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

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82

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85

91

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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

vii

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

2

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

4

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

6

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

9

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.

10

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

11