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Foreign Direct Investment, Trade and Real Exchange Rate Linkages in Developing Countries

Trade flows and foreign direct investment are linked in a variety of ways. Direct investment may set the stage for export promotion, import substitution or greater trade in intermediate inputs, especially between parent and affiliate producers. These trade implications of foreign direct investment may be observed between the host and source country or with a set of third country markets. In addition to this direct linkage, there is an indirect linkage between trade flows and direct investment since each share the common determinant of the real exchange rate.

In this paper we work toward disentangling the scale of the direct and indirect linkages between trade flows and direct investment in order to completely trace the role of the real exchange rate on each of these activities. The data we examine are for the trade and investment between a set of developing countries from South East Asia and Latin America with both Japan and the United States.

As with much other empirical research, we find that the real exchange rate significantly affects trade. For our sample of developing countries, import elasticities with respect to real exchange rates exceed their export elasticities. We also find that for South East Asian countries exchange rates affect direct investment not only from Japan but also from the United States. FDI from Japan into South East Asia has been very sensitive to changes in the yen-dollar exchange rate: dollar depreciations lead to investment surges from Japan.

Moreover, holding constant the effect of the real exchange rate, direct investment from Japan promotes trade between Asia and both Japan and the United States. Japanese direct investment expands both the export and import linkages of South East Asia. United States FDI plays a different role in the region: it substitutes for South East Asian imports from the United States. In contrast to our findings for South East Asia, FDI into Latin America from the United States and Japan are not responsive to real exchange rates. Moreover, the trade-promoting effects of this FDI appear to be weak or insignificant with regard Latin American trade with the United States and Japan.

Foreign Direct Investment, Trade and Real Exchange Rate Linkages in Developing Countries