DFI components: Relationships to exchange rate changes

Direct foreign investment (DFI) is distinguished from portfolio or indirect foreign investment in that it involves the ownership and control of business enterprises in foreign countries. In the literature, DFI is treated as a single capital flow rather than the aggregate of three distinct capital flow components--equity outflows from parent to foreign subsidiary, reinvested earnings of the foreign subsidiary's income, and debt outflows from parent to foreign subsidiary. Numerous empirical studies have been performed to identify the determinants of DFI flows. However, the influence of some DFI determinants may have been underestimated because studies have analyzed the total flow rather than the component flows. For example, a determinant could produce a significant positive change in equity outflows, a significant negative change in debt outflows, and no significant change in reinvested earnings. The total DFI flow from one period to the next would indicate no change in response to the determinant when, in fact, the composition of the DFI flow was significantly altered. Except for an earlier study by the authors, "The Effect of Exchange Rate Changes on the Composition of Direct Foreign Investment" (1994) a review of the literature revealed no research to identify the determinants of the three component capital flows. Statistics provided by the BEA currently include two methods of classifying DFI for the period 1982-1988. Prior to the availability of data under the new classification method, a study was performed by the authors using data under the old classification scheme. Under the former classification scheme, gains or losses due to changes in exchange rates were included in the reinvested earnings component of DFI. Under the reclassification methodology, the translation adjustment is no longer included as part of DFI components, but is included in the valuation adjustments figure. The purpose of this study is to re-examine the affect of exchange rate changes on the composition of DFI under the new classification scheme. This study replicates the methodology of the earlier study by the authors and compares the results using the former and current Department of Commerce calculation of DFI. DFI flows move from parent to foreign subsidiary; therefore, the composition of the DFI flow is assumed by the authors to be controlled by the parent. The DFI from parent to foreign subsidiary may be treated as a portfolio of three types of investment. It is asserted in this study that a change in exchange rate will alter the parent's preference for the types of investment and rebalancing will occur. The following three hypotheses will be tested and compared with the results from the earlier study. H~: The proportion of equity outflows to direct investment capital outflows will increase (decrease) in response to appreciation (depreciation) of the parent's currency relative to the currency of the foreign subsidiary. This is expected because ownership in the foreign subsidiary becomes less expensive as the parent's currency strengthens and more expensive as the parent's currency weakens.