Real Exchange Rate Risk, Expectations, and the Level of Direct Investment

Four models of direct investment are analyzed assuming various relationships between foreign and domestic production. The direct effect of risk-adjusted expected real foreign currency appreciation is to lower foreign capital cost, thus stimulating direct investment. However, when costs of other inputs are also affected, induced productivity changes or output price changes may offset the direct effect, reducing direct investment. Pooled estimation results for U.S. annual, bilateral direct investment flows to five industrialized countries show significant reductions associated with expected appreciation of real foreign currency and significant increases associated with risk. These results are consistent with the model where, in response to risk, the multinational firm reduces exports to the foreign country but offsets this somewhat by increasing foreign capital input and production.