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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