Exchange Rate Volatility and the Timing of Foreign Direct Investment: Market‐Seeking versus Export‐Substituting

Abstract

Abstract This paper examines the impact of exchange rate uncertainty on the timing of foreign direct investment (FDI) with heterogeneous investing motives. We first extend Dixit–Pindyck's real options model to show that while an increase in exchange rate volatility tends to delay FDI of a market‐seeking firm, it might accelerate FDI of an export‐substituting firm if the firm's degree of risk aversion is high enough. The rationale behind this finding is that a market‐seeking FDI might increase the exposure of the firm's profits to exchange rate risk, while an export‐substituting FDI might reduce it. Empirical evidence from a survival analysis based on firm‐level data on the entry by Taiwanese firms into China over the period between 1987 and 2002 is consistent with the theory. These results reveal that the relationship between exchange rate uncertainty and FDI is crucially dependent on the motives of the investing firms.

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