Foreign direct investment (FDI) is money that corporations from one country invest in companies in another country. In the process, the investing company usually buys a company or a percentage of shares in that company. A common belief is that FDI causes an exchange rate effect because it’s viewed as a supply of capital. That’s because FDI is a type of capital investment. The thinking goes that when investors have more capital, they demand stronger currencies to hold as reserves. This makes the local currency less attractive and depreciates its value. This article explains how FDI might affect the value of a nation’s currency and why it doesn’t always do so—especially when you consider why businesses choose to make such investments in the first place.
What is Foreign Direct Investment?
A common definition of foreign direct investment is the acquisition of a lasting interest in real assets, such as plants and machinery, located outside the borders of one’s own country. To put it another way, when a company based in one country buys a controlling interest in a company based in another country, it is considered to be FDI. The investing company usually buys a company or a percentage of shares in that company. There are many reasons why a company would choose to make an investment in another country. Some firms have the resources and expertise to expand into other countries and benefit from their advantages. Others are looking for a new source of income because their home market is too saturated for further growth.
Learn more about FDI in India
How does FDI affect the exchange rate?
The relationship between FDI and the exchange rate depends on the investor’s intentions. There are two main reasons why a company would make an investment in another country—to sell products in that country and to buy assets in that country. The former is known as “going out.” The latter is “going in.” Each has a distinct impact on the exchange rate because each is associated with a different type of capital demand.
Why does FDI cause a change in currency value?
Investing money in another country creates demand for some type of capital that is denominated in the foreign currency. For example, if a Japanese company buys a factory in another country, it will have to convert the Japanese yen into the local currency to pay for the factory. That creates demand for the local currency. Another investment is a joint venture to produce parts in another country. If a U.S. automaker buys parts from a Canadian manufacturer, it will pay Canadian dollars for the parts. That also creates demand for the Canadian dollar. The capital demand associated with going out is an investment in productive assets, including spending on research and development, or R&D. The capital demand associated with going in is spending on assets that are not involved in the company’s operational business, such as the shares and bonds of another firm or real estate.
When does Foreign Direct Investment not have an effect on the exchange rate?
Supply and demand is the basic model for how currencies are valued. In other words, when there is more demand for a currency than there is supply, the currency will rise in value. There are four factors that affect capital demand, and each of them must be present for an increase in demand to cause an appreciation. A factor that could counteract the increase in demand for a currency is whether the investors’ expectations are met. If a Japanese manufacturer buys a Canadian factory to increase its production, it may expect to increase sales in Canada due to lower production costs. If the Canadian market does not grow as quickly as expected, the Japanese company may conclude that the purchase was not cost-effective. In this situation, investors may sell the Canadian dollar and its value will fall.
Summary
Foreign direct investment is a transfer of capital across a country’s borders. When a foreign investor invests in another country, it can affect the exchange rate in two ways. One way is when the investment is going out, when the investor builds a factory or buys land in the other country. In this situation, the investor usually pays the currency of that country. The other way is when the investment is going in. An investor buys shares of a company in the other country. In this situation, the investor usually pays the currency of that country. All investments add to the total supply of capital in the market, which can affect the exchange rate. The exchange rate is determined by the amount of demand for the currency relative to the supply. When there is more money flowing into a country than out, there is likely to be an appreciation of the exchange rate.
