Effect of exchange rate volatility on foreign direct investment in East Africa

Abstract

The aim of this study was to dete1mine the impact of exchange rate volatility on Foreign Direct Investment (FDI) inflows into the East African region. The countries studied include Kenya, Uganda, Tanzania and Rwanda. The study period was 2001-2016. The Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model was used to obtain the exchange rate volatility while the Vector Error Connection Model (VECM) was used to study the relationship between exchange rate volatility and FDI. The results reveal that in the short-run, exchange rate volatility and FDI have a negative significant relationship. However, in the long-run, the relationship is positive but insignificant. Other factors such as infrastructure are found to have a positive relationship with FDI both in the short-run and in the long-run. However, the relationship is only significant in the long run. Trade-openness is found to have a negative and significant relationship with FDI. Political stability, Interest rates and GDP exhibit an insignificant relationship with FDI. The main policy recommendation from this research is that the governments of East African countries should aim to maintain low exchange rate volatility in the short-run. It is also important for policy makers to coordinate the policies promoting trade openness and those promoting competitiveness of local products so as to attract FDI.