Global Economy Journal 2014; 14(3-4): 453–465

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Anindya Biswas*, Biswajit Mandal and Nitesh Saha

Foreign Capital Inflow and Real Exchange
Rate Appreciation in Developing Economies:
Theory and Empirical Evidence
Abstract: Foreign direct investment specially targeted to export sector is rela-
tively new phenomenon in the global economy. Such inflow of foreign capital
changes the sectoral composition of the economy, and it has some influence on
the exchange rate of the destination country. In this study, we attempt to
provide underlying theoretical and empirical explanations for exchange rate
appreciation due to foreign capital inflow. We first use an extended three-sector
specific factor model to explain analytically why and how an inflow of foreign
capital boosts the price of a nontradable good that helps tilting the exchange
rate in favor of the host country and then conduct an empirical analysis based
on a panel dataset of 12 prominent developing countries over the time period
1980–2011 to substantiate our theoretical findings. We also strive to look at the
possible consequences on factor prices and on sectoral de-composition of a
representative economy.

Keywords: foreign capital inflow, real effective exchange rate, international

trade, developing economies, traded and nontraded goods
JEL Classifications: F21, F31

DOI 10.1515/gej-2014-0020

1 Introduction
Foreign exchange reserve, undoubtedly, resembles the structural and interna-
tional strength of an economy that is connected with the rest of the world via

*Corresponding author: Anindya Biswas, Department of Business, Spring Hill College, 4000
Dauphin St., Mobile, AL 36608, USA, E-mail: abiswas@shc.edu
Biswajit Mandal, Department of Economics & Politics, Visva-Bharati University, Santiniketan,
India, E-mail: biswajiteco@gmail.com
Nitesh Saha, GlaxoSmithKline, 5 Crescent Drive, Philadelphia, PA, 19112,
E-mail: saha.nitesh@gmail.com

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454 A. Biswas et al.

trade. Hence there is no denying that one of the prime agenda of economic
policy makers would be to guarantee a good exchange reserve along with a
steady appreciation of real exchange rate. Keeping an eye to this sometimes
international economic policies are framed in such a way that eventually pro-
mises to ensure the phenomenon just described. One possible policy initiative is
to invite foreign capital in a sector that is purely motivated to produce only
exportable commodity. This is supported by one of the common features of the
developing economies are plagued with – lack of domestic supply of capital or
investment. The idea that we are going to use in this study is that domestic
government’s emphasis on export induces them to allow foreign capital or
investment in such a sector that produces only exportable.1
In the hindsight of the theoretical analysis, we have an interesting empirical
observation that motivated us to frame a trade-theoretic model to explain the
phenomenon. The correlation coefficients between the log of real effective exchange
rate (RER) and the foreign direct investment (FDI) as a percentage of GDP for
the 12 prominent developing countries, namely, Brazil (–0.121), Chile (–0.396),
Colombia (–0.070), Ecuador (–0.319), Ghana (–0.457), Morocco (–0.339), Pakistan
(–0.552), Philippines (–0.391), South Africa (–0.553), Togo (–0.431), Tunisia (–0.222),
and Venezuela (–0.192), are found to be negative. Here data on FDI as a percentage
of GDP were obtained from the World Development Indicators published by the
World Bank (2013), and the data on RER were collected from International Financial
Statistics published by International Monetary Fund (2013) for the period starting
from 1980 to 2011. It is also to be noted that we covered a relatively shorter time
period (1980–2011) for each country so that FDI in an economy can be a good proxy
for the FDI in export sectors, and we want to focus on those years after General
Agreement on Trade and Tariff (GATT) policies came into effect.
Following Gruen and Corden (1970), Jones and Marjit (1992, 2008), and
Marjit (2003, 2005, 2008), this study considers a small, open economy with
traded and nontraded goods sectors. The traded sector consists of both export-
able and importable sectors. Using this three-sector model, we analyze both
theoretically and empirically the possible impact on the RER when the foreign
capital is directed to the export sector by taking into account the interaction
among these three sectors. Such an analysis can be of substantial interest
while evaluating the RER movements in developing economies since policy
makers should take into account the possible upshots of FDI on the RER while
formulating the exchange rate policy. Since the idea of focusing the export
sectors to attract FDI is a recent phenomenon, so far no theoretical work has

1 These are often called export enclaves.

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 Foreign Capital Inflow and Real Exchange Rate Appreciation 455

been done, to the best of our knowledge that specifically looks into the effect
of FDI on the RER.2
This paper is organized as follows. The basic analytical model is described
in Section 2 along with the effects of an inflow of foreign capital on factor prices
and RER. Then we briefly discuss related output effects. The next section
provides empirical findings, and Section 4 concludes.

1.1 The basic model and analytical results

A simple amalgam of both the Heckscher–Ohlin and Ricardo-Viner-Jones models
is used in a perfectly competitive small open economy with three sectors: a
nontraded goods sector producing Z; an importable goods sector producing Y;
and an exportable sector producing X; similar to Nowak, Sahli, and Sgro (2003).
The structure closely follows Jones (1965, 1971), and the symbols used in this
study are also extensively used in trade and development literature.3
Technology in all three sectors is concave and continuous and exhibits constant
returns to scale. It is assumed that goods Y and Z are produced with labor (LY and
LZ , respectively) and domestic capital (KY and KZ , respectively), whereas X uses
labor LX and a different kind of capital. This is denoted by K
. Note that this capital is
available in both domestic and international markets. Foreign capital K
and
domestically owned counterpart Kd
are similar in nature. We consider a broad
definition of foreign capital. It includes foreign physical capital, foreign produc-
tion technology, and entrepreneurial skills, and its rent r
captures the rate of
return to K
.
We assume that our representative economy has some capital Kd
to begin
with. However, there is a huge deficiency in such capital and that leads to much
higher interest rate in domestic market. Say it is r
whereas the interest rate
prevails in the international market is
r
. Let us sensibly assume that (r
 r
).
Deficiency in supply of such capital is the prime reason for the economy to set
up an export enclave where considerable gap between r
and
r
attracts foreign
capital. Therefore, foreign capital is a function of the differences in interest rate

K
¼ f ðr

r
Þ ½1


where f 0 ðr

r
Þ>0, assuming (r
 r Þ" r
.

2 In a few related papers the issue of RER and FDI is touched upon but the way we look at the
issue is markedly different from the approach used in these papers (e.g. Basnet and Upadhyaya
2004; Whalley and Weisbrod 2012; Tiwari 2011; Ghosh and Wang 2010; Boyrie 2010 etc.).
3 Li and, KI i ¼ Y; Z represent allocations of labor and domestic capital, respectively, in the ith
sector. LX represents labor allocation in the exportable sector.

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456 A. Biswas et al.

For brevity of our analysis we simplify it as follows:

1
r
¼ ½2
K

The full employment conditions for these factors can be represented as follows:

 aLX X
aLY Y þ aLZ Z ¼ L ½3

aKY Y þ aKZ Z ¼ K ½4

aKX X ¼ K
þ Kd
½5

and K
where the aji ’s denote the technology of production, L
are the total labor
and domestic capital endowments, respectively, in the economy, and Kd
is the
amount of domestic capital that is particularly used in exportable sector.4 K
is
the foreign capital employed in the exportable sector. The zero profit conditions
in this competitive economy are5

aLX w þ aKX r
¼ PX
½6

aLY w þ aKY r ¼ PY
¼ 1 ½7

aLZ w þ aKZ r ¼ PZ ½8

where w, r, and r
are the wage rate of labor, the rental for K, and the rental
for K
or Kd
, respectively. The world price of Y is normalized to one so that PX

and PZ represent the relative price of the exportable and nontraded good,
respectively.
Finally, we define the RER as the domestic relative price of tradable goods
(exportables and importables) to nontradable goods.

γpX þ ð1  γÞpY pY
"¼ ¼ ½9
pZ pZ

where the numerator represents the composite price index for tradable goods
in the economy and γ and ð1  γÞ are the weights of exportables and

4 The quantity of factor j required to produce a unit of good i that follows from the derivative
properties of the unit costs functions by Shepherd’s lemma.
5 When both goods are being produced in a competitive equilibrium with constant returns to
scale technology, the Euler condition states that the total product of a commodity will be
exhausted in paying out the factors.

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 Foreign Capital Inflow and Real Exchange Rate Appreciation 457

importables, respectively. For simplicity, we assume that exportables are not

consumed domestically, γ ¼ 0 and the RER equals " ¼ ppYZ . Here it is worth
mentioning why we consider the above definition of the RER. If all the goods
and services are traded, we have ample scope for designing and defining RER.
But the scope becomes really constricted if the economy produces nontraded
good along with other traded goods. Nontraded good cannot be left aside as
this induces changes in traded goods’ production and factor prices of the
economy. So the RER should take into account both traded and nontraded
goods, and to the best of our knowledge the above is the only definition that
takes care of both the goods.
Because of small economy assumption, prices of traded goods are deter-
mined in the rest of the world. The model has seven unknown variables
(r
; w; r; PZ ; X, Y, and Z). These values can be solved from eqs [2]–[8]. Once
PZ is determined we can have the effect on RER as PY
is given. One dis-
tinctive feature of the model is the determination of the price of nontraded
good (PZ ) from the price equation. So this study departs from the conven-
tional approach of determining the price of nontraded goods based on
demand–supply equilibrium in isolation which is another value addition of
the current paper.
Inflow of foreign capital depresses r
from eq. [2]. w has to rise as PX
is constant
(see eq. [6]). Therefore r must fall in eq. [7]. Thus we get the values of w and r that
directs us to solve the value of PZ . Hence, given factor endowments L,
K,

K
, and K
,
d
eqs [3]–[5] determine X, Y, and Z. However, note that change in factor prices may
indicate some factor substitution in the model. We will discuss it later.

1.2 Inflow of capital and prices

In this subsection we will systematically evaluate the impact of foreign capital

accumulation in the above model. By totally differentiating the equations we
derive the standard Stolper–Samuelson results:

^

K
^r
¼  <0
K
r

θK
X ^
θK
X
K
^ ¼ rb

w ¼

>0
θLX K r θLX

θK
X θLY ^
θK
X θLY
K
^r ¼ ¼ ðÞ

<0
θLX θKY K r θLX θKY

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458 A. Biswas et al.

  ^
θK
X ðθKz  θKY Þ
^ ^r
θK
X θKZ  θKY K
PZ ¼ ¼ ðÞ


θLX θKY K r θLX θLY

where the hat “^” notation denotes the proportional changes of the respective
variable, θji denotes the cost shares. Since the nontraded sector is labor
intensive (we assume that Z is labor intensive and Y is capital intensive), we
have ðθKZ  θKY Þ<0: Therefore, PZ must rise when foreign capital comes in as
^r
<0: Given the small country assumption, the price index for tradables is
given, and thus an increase in P^Z indicates a proportionate decrease in ", RER
appreciation. Therefore the following proposition is immediate:

Proposition: An inflow of foreign capital in the export sector leads to appreciation

of RER if (θKZ  θKY Þ<0.

Now let us move to the output effects. It is also not less interesting as changes
in factor prices open factor substitution possibility. It seems a priori that an
inflow of foreign capital should increase X. But it is not so apparent as r
falls
and w rises. This calls for factor substitution, inducing producers to use more
K
instead of L per unit of X as labor is dearer now. Hence X rises subject to
the condition that the degree of substitution should not be very high. If
producers’ intensity to use K
rises significantly, output of X may in fact go
 
down eventually. This is shown as X ^¼K c
1 
σX
θK
X σ X . In what follows
r K θKY
   
Y^ ¼ ðÞ jλ1j K r K θKY
^¼ 1K
c
1 
σX
θK
X λLX λKZ and Z
jλj
c
λLX λKY 1 
σX
θK
X jλjjλj<0.
r K θKY

2 Empirical findings
This section empirically tests the above analytical relationship between the
effects of an increase in FDI inflow on the RER for developing economies.
The graphical relationship between the log of RER and the FDI as a percen-
tage of GDP for the 12 selected countries over the period 1980–2011 is reported in
the Figure 1. It is clear from this graph that the emergence of FDI as an important
instrument in international trade is a recent phenomenon. For most of the
countries, this ratio witnessed a sharp increase from mid-1990s and reached a
momentum in the 2000s and then suffered from the time of recent great reces-
sion around 2008. Although, at times there were no unambiguous relationships
between these two series but it is clear from this plot that overall the FDI inflows
as a percentage of GDP increased and the RER appreciated.

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 Foreign Capital Inflow and Real Exchange Rate Appreciation 459

Brazil Chile Colombia Ecuador

15
10
5
0

Ghana Morocco Pakistan Philippines

15
10
5
0

South Africa Togo Tunisia Venezuela

15
10
5
0

1980 1990 2000 2010 1980 1990 2000 2010 1980 1990 2000 2010 1980 1990 2000 2010
Year
RER FDI
Graphs by country

Figure 1:

Before we move to the focal point of the paper, i.e. empirical verification of
the theoretical arguments we propose, let us briefly discuss the conventional
ways to define the relationship between the RER and its other determinants
since our theoretical model is too stylized for a complete empirical model
specification for the RER determination. The other variables most often used in
the empirical literature in the determination of the RER are GDP growth, fiscal
policy, trade policy (TP), terms of trade (TOT), and real interest rate. Real GDP
growth appreciates the RER because of differential productivity growth in the
tradable and nontradable sectors. Balassa (1964) showed that the share of
productivity growth in the tradable sector is higher compared to that in the
nontradable sectors in the total productivity growth. Total productivity growth is
also positively correlated with the GDP growth. The productivity differential in
the tradable and nontradable sectors will increase the relative price of the
nontradable by increasing the economy-wide wage rate. This relation is known
as the “Balassa–Samuelson Hypothesis” in the literature. Thus, the hypothesis
states that the RER appreciates from economic growth. The GDP growth rate is

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460 A. Biswas et al.

also used as a proxy of technological progress (Edwards 1989). Increased income

from a positive productivity shock increases the demand for nontradables,
which increases the price of nontradables and appreciates the RER (Aron,
Eldadawi, and Kahn 1997). When the supply side effect from the productivity
shocks outweighs this demand side effect, the RER could depreciate (Edwards
1989).
The fiscal policy measured in terms of public deficit/surplus or the govern-
ment consumption (GC) expenditure can play an important role in the RER
determination as it reflects the country’s stabilization policy. Fiscal expansion
as a result of increased GC of nontraded (traded) goods will lead to RER
appreciation (depreciation) (Edwards 1989). But if an increase in the public
deficit is an indicator of the government’s inability to balance its budget and
is unsustainable in the future, the RER will depreciate. In this study, we use
GC expenditure as a measure of fiscal policy with an expected negative sign
because government expenditure tends to be spent more on nontradables.
The effect of the change in the TOT, the price of exportable to importable,
on the RER is ambiguous depending on the relative strength of direct income
effect on demand for nontradables and the indirect substitution effect on
supply of nontradables. If the income effect from an increase in the TOT
outweighs (less than) the substitution effect, RER will appreciate (depreciate)
from an increase (a decrease) in the price of nontradable (Edwards 1989;
Baffes, Elbadawi, and O’Connell 1999). The conventional wisdom is that
the income effect generally outweighs the substitution effect causing a RER
appreciation with an improvement of TOT.
TP can also change the RER. Two alternative measures of trade policies are
frequently used in the literature: openness (exports plus imports as a percentage
of GDP) and import duties (import revenues as a percentage of total tax rev-
enue). In this study we consider openness mainly because of its data avail-
ability. Finally, the real interest rate is also used empirically to determine the
RER determination. But whether it is a pertinent determinant of RER remains
inconclusive (Edison and Pauls 1993; Meredith and Chinn 1998). It is omitted
from this analysis partly because of this ambiguity and the absence of data for
different countries in the dataset. Moreover, the T-bill rate (the basic input for
real interest rate determination) in developing countries cannot be considered as
a market-determined rate, since it has been highly regulated by the respective
central banks from periodically in the past.
Based on the above discussion of RER and its determinants, a panel data
analysis is conducted to empirically measure the effect of FDI on the RER while
controlling for other important factors for RER determination. This empirical
analysis utilizes the following basic formulation:

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 Foreign Capital Inflow and Real Exchange Rate Appreciation 461

RERit ¼ β1 þ β2 FDIit þ β3 GYit þ β4 GCit þ β5 OPENit þ β6 TOTit þ uit ½10

 
where i ¼ 1, 2,…, 12 and t ¼ 1, 2,…, 32 and E ðuit Þ,N 0; σ 2u . The RER index is
Consumer Price Index in IMF-IFS database. Note here we have not calculated
RER rather we are collected the RER series directly from the IMF-IFS database.
This is because calculating the RER empirically is a debatable topic and it is
beyond the scope of the present study. FDI is the FDI inflow as a percentage of
GDP; GC is the general government final consumption expenditure as a percen-
tage of GDP, OPEN is a measure of openness which is the sum of exports and
imports of goods and services measured as a share of GDP (World Bank online
data library, 2013). All variables are expressed in natural logarithms, except FDI
and GY, so that the estimated coefficients are interpreted as elasticities. The
variables along with their data sources used in this econometric analysis are
described concisely in Table 1.

Table 1: Variable definitions and sources

Variable Variable definition Sources

RER Real effective exchange rate International Financial Statistics-IMF

(Concept code: EREER)
FDI Foreign direct investment as a percentage World Development Indicator-Online
of GDP Database
GY Growth rate of gross domestic product World Development Indicator-Online
(GDP) per capita Database
GC General government final consumption World Development Indicator-Online
expenditure as a percentage of GDP Database
TOT Net barter terms of trade World Development Indicator-Online
Database
OPEN Openness as measured by export plus World Development Indicator-Online
import as a percentage of GDP Database

The empirical estimation is based on the annual data for each country on the
above six variables for the period 1980–2011. Thus, there are 12 cross-sectional
units and 32 time periods. In all, therefore, we have 384 observations. Many East
Asian countries are not considered in the dataset mainly because of the flows of
foreign capital that tumbled following the onset of the East Asian crisis in the
second half of the 1990s. We have considered only FDI among different forms of
foreign capital inflows (i.e. foreign portfolio investment) because of three rea-
sons. First, FDI constitutes the biggest part of capital flows in recent years
probably because of the favorable treatment of FDI as a long-term investment

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462 A. Biswas et al.

from the government of the developing countries. Second, FDI has a tendency to
concentrate more in the tradable sector for developing countries. Third, FDI is
generally less volatile compared to other foreign capital flows.
At the outset, eq. [10] is estimated with ordinary least squares on pooled
time-series cross-section data. Thereafter, we have considered a fixed effect (FE)
model [10a] by adding dummy for each country so that we are able to estimate
the pure effect of the explanatory variables on the RER by controlling for the
unobserved heterogeneity.

RERit ¼ β1i þ β2 FDIit þ β3 GYit þ β4 GCit þ β5 OPENit þ β6 TOTit þ uit ½10a

Each dummy (β1i Þ is absorbing the time-invariant effects, if any, particular to

each country. Since our group of countries is diverse we have a reason to believe
that differences across countries may have some influence on the RER therefore
we proceed by considering a random effect model [10b]. The results are reported
in Table 2.

Table 2: Panel data analysis: RER determination

Variables OLS (pooled) FE RE

FDI −0.035*** −0.056** −0.054***

(5.73)a (3.61) (3.64)
GY −0.018 −0.007 −0.008
(1.53) (0.64) (0.70)
GC −0.022** −0.025 −0.025
(2.31) (1.56) (1.54)
OPEN 0.025* 0.028 0.026
(1.68) (0.59) (0.60)
TOT −0.016 −0.025 −0.024
(1.24) (0.71) (0.69)
Constant 4.881*** 4.926*** 4.926***
(49.37) (22.00) (20.05)
a
t-Value (corresponding to robust standard error) in parentheses.
***Significant at 1% level. **Significant at 5% level. *Significant at
10% level.

RERit ¼ β1 þ β2 FDIit þ β3 GYit þ β4 GCit þ β5 OPENit þ β6 TOTit þ ei þ uit ½10b

where ei is a random error term with a mean value of zero and variance of σ 2e .
All panel data regression models pass the standard F test for overall sig-
nificance at the 1% level. Since we have used the time-series cross-section data

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 Foreign Capital Inflow and Real Exchange Rate Appreciation 463

for different countries, the residuals might be suffered from heteroskedasticity

problem and it is corrected by providing t-value based on heteroskedasti-
city corrected robust estimation method. The impact of FDI on the RER is largely
consistent with our analytical model. The estimated coefficient of the FDI in the
RER equation is negative and statistically significant for all the three panel data
models, whereas none of the control variables are statistically significant in the
FE and RE models.
To decide between the FE and RE for the appropriate model particular to our
dataset, we conduct a Hausman test where the null hypothesis is the preferred
model is RE model and we found that we failed to reject the null. Thereafter we
proceed by conducting the Lagrange Multiplier (LM) test for the panel effect with
the null hypothesis that the variance across countries is zero and the result
indicates that we failed to accept the null hypothesis and that substantiate
our empirical analysis with panel data instead of considering separate OLS
regression for each country.
Moreover, the differences among the three approaches in this study are
modest. This result suggests that, on average, a 1% increase in FDI across time
and between countries causes about 0.05% overall appreciation in the RER. To
check the robustness of these empirical findings, we also halved the dataset into
two subsamples starting from 1980 to 1995 and 1996 to 2011, and we found very
similar results.6 These results based on the panel data provide strong support to
the hypothesis that the foreign capital inflow causes RER appreciation, and the
consideration of the other conventional determinants of the RER does not impact
our hypothesis of the positive relationship between RER and FDI across
countries.

3 Conclusions
This study provides with a plausible explanation why countries allowing foreign
capital in the export sector experience an appreciation of RER. Here we have
argued that the inflow of foreign capital puts it mark on factor prices and hence
even in a competitive setup with a nontraded good may enjoy an increase in
the price of nontraded commodity. This is not channelized through equilibrium
price determination via demand–supply equality, rather more interestingly it is
directed by factor prices. We have also shown that inflow of such capital may
not guarantee an expansion of export sector. However, any developing

6 For the sake of brevity we did not report those results.

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464 A. Biswas et al.

economies flooded with huge labor supply is likely to observe the desired
expansion as labor price should not rise to a considerable extent to offset the
benefit bestowed by an increase in capital specific to exportable sector.
There are some areas for further research. Because of the data unavailability
for the FDI in export enclaves for developing economies, we use the FDI in an
economy as a proxy for FDI in the enclave. More accurate data on FDI in the
enclave should be used to test the hypothesis about the relationship between
FDI in the enclaves and the RER. Although this study captures the impact of an
increase in FDI in a country’s export sector only to promote capital-intensive
exportable goods in a general equilibrium framework, it lacks the intertemporal
effect which is another possible way to extend the current paper.

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