The Effects of Real Exchange Rate Volatility on Sectoral Investment

Empirical Evidence from Fixed and Flexible Exchange Rate Systems

Bahar Erdal

• Publisher: Routledge
• Year: 2017
• Print ISBN: 9781138633186
• eBook ISBN: 9781351801713
• Topic: Business
• Subtopic: Business General
• Index: Business

Originally published in 1997. This study investigates what the effects of real exchange rate volatility are on sectorial investment in the fixed and flexible exchange rate systems. It lays out the results of research into the effects of the levels and volatility of real exchange rates on investment in the manufacturing sectors of the countries in the European Monetary System as well as of the countries in the flexible exchange rate system, with data from between 1973 and 1993. Examining the differences between the two systems in the results this book also looks at exchange rate effects on interest rates at the time.

The Effects of Real Exchange Rate Volatility on Sectoral Investment

I
Introduction

The Exchange Rate Mechanism (ERM) of the European Monetary System (EMS)¹ adopted a target zone system in March 1979, because the flexible exchange rates were too volatile. The ERM provides that each participating currency has a central rate expressed in terms of the European Currency Unit (ECU), an index based on member currencies, and the currencies cannot deviate from their central rates beyond a margin of +/- 2.25 percent. When the currency deviates from its central rate beyond the margins, its ECU rate is redefined by realignments, and revaluation (or devaluation) of the currencies are determined in order to eliminate changes in relative price levels.

Although the ERM experience introduces a new kind of volatility, volatility caused by the expectations of the realignments, Engel and Hakkio (1993) showed that the real exchange rate volatility in the ERM is smaller when compared with that in the flexible exchange rate system.

One of the main reasons for the establishment of the ERM of the EMS was to create a stable exchange rate environment, and by that to induce investment and trade in Europe. Artis and Taylor (1994), and Grauwe and Verfaille (1988) showed that the EMS was successful in reducing real exchange rate volatility. Grauwe and Verfaille (1988) also showed that the EMS helped to increase trade between the EMS versus non-EMS countries instead of intra-EMS trade. Since no empirical study has been done about the effects of real exchange rate volatility on the European investment, it is not possible to talk about the effects of real exchange rate volatility on investment in Europe.

This study analyzes the effects of real exchange rate volatility on investment in manufacturing sectors for countries under quasi-fixed (that is, the EMS) and flexible exchange rate systems, by answering the question, "In which system does real exchange rate volatility have depressing effects on sectoral investment?"

This study can help to determine whether adopting an exchange rate system like the ERM of the EMS is worthwhile for non-EMS countries.

Since, exchange rates fluctuate within narrow margins in the quasi-fixed exchange rate system, real exchange rate volatility should not have depressing effects on sectoral investment. On the other hand, in the flexible exchange rate system, exchange rates fluctuate randomly, so, real exchange rate volatility should have depressing effects on sectoral investment.

Theoretically, real exchange rate volatility can have important effects on domestic and foreign investment decisions. Real exchange rate volatility changes the international competitiveness of the countries, causes reallocation of resources among the sectors, causes relocation of resources across countries, and creates an uncertain environment for investment decisions if the investments are irreversible. Krugman (1989) states that

Uncertainty creates an incentive for firms to pursue a "wait and see" attitude, widening the range of no change in which firms neither enter nor exit. And now we come to the important point: The incentive not to act is greater the more volatile the exchange rate. It is a straightforward result from option pricing that the ratio of the market price at which an option is exercised to the strike price is higher the greater is market volatility. Similarly, in the sunk cost model a firm will wait for a more favorable exchange rate before entering, and will remain in the market for a more unfavorable rate, the greater the perceived future uncertainty of the rate.²

A theoretical study by Aizenman (1992) showed that both domestic and foreign investments are higher in a fixed exchange rate system. There are few empirical studies about the effects of both real exchange rates and real exchange rate volatility on investment. Just as empirical studies give ambiguous results about the relation between the changes in real exchange rates and investment expenditures, they also do not show clear correspondence of the effects of real exchange rate volatility on investment expenditures.

Empirical evidence by Goldberg (1993) showed that the U.S. dollar appreciations (depreciations) during the 1980s caused investment expansions (contractions) in the U.S. durable goods manufacturing and nonmanufacturing sectors, and mixed effects in nondurable goods manufacturing sectors. Luehnnan (1991) found that depreciation of domestic currency did not increase international competitiveness of the firms in the auto and steel industries of the G-7 countries. Froot and Stein (1991) showed that real exchange rate movements are not strong enough to affect foreign direct inve...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Original Title
• Original Copyright
• Dedication
• Contents
• List of Tables
• Preface
• Acknowledgments
• Chapter
• Appendix
• Bibliography
• Index