of the
currency would bring negative impacts on the economic growth or trade as well as
FDI. In theory, the devaluation of a currency in the host country would attract foreign
investment since the amount of investments in the host country would become lower,
thus, FDI inflows increase and vice versa. However, previous studies have shown the
different impacts of exchange rate volatility on FDI: exchange rate volatility and FDI
is ambiguous (Bailey & Tavlas, 1991), exchange rate volatility is detrimental to FDI
(Benassy-Quereet al., 2001; Kiyota & Urata, 2004; Giorgioni, 2007; Ogunleye, 2009)
and exchange rate volatility has positive impact on FDI (Chowdhury & Wheeler,
2008). There are no consistent results for the exchange rate volatility on FDI just like
the results for the exchange rate and FDI. Therefore, the impacts of exchange rate
volatility on FDI are seen as an interesting motive especially for BRICs which are
gaining more popularity in today's global economy.
Exchange rate volatility shows the degree of currency changes over time. The
larger the magnitude of a currency change or the more quickly it changes over time,
the more volatile it is. The stability of the exchange rate enhances the FDI. The
exchange rate volatility would influence the rate of foreign investment when the
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currency appreciates or depreciates. When the local currency depreciates, foreign
investors will invest in the local market since they could have more investments and
FDI increases vice versa when the local currency appreciates. Therefore FDI will be
affected in the long run because of the volatility of the exchange rate (Darby et al.,
1999). However, the impact of exchange rate volatility on the FDI is not consistent for
developed and developing countries as previous studies have shown different
relationships; negative relationship (Gorg & Wakelin, 2002; Kiyota & Urata, 2004;
Giorgioni, 2007; Ogunleye, 2009) and positive relationship (Cushman, 1988;
Chowdhury & Wheeler, 2008) between exchange rate volatility and the FDI.
Nonetheless, there are fewer studies on the relationship between exchange rate
volatility and FDI for BRICs so far. Yu and Cheng (2010) found that the increase in
exchange rate volatility in China will reduce the FDI inflows in the future. Therefore,
the exchange rate volatility may also affect the decision in locating investments in
transition and accession of countries negatively (Brzozowski, 2003). Therefore, it is
interesting to know if the exchange rate volatility has an inverse or direct relationship
on BRICs FDI inflows.
Besides, oil price is the most arguable topic in the world compared to other
natural resources. Oil plays an important role in the economy since it has the highest
usage in production. There are some studies related to oil price and macroeconomics
which have been examined: oil price and exchange rate, economic growth, output,
inflation and so on. Nevertheless, most of the previous studies had been on the effects
of oil price and also the economic growth (Abeysinghe, 2001; Rautava, 2004; Guo,
2008; Aliyu, 2009) and exchange rate (Amano & Norden, 1998b; Benassy-Quere et
al., 2005; Dawson, 2007; Olomola & Adejumo, 2006; Chen & Chen, 2007; Huang &
7
Guo, 2007) but so far there is no research done on the impact of oil price to foreign
investments. Though oil price is claimed to have effects on macroeconomics, there
has been no study to examine the effect of oil price on FDI inflows. In addition, the
oil demand for BRICs is rising steadily and the demand on other natural resources is
also expected to increase in the next decade. As indicated in Table 1, the oil
consumptions for BRICs is in the top ten ranks with other developed countries such as
the US, Japan, Germany and Canada. Among the BRICs, China is ranked highest with
7,831 thousand barrels per day while India, the Russian Federation and Brazil are
ranked higher than Canada and South Korea.
As shown in Table 2, the oil consumption for the BRICs in thousands of
barrels daily is increasing. This shows the increasing importance of oil for the BRICs.
On the other hand, the oil price volatility could influence the FDI. When the oil price
increases, the price of goods and services would also increase including the demand
on goods and services. Thus, investors will delay or cancel their investment plans and
this will affect the FDI. Rafiq et al. (2009) believed that the uncertainty of oil price
would delay the business investment plans of investors since the uncertainty may
increase the cost of investments and decrease the returns of investments. In addition,
oil price theoretical analysis on supply side was said to be limited in predicting the
macroeconomics and there are relatively few studies investigating the relationship of
oil price and its volatility for developing countries' foreign investment. For instance,
Rafiq et al (2009) found oil price volatility has unidirectional causality relationship to
investment for Thailand. Thus, does oil price volatility have influence on FDI inflow
in the BRICs?
8
Rank Country Table 1: Top World Oil Consumers 2008
I United States 2 China 3 Japan 4 India 5 Russian Federation 6 Germany 7 Brazil 8 Saudi Arabia 9 Canada 10 South Korea Source: U. S. Energy Information Administration (EIA)(2011).
Consumption (thousand barrels per day) 19,498 7,831 4,785 2,962 2,916 2,569 2,485 2,376 2,261 2,175
Table 2: Oil Consumption for BRICs in thousand barrels daily Year Brazil China India 1985 1262 1825 1986 1404 1941 1987 1439 2062 1988 1478 2211 1989 1517 2340 1990 1476 2323 1991 1500 2524 1992 1533 2740 1993 1569 3051 1994 1648 3116 1995 1736 3395 1996 1847 3702 1997 1968 4179 1998 2034 4228 1999 2114 4477 2000 2056 4772 2001 2082 4872 2002 2063 5288 2003 1985 5803 2004 1999 6772 2005 2033 6984 2006 2087 7410 2007 2258 7771 2008 2397 8086 2009 2405 8625 Source: BP Statistical Review of World Energy (2010).
895 943 974 1069 1164 1211 1233
Russian Federation
1296 4597 1313 3875 1413 3359 1580 3025 1700 2686 1828 2689 1963 2554 2134 2625 2254 2583 2284 2566 2374 2606 2420 2622 2573 2619 2569 2601 2580 2709 2838 2708 3071 2817 3183 2695
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1.3 Objectives of Study
The main purpose of this research is to investigate the impacts of exchange
rate volatility and oil price volatility on FDI inflow for the BRICs.
The specific objectives of this research are:
(i) To study the impact of exchange rate volatility and FDI inflows.
(ii) To study the impact of oil price volatility and FDI inflows.
(iii) To study the short-run causal relations between FDI inflow and its
determinants.
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1.4 Significance of Study
Emerging countries such as India and China have become more influential in
the international market because of the rise of their exportation. The emergence of
India is moving up in becoming an industrial output country and consequently a
service-based nation since India has a huge population and good economic
development. Before becoming an influential nation globally, India was considered as
a poor country with high unemployment and poverty rate. However, the shifting of
the economic policy worked and thus moving them up from the lower stage. This
research is able to let the less developed countries (LDC) to have a guide and a model
in economic development in order to improve their economic performance and
increase their living standards.
In addition, the increase of oil consumption in recent years has been
considered a significant variable since it could influence the trade and balance of
payments for countries. Oil price is a good approximation for some industrialised
nations such as the US, Japan and Germany (Amano & Norden, 1998a). Nonetheless,
although the BRICs were not considered industrialized nations yet, still oil
consumption could be seen as vital to every country especially for those less
developed countries. This is because oil is an important energy resource that would
affect the economy of any country in the world.
In addition, currency plays an important role in the international trade market,
thus, the exchange rate is the most important variable. Therefore, the fluctuations of a
currency would constantly affect economic growth, trade and foreign investments.
The effect of the exchange rate volatility on FDI is not consistent: exchange rate
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