Exchange-Rate Volatility and Foreign Investment in an Emerging Economy

Abstract

This article investigates whether there is an inverse relationship between fluctuations in a nation's exchange rate and the flow of foreign direct investment into the country. The significance of the question lies in the fact that developing economies are vying for access to a shrinking pool of long-term international capital, and that Pakistan has seen an increasing number of instances of exchange-rate pressures, reserve stress, and policy adjustments. The paper presents an empirical design that is transparent and based on the GARCH model, using official data from the State Bank of Pakistan. Data on annual net FDI flows are supplemented by monthly nominal and real effective exchange rate indices for the period January 2013 to December 2023. Realized volatility, GARCH(1,1) conditional volatility, and an asymmetric GJR-GARCH specification are used to measure exchange-rate risk. These currency-risk indicators for the fiscal years are then linked to FDI using both static and robust models that account for thresholds and event analysis, confidence intervals calculated via a bootstrap technique, a dynamic growth specification, and asymmetric depreciation/appreciation measures. The results show that Pakistan's currency market is highly volatile and persistent. The coefficient estimates for the low-volatility years are statistically fragile, as the matched sample is short and low-volatility years have lower average FDI and lower average FDI growth than high-volatility years. Focusing solely on the exchange rate level, the article suggests a more conservative view of the effect of currency risk: investors do not seem particularly deterred by it. As for the policy implications, Pakistan is required to place greater emphasis on establishing a credible reserve management system, transparent communication on foreign exchange, developing the hedging market, establishing predictable profit-retention rules, and facilitating sector-level investment. The results add to the existing FDI literature on macroeconomic uncertainty by demonstrating the application of currency risk measurement based on a GARCH model to investment analysis in Pakistan.

Keywords: Exchange-Rate Volatility; Foreign Direct Investment; Pakistan; GARCH; GJR-GARCH; Currency Risk; Investor Confidence