RELATIONSHIP BETWEEN EXCHANGE RATE VOLATILITY AND FOREIGN DIRECT INVESTMENT IN KENYA

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ABSTRACT

The purpose of the study was to assess the relationship between exchange rate volatility and foreign direct investment in Kenya   between the year 2013 to 2017. Kenya, like other developing countries, can on count foreign direct investment as one of the crucial factors in determining its economic growth. Foreign direct investment is essential to a developing economy if it can effectively absorb its spill-over effects.

The study results indicated that average total foreign direct investment remittances from different sectors of economy remained steadily between 2013 and 2015 with a slight decrease between 2014 and 2015 followed by a sharp increase between 2014 and 2016.

The per capita income increased significantly between 2013 and 2014 with a stead movement between 2014 and 2016 while exchange rate measured by Kenya shilling compared to Dollar fluctuates upward between 2013 and 2017 with the highest point been in 2015 and lowest rate recorded in 2013. The findings show that inflation rate recorded an increase between 2013 and 2015 with a slight drop in 2014.

The findings also found that there exists a strong relationship between exchange rate and total foreign direct investment remittances; total foreign direct investment remittances were found to be strongly affected by the inflation rate increase.

 

TABLE OF CONTENTS

DECLARATION.......................................................................................................... ii

ACKNOWLEDGEMENT.......................................................................................... iii

DEDICATION............................................................................................................. iv

TABLE OF CONTENTS............................................................................................. v

LIST OF FIGURES................................................................................................... viii

LIST OF ABBREVIATIONS..................................................................................... ix

ABSTRACT.................................................................................................................. x

CHAPTER ONE........................................................................................................... 1

INTRODUCTION........................................................................................................ 1

1.1  Background of the Study........................................................................................ 1

1.1.1  Exchange Rate Volatility................................................................................... 2

1.1.2  Foreign Direct Investment.................................................................................. 3

1.1.3  Foreign Exchange Rate Volatility and Foreign Direct Investment.................... 5

1.2  Research Problem...................................................................................................... 8

1.3  Research Objective.................................................................................................. 10

1.4  Value of the Study.................................................................................................. 11

CHAPTER TWO........................................................................................................ 13

LITERATURE REVIEW.......................................................................................... 13

2.1  Introduction............................................................................................................. 13

2.2  Theoretical Review.................................................................................................. 13

2.2.1  Purchasing Power Parity Theory....................................................................... 13

2.2.2  International Fisher Effect............................................................................... 15

2.2.3  Interest Rate Parity........................................................................................... 16

2.3  Determinants of Foreign Direct Investment............................................................ 17

2.3.1  Inflation............................................................................................................ 18

2.3.2  Economic Growth............................................................................................ 19

2.3.3  Exchange Rates................................................................................................ 19

2.4  Empirical Review.................................................................................................... 20

2.5  Conceptual Framework........................................................................................... 25

2.6  Research Gap........................................................................................................... 25

2.7  Summary of the Literature Review......................................................................... 26

CHAPTER THREE.................................................................................................... 27

RESEARCH METHODOLOGY.............................................................................. 27

3.1  Introduction............................................................................................................. 27

3.2  Research Design...................................................................................................... 27

3.3  Data Specification................................................................................................... 27

3.4  Data Collection........................................................................................................ 27

3.5  Data Analysis........................................................................................................... 28

3.5.1  Analytical Model.............................................................................................. 28

3.6.2 Tests of Significance........................................................................................ 29

3.7.1  Auto-Correlation Tests..................................................................................... 29

3.7.2  Multicollinearity Tests...................................................................................... 30

3.7.3  Multivariate Normality Tests............................................................................ 30

CHAPTER FOUR...................................................................................................... 31

DATA ANALYSIS, FINDINGS AND DISCUSSION............................................ 31

4.1  Introduction............................................................................................................. 31

4.2  Findings................................................................................................................... 31

CHAPTER FIVE........................................................................................................ 40

SUMMARY, CONCLUTION AND RECOMMENDATIONS............................. 40

5.1 Introduction............................................................................................................. 40

5.4  Recommendations for the Policy............................................................................ 41

5.5  Limitations for the Study........................................................................................ 42

5.6  Suggestions for Further Study................................................................................ 42

REFERENCES........................................................................................................... 44



 

LIST OF TABLES

Table 4.1 Descriptive Statistics..................................................................................... 31

Table 4.2 Correlation Analysis....................................................................................... 36

Table 4.3 Model Summary............................................................................................ 37

Table 4.4 Anova Analysis.............................................................................................. 38



 

LIST OF FIGURES

Fig. 2.1     Conceptual Framework..................................................................... 25



 

LIST OF ABBREVIATIONS

FDI              Foreign Direct Investment

IFE              International Fisher Effect

CBK            Central Bank of Kenya

PPP             Purchasing Power Parity

IRP              Interest Rate Parity

MNC           Multi-national Companies

OECD         Organization for Economic Corporation and Development

KNBS          Kenya National Bureau of Statistics

GDP            Gross Domestic Product

UNCTAD       United Nations Conference on Trade and Development

USD            United States Dollar

KES             Kenya shillings

SPSS           Statistical Package for the Social Sciences

USA            United States of America

UK              United Kingdom



 

 

CHAPTER ONE

INTRODUCTION

1.1       Background of the Study

Kenya, like other developing countries, can on count foreign direct investment as one of the crucial factors in determining its economic growth. Foreign direct investment is essential to a developing economy if it can effectively absorb its spill-over effects. FDI is a significant source of capital inflows with the positive impact on the host country's economy through direct technology transfer, technological spillover, human capital formulation, international trade integration, and competitive business environment (OECD, 2002). However, the macroeconomic environment in the host country must be attractive to foreign investment, and one of the main factors of the operational monetary policy regime are exchange rates of its currency against other foreign currencies. Kenya liberalized her exchange rate market in the early 1990s, though this has done little to boost FDI inflows. The exchange rate has been volatile over the free regime with fluctuations pitting the shilling at historical highs and lows against foreign currencies (Mishkin & Eakins, 2009).

The current account balance of a host country can be viewed as an indicator of the strength of its currency. A deteriorating current account balance is likely to lead to a depreciation of the hostess country's currency. It is possible that potential multinational investors view current account deficits negatively because such deficiencies may lead to inflation and exchange rate variations. If this is the case, then an increase in the current account deficit may lead to a reduction in FDI inflows. 

In contrast, if multinational companies take advantage of the current account deficits of the host country by negotiating more favorable operative terms, then the current account deficits may increase FDI inflows (Mishkin & Eakins, 2009).

Kenya has had a long history with foreign firms dating back to the 1960s. For years Kenya has been seen as an attractive destination for foreign investors seeking to invest in the greater East and Central Africa region. It serves as the East African business hub for many international companies like General Motors, Proctor & Gamble, Microsoft, Google, Ogilvy and Mather, Coca-Cola and Citibank among others. Foreign investors control 51% of the total banking assets in the country (CBK, 2015). Kenya has been seen as a favorable hub for the region because of its connectivity to global hubs, its skilled and educated workforce, advanced financial system, developed infrastructure, and strategic regional trade memberships and partnership agreements (Ryan, 2006).

 

1.1.1   Exchange Rate Volatility

For currencies to trade in a common market, one currency must be expressed in terms of the other. An exchange rate is the price of one currency in terms of another (Mishkin & Eakins, 2009). They can either be direct or indirect where by a direct quotation refers to how much of the home currency  is required to buy a unit of the foreign currency while an indirect reference refers to how much a unit of the foreign currency can be obtained for a unit of the home currency (Howells & Bain, 2007). The exchange rate is referred to as the nominal exchange rate when inflation effects are embodied in the rate and as the real exchange rate when inflation influences have not been factored in the rate (Lothian & Taylor, 1997). Before 1972, all countries of the world were operating a fixed exchange rate regime where each country currency had affixed exchange rate relative to the USD. 

The significance of the exchange rate is that it allows a continuous adjustment of the exchange rate in line with the demand and supply conditions of foreign exchange in the economy. It equilibrates the demand and supply of foreign exchange by changing the exchange rate rather than the level of reverse. It allows the country to pursue its monetary policy without having to be overly concerned about the balance of payments effects. External shocks and imbalances are reflected in exchange rate movements rather than in reserve movements or Central Bank intervention to control the adjustment process (Ndungu, 2000). The exchange rates are primarily driven by market supply and demand. Using the flexible exchange rate system regime, the price of currencies is determined by the supply and demand of the currency in the forex market.

 

1.1.2   Foreign Direct Investment

The common goal of all businesses is wealth maximization and companies will seek all ways to remain profitable and increase shareholders’ wealth. Muema (2013) defined FDIs as investments that are meant to be long lasting and those that are outside the economic or physical boundaries of the investor. The beneficiary country of FDI will gain with the capital flow as well as technology flow that will aid in its development. When a nation seeks to invest in another, the benefit it aims to achieve must be higher than the risks it must deal with. UNCTAD (2002) describes three different types of FDI. These are: equity capital, reinvested earnings and other capital which mainly consist of intercompany loans. FDIs create new job opportunities as upon setting of the business, recruitment, and training of the locals in the host country is undertaken transferring skills and technological knowhow as well as providing jobs. According to Kinuthia (2010), FDI usually represents a long-term commitment to the host country. It is a preferred form of investment because it has no obligations to the host country.

FDI plays a vital role in the up gradation of technology, skills and managerial capabilities in various sector of the economy that would be difficult to generate through domestic savings, and even if it were not, it would still be difficult to import the necessary technology from abroad, since the transfer of technology to firms with no previous experience of using it is difficult, risky, and expensive (Olson, 2008). FDI creates many externalities in the form of benefits available to the whole economy which the host countries cannot appropriate as part of their own income. FDI is important for developing countries as it makes available the resources that could bring about an optimal level of economic development (Ismaila & Imoughele, 2010). This is because their economies are plagued with problems associated with low domestic savings, low tax revenue, low productivity and limited foreign exchange earnings.

A country’s appeal for FDI is affected by changes in restrictions, that includes removal of government barriers to trade as well as privatization whereby some governments sell off some of their operations to corporations and other investors. Potential economic growth is also a factor that affects a country’s appeal for FDI as countries that have greater potential for economic growth may enable the firms to be able to capitalize on that growth by establishing business there. Exchange rates and tax rates are also factors that affect a country’s appeal for FDI. Low tax rates on corporate earnings are more likely to attract FDI while firms prefer to direct FDI to countries where the local currency is expected to strengthen against their own.


1.1.3   Foreign Exchange Rate Volatility and Foreign Direct Investment

A company that seeks to invest in another will always seek out a host country that has a local currency that will be expected to strengthen against their own. Madura and Fox (2011) argue that a firm will invest funds in a country whose local currency is currently weak in order to earn from new operations that will be periodically converted back to the firm’s currency at a more favourable exchange rate. Exchange rate movements affect FDI values because they affect the amount of cash inflows received from their investments and the amount of cash outflows needed to pay to continue operating these investments.

Currencies appreciate and depreciate according to prevailing market conditions. Firms that have operations in other countries other than their mother countries must understand the forces that cause exchange rates to change over time in order to gauge how currencies may be affected by these forces and in so doing be in a position to mitigate these losses.

Theoretically, exchange rates affect FDI because the rate at which one currency is expressed in terms of another will determine how viable an investment will be. In determining exchange rates, the factors that influence how much of a currency will be exchanged for another will ultimately determine how much of FDI will be invested in a country. The two cannot be held in isolation as FDI is determined by how much of a currency is available for use. An investor will identify a country that will enable him to gain in expressing his currency in terms of the host currency. The theories that explain the determination of exchange rates will help to determine how these exchange rates affect FDI in a country. The cost of goods in one country as determined by the amount of money that a particular currency will enable an investor to seek a country that will provide the best exchange rate (Madura & Fox, 2011).

Madura and Fox (2011) assert that demand and supply of currencies is price driven and at any point in time, a currency should exhibit the price at which the demand is equal to that currency in order to represent the equilibrium exchange rate. Exchange rates therefore affect FDI in that when a currency, expressed in terms of another loses its value relative to the currency of the foreign country, investors will be attracted to that host country because it will be cheaper to operate in that host country. The relationship that exists between exchange rates and FDI being that if a currency loses its value, FDI is expected to increase while if a currency gains value, FDI is expected to reduce (Madura & Fox, 2011).

In international transactions, country and currency risks are encountered. Country risk occurs when financial claims and business contracts become unenforceable while currency risks occur when the values of currencies fluctuate relative to each other. Foreign exchange markets developed in order to enable the conversion of cash to different currencies to be able to transact (Kidwell et al., 2008). There is no physical location for the foreign exchange market in Kenya as no physical goods are being exchanged at any given time, preferably it is an over the counter market, a linkage of bank currency traders. Mishkin and Eakins (2009) define a foreign exchange market as a place of trading of currencies and bank deposits.

It encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, international trade financing, trading in foreign currency options and futures contracts, and currency swaps (Eun & Resnick, 2009). These transactions ultimately determine the rate at which currencies are exchanged and will, in turn, determine the cost of purchasing foreign goods and financial assets.

Trading that occurs in the foreign exchange market will determine the rate at which an investor will trade his foreign currency to invest in Kenya. The Central Bank of Kenya Act, Cap 491, Section 28, provides that CBK may engage in foreign exchange transactions with authorized dealers, public entities, foreign central banks as well as foreign governments or their agencies as well as international financial institutions and any other person or body of persons who may be gazetted for that purpose.

FDI in Kenya is covered in all the sectors, be it in the banking, automobile or telecommunications sector. Various multinational companies have set up operations in Kenya, and they include Car and General, Coca-Cola as well as communication firms like Airtel. In every aspect of our lives, FDI is felt that is in the goods and services that we use. FDIs are not in isolation as they have provided jobs and with them, technical knowledge as they train their Kenyan employees to maintain the standards that are there in their other investments all over the world. They are the major source of foreign exchange to the country. FDI has not been consistent over the years with some periods recording low inflows. In the 1980s and 1990s, FDI inflow was low due to deterioration in economic performance as well as rising problems of poor infrastructure and the high cost of living greatly impacted negatively on FDI inflows in Kenya (KPMG, 2012). In total, Kenya has more than 200 multinational companies across the sectors with Britain, USA, Germany, South Africa, Netherlands, Switzerland, China and India being the main traditional sources of FDI (Kinuthia, 2010).

Kenya serves as the East African business hub for many international businesses. This translates to a dependence of FDI for capital inflow that in turn reflects on provision of jobs and an economy that is helped to grow by these foreign investments. Kenya’s FDI average growth between 2007 and 2015 was forty percent (40%) with the inflows primarily going into retail and consumer products, telecommunications, technology, media, minerals, oil and natural gas sector mainly from   the UK, USA and India (Ernest & Young, 2015). This growth rate earned Kenya the status of a FDI hotspot joining Ghana, Mozambique, Zambia, Tanzania, Uganda, Nigeria and Rwanda. In 2015, FDI inflows stood at USD 1076.9 million (KES 105.29 billion), up from USD 670 million (KES 65.51 billion) a year earlier which is a sixty per cent (60%) increase. This capital mainly went to oil, gas and the manufacturing industries (UNCTAD, 2015).

 

1.2       Research Problem

When a country opens its borders for people with different ideas, the host country gets a chance to  learn new ways of doing things. Wealth is transferred not only through the exchange of goods and services but also through the exchange of ideas, exchange of technology and the exchange of workforce. FDI, which involves the investment of assets in a host country subjecting it to the laws of that land, seeks to provide a country such as Kenya with its many advantages. One of the determinants of FDI is the exchange rate. A nation whose currency is weaker compared to that of the foreign country will make it attractive as the costs of production are bound to be cheaper than in the FDI’s home country.

When a currency, for example, a dollar, is exchanged at the current rate, it will give KES 101.3972 (CBK, 2016) that will enable the firm to pay for the goods and services it requires to set up business in Kenya. This rate is beneficial to the firm as it gets more shillings for fewer dollars thereby making Kenya an attractive location for FDI. This should be the idea that because one dollar provides more shillings, investors in the United States should be flocking to Kenya to take advantage of the exchange rate provided. This has not been the case observed. The foreign exchange market is expected to maintain a balance between attracting FDI and ensuring that the local currency is able to keep its strength in a bid to ensure that the cost of living does not escalate to a point whereby the gains of FDI are used to offset poverty.

Exchange rates as one of the determinants of foreign direct investment are one of the reasons that a foreign investor would seek to invest in Kenya, mostly that the Kenyan shilling should be weaker than the currency of the home of the foreign investor. What is in question is the price the country has to pay to attract these investments and whether the benefits outweigh the costs associated with   them. If a currency is weaker, is it evident that FDI will flow into that country? This has not been researched on. Once FDI has been attracted, it is expected to help the economy grow and with its growth, a stronger shilling is supposed to be a characteristic of a country with FDI. This is far from   what the country has experienced. Despite being home to many FDIs, the currency has not vastly improved. The exchange rates have been skewed to enabling FDIs to thrive which in reality has not been observed. Kinuthia (2010) finds that FDI is a critical element in the reduction of poverty levels in developing countries. He further attests that those factors that are favorable to domestic investment are often likely to propel FDI. This would in effect mean that a weak currency, as a determinant of FDI should also encourage local investments.


Currencies tradings at the foreign exchange market determine the exchange rates to be used as the market is expected to decide which currency is demanded more than it is supplied. The arrival of FDIs would imply that more shillings are required to buy assets as well as set up operations in Kenya. The high demand would be countered by the need for foreign currencies when remitting revenue after activities. As such market forces would determine the exchange rate was holding all other factors constant. This would be the ideal whereby the exchange rates would imply that there will be a significant rise in FDI in a country. Unfortunately, this has not been witnessed. The question that arises therefore is to what level do exchange rates determine FDI?

Ideally, FDI should aid the host country to benefit from the capital invested as well as technological   advancements at the expense of a weaker currency. The current situation is that despite the Kenyan   currency’s decline, there has not been any record of any new FDI. It is evident that there exists a gap. This study seeks to ascertain why there is a deviation from the ideal and the effects of this deviation on the foreign exchange market in Kenya. What has been the role of exchange rates on the declining FDI? While there have been studies on the determinants of FDI (Kinuthia, 2012; Muema, 2013), on the other hand, Otieno (2012) focused on the impact of exchange rate fluctuations on FDI. No known study has been undertaken to determine the relationship between exchange rates and FDI in Kenya. The question that this study seeks to answer is, to what extent do exchange rates influence on FDI in Kenya?

 

1.3       Research Objective

1.3.1  The objective of this study is to establish the relationship between the exchange rate volatility and foreign direct investment in Kenya.

1.3.2   Specific Objectives

i.          To identify how the inflation rate affects the valuation of the national currency.

ii.         To determine the impacts of foreign exchange rate volatility on foreign direct investments.

iii.    To determine how imports and exports trade affects the exchange rate in Kenya.

iv.    To identify the significant factors that affect the levels of foreign direct investments, Gross domestic product and national income of the Kenyan economy.

 

1.4       Value of the Study

The findings are hoped to be of benefit to policymakers in developing investment strategy policies and developing the necessary institutional framework necessary to market Kenya as an ideal foreign investment destination. It will also help them in coming up with monetary policies that ensure exchange rate stability thus protecting the profit margins and net present values of current and potential investors alike.

The government also stands to benefit from this study as it would be able to understand the factors underlying the dismal performance in the FDI sector specifically exchange rate volatility. This indeed would help it come up with marketing strategies especially under the brand Kenya initiative to actively market the country as the FDI destination of choice while addressing the factors that would curtail this noble initiative i.e. exchange rate volatility. It would also try to contain the political situation in the country which has for a long time impacted negatively on the exchange rates and by extension FDI inflows into the country.

The results of this study would also be invaluable to researchers and scholars, as it would form a basis for further research. The students and academicians would use this study as a basis for discussions on relationship between exchange rates and FDI in the country and Africa as a region. The study would be a source of reference material for future researchers on other related topics; it would also help other academicians who undertake the same topic in their studies.


 

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