Real Effective Exchange Rates and Foreign Direct Investment Inflows: Empirical Evidence from India’s Sub-National Economies

Abstract

This paper investigates the impact of real effective exchange rates (REER), both in terms of levels and volatility, on foreign direct investment (FDI) inflows for a panel of 35 Indian sub-national economies over the period 2000-2013. In light of the asymmetric distribution of FDI inflows within India, we focus on examining the nexus between FDI inflows at the sub-national level and India’s competitiveness captured by REER. Our empirical analysis reveals that movements in REER have a significant and negative impact on FDI inflows, while REER volatility is found to be inducing FDI. Our results are suggestive that FDI inflows into India are largely domestic market oriented in nature.

Purpose: In light of the asymmetric distribution of FDI inflows within India, we focus on examining the nexus between foreign direct investment (FDI) inflows at the sub-national level and India’s competitiveness captured by real effective exchange rates (REER). This paper investigates the impact of REER, both in terms of levels and volatility, on FDI inflows to 35 Indian sub-national economies over the period 2000-2013.

Research Methodology: To examine the impact of REER on FDI inflows, we compile a panel dataset for 35 sub-national economies covering the time period 2000 to 2013. We employ panel fixed effects models to explore our relationship of interest between REER and FDI, controlling for other characteristics specific to a sub-national economy.

Findings: Our empirical analysis reveals that movements in REER have a significant and negative impact on FDI inflows, while REER volatility is found to be inducing FDI. Our results are suggestive that FDI inflows into India are largely domestic market-oriented in nature.

Originality/Value: Considering that India’s FDI inflows exhibit significant concentration patterns among selected regions, we exploit this heterogeneity at the sub-national level to empirically understand the determinants of FDI, with a particular focus on cost competitiveness as captured by REER. The extant literature has not explicitly focused on testing the impact of REER both in terms of its levels and volatility on FDI inflows to India at the sub-national level, especially not at the sub-national level. While admittedly the exchange rate varies only at the national level, the value-addition comes from understanding its interaction with state-varying macroeconomic indicators.