Does Exchange Rate Matters for Foreign Direct Investment Inflow to Ethiopia?

Abstract

This study examines the effect of exchange rate on foreign direct investment inflows in Ethiopia. The aim of the study is to investigate how foreign investors through FDI respond to change in exchange rate level in Ethiopia.  In line with the explanatory variable exchange rate; economic growth, inflation, trade openness, and external debt are added as a control variable in the study.  The study uses explanatory research design and quantitative research approach with secondary time series data utilized over the study period 1992-2017(26 years).  More specifically, the study adopts an autoregressive distributed lag (ARDL) model. Furthermore, the long run relationships of variables are quizzes through bound tests and confirm the existence of a long-run relationship among variables. So, in order to investigate the short run relationship among variables, the error correction model is employed in the study. The finding of the study reveals that; exchange rate level and foreign direct investment have a positive relationship in the short run as well as in the long run and statically significant at 1 percent significance level. So, devaluation of Ethiopian Birr against US dollar affects foreign direct investment positively in both cases. But, the last year effect (one period lag) of devaluation on current year foreign direct investment was found negative. On the other hand, variables like economic growth and inflation have a negative relationship with foreign direct investment in the long run as well as in the short run. But, except economic growth, inflation found insignificant in the long run. External debt found positive and insignificant in the long run.  However, the relationship between trade openness and foreign direct investment were found positive and statically significant.  This study suggests that the government shall ensure the stability of the exchange rate once devaluation is made.

Keywords: exchange rate, foreign direct investment, Autoregressive distributed lag model

DOI: 10.7176/RJFA/10-11-02

Publication date:June 30^th 2019