The heterogeneous sectoral productivity impacts of FDI on real exchange rate

Abstract

The Balassa-Samuelson effect provides a theoretical explanation for the deviation of the real exchange rate (RER) from its purchasing power parity based on the heterogeneous productivity growth in the tradable and non-tradable sectors. This paper bridges the literature on foreign direct investment (FDI) spillovers with the Balassa-Samuelson effect by theoretically and empirically showing that (1) the productivity impact of inward FDI is notably larger in the tradable sector than in the non-tradable sector, generating an appreciation effect on the RER; (2) the magnitude of heterogeneous productivity impacts of inward FDI in the tradable and non-tradable sectors is commensurate with the technological backwardness in the two sectors relative to the world leaders.

KEYWORDS:

• Tradable and non-tradable sectors
• real exchange rate
• foreign direct investment
• productivity impacts

JEL Classifications:

• F21
• F31
• F43

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 See for example: Adler and Lehmann (1983), Abuaf and Jorion (1990), Frankel and Rose (1996), Sarno and Taylor (2002), Pelagatti and Colombo (2015).

2 The data are available on https://www.oecd-ilibrary.org/science-and-technology/oecd-science-technology-and-industry-scoreboard-2017/r-amp-d-intensity-by-industry-2015_sti_scoreboard-2017-graph122-en

3 Mainly we use the classification in Kakkar and Yan (2014). For the industries not classified in Kakkar and Yan (2014), we use Hlatshwayo and Spence (2014) to do the classification as a complement.

4 T for the tradable sector and N for the non-tradable sector.

5 Here we use the first order Taylor expansion of ln(1+x) at x = 0, which is ln(1+x) ≈ x. When applying this on equation (8(8) $e_{i,US}=P_i/E_{i,US}{P}_{US},$(8) ), we choose one of the two cases in the equation. This will not affect the final result.

6 Difference in technological difference is found to be a key determinant of difference in labor productivity (Santacreu 2015).

7 The data that support the findings of this study are available from the corresponding author upon reasonable request.

8 We source bilateral geographic distance data from the CEPII database.

9 We use the total patent grants (direct and PCT national phase entries).

10 Long run interest rate differential is the difference of the real interest rate between the host country and the US, data of which are taken from the International Financial Statistics (IFS). This has an impact on the real exchange rate, since the shock from monetary side may affect the real exchange rate (Kakkar and Yan 2014).

Additional information

Funding

Isabel acknowledges research support from the Strategic Research Grant (SRG) from City University of Hong Kong, the Global Research Unit (GRU) of the City University of Hong Kong, and the Hung Hing Ying and Leung Hau Ling Charitable Foundation.