Asia Pacific Journal of Marketing and Logistics

Impacts of Currency Fluctuations on Japanese Foreign Direct Investment

Doren D. Chadee Don Crow
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 Impacts of Impacts of Currency
Currency
Fluctuations on Fluctuations on Japanese
Japanese Foreign
Direct Investment Foreign Direct Investment
Doren D. Chadee, Department of International Business, The University of
Auckland, New Zealand and Don Crow*, School of Business, Auckland
Institute of Technology, New Zealand

Abstract

The Japanese currency has appreciated substantially against most other

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currencies over the last two decades. During the same time Japan has become
one of the world's largest providers of FDI. Japan's share of total FDI
outflows increasedfromabout 6 percent during the late 70's to 21 percent in
1990 while its share of the total stock of FDI in the world increasedfromless
than 1 percent in 1960 to more than 13 percent in 1993. Not surprisingly,
Japan's role in international business in general and its FDI activities, in
particular, have attracted considerable attention from researchers world
wide. However, much of this attention has been directed towards the patterns
and determinants of Japanese foreign direct investment, in particular to the
United States. The impact of changes in the value of the Yen on Japanese
FDI has been largely overlooked. Thus, this paper fills an important gap in
the literature by focusing on the influence of changes of the exchange rate
on Japanese foreign direct investment. A comprehensive simultaneous equa-
tion model of Japanese FDI is developed on a regional level to gauge the
extent to which currency fluctuations affect Japanese FDI activities. The
results suggest that the exchange rate is an effective mechanism through
which to influence FDI. Thus, the exchange rate should not be overlooked
by the World Trade Organisation in its efforts to further liberalise investment
through the Multilateral Agreement on Investment.

Keywords: Currency Fluctuations, Foreign Direct Investment

Introduction

Conventional wisdom and economic theory suggest that exchange rate

changes will lead to changes in the balance of trade. The basic argument is
that a currency appreciation, for instance, will increase the price of exports,
thereby decreasing the demand for exports. Similarly, imports become
relatively cheaper and leads to an increase in the demand for imports. Thus,
an appreciation of the domestic currency will likely lead to an increase in the
terms of trade as export prices increase and import prices decrease, thereby
increasing the trade surplus in the short -term.

40 APJML
 Based on this line of reasoning, numerous attempts have been taken to
adjust the value of the Yen as a means of controlling the Japanese balance Impacts of
of trade surplus between 1970 and 1990's. It should be noted that at the end Currency
of WWII in 1949 the value of the Yen was set at 360 Yen per US dollar as Fluctuations on
part of the Bretton Woods fixed exchange rate system. By 1971 Japan's trade Japanese Foreign
surplus with the United States had rapidly increased to US$4 billion. At the Direct Investment
same time the Bretton Woods system of fixed exchange rates collapsed
followed by a devaluation of the US dollar the same year. The resulting
Smithsonian Agreement reset the exchange rate to 308 Yen per US dollar; a
rate which proved difficult to maintain and the longstanding system of fixed
exchange rates was abandoned in 1973 as the major western industrialised
countries allowed their exchange rates to float (Army Area Handbooks,
1993).
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Concerns with United States' growing trade deficit with Japan, thought
to be due to the weakening of the Yen, led the G5 countries to adopt a policy
aimed at the appreciation of the Yen and the deutschmark relative to the
dollar in 1985. This agreement, termed the Plaza Accord, set a short -term
target of a 10% to 12% depreciation of the US dollar relative to the Yen and
considered that a further long-term depreciation of the dollar was also
desirable. Over a six week period each of the G5 countries used their foreign
exchange reserves to intervene in currency markets to achieve the desired
effect. As a result, the competitiveness of Japanese exports fell by 29% (Das,
1993). By 1987 the major currencies were within ranges which were consis-
tent with economic fundamentals and, with the Louvre Accord, the G5
countries agreed to work together to maintain exchange rates at approxi-
mately the currentlevels.Despite this agreement, the stock market crash later
that year led to a depreciation of the dollar and an appreciation of the Yen
(Das, 1993).

Japan has also made unilateral attempts to reduce its substantial trade
imbalance, using both monetary and fiscai policies. In the late 1980s an
easing of monetary policy was aimed at increasing domestic demand (and
imports) (Bergsten & Noland, 1993). Although demand increased substan-
tially, the low interest rates which were an element of Japan's expansionary
monetary policy in this period led to a depreciation of the Yen which more
than counteracted the effect of increased domestic demand on the trade
balance. The bubble economy which resulted from this monetary policy
eventually burst by acute monetary tightening, leading to a recession in the
early 1990s. This recession, coupled with the depreciating Yen, caused the
trade surplus to continue to grow. In the aftermath of the collapse of the
bubble economy the government switched to fiscai policies to stimulate the
economy and reduce trade imbalances. One effect of this was to increase
domestic interest rates, thereby leading to a renewed appreciation of the Yen
(Bergsten & Noland, 1993).

Asia Pacific Journal of Marketing and Logistics 41

 The adverse reactions of most western economies to the rapid increases
Impacts of in Japanese trade surpluses exerted pressure on Japan to diversify its mode
Currency of foreign market entry. Until the mid 1980's Japanese multinationals (MNE)
Fluctuations on relied primarily on exporting as a means of serving world markets. This
Japanese Foreign method of foreign market entry was remarkably successful as evidenced by
the substantial trade balance surpluses over that period. Following increasing
Direct Investment
pressure from its major trade partners to diversify its mode of foreign market
entry, Japanese MNE started to undertake more foreign direct investments
starting in the mid 1980's. The data in Figure 1 shows that the stock of
Japanese FDI since 1985 has grown exponentially.
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Clearly, one major instrument for controlling Japanese trade surpluses

over the last two decades has been through the exchange rate mechanism. As
discussed above, economic policy in Japan, the US, and other major countries
have focused on reducing Japan's trade surplus with the US (and most of the
rest of the world) and decreasing the US trade deficit by manipulating the
exchange rate. To some extent this approach has been successful with Japan's
trade surplus dropping by around 30% in the five years following the Plaza
Accord (Uchida & Ui, 1995). However, as Japanese trade surpluses decline
in the years following the Plaza Accord, Japanese outward foreign direct
investment (FDI) increased dramatically during the same time.

The information in Figure 1 show the stock of Japanese FDI and the
value of the Yen in terms of the US dollar. Clearly, the Yen has appreciated
consistently over the 1970 -1993 period. In 1970, the US dollar was worth
approximately 360 Yen. By 1993, the US dollar was worth only about 110
Yen; representing an appreciation of the Yen of approximately 70 percent.
During the same time, the stock of Japanese FDI has also increased substan-

42 APJML
 tially by about 3000 percent. Thus, an opportunity exists to investigate the
extent to which the appreciation of the Yen has contributed to the phenome- Impacts of
nal increase in Japanese stock of FDI. Currency
Fluctuations on
To date, only a few attempts have been made to analyse the effects of Japanese Foreign
the exchange rate on Japanese FDI. Iwamoto (1990), for example, analysed
Direct Investment
Japanese investment in the United States between 1977 and 1988 and used
the exchange rate as one of the explanatory variables. Neither this nor later
studies of Japanese FDI in the United States by Ray (1988), Mann (1993)
and Healy & Palepu (1993) were able to establish a significant relationship
between Japanese FDI and the exchange rate. On the other hand, Froot &
Stein (1991), did find that the appreciation of the Yen led to increased
Japanese FDI flows into the United States, and Crow and Chadee (1996)
found that both the current account balance and the exchange rate were both.
significant determinants of Japanese total FDI outflows.
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The relationship between the current account balance and FDI flows is
relatively straightforward. Concern with controlling foreign exchange re-
serves following World War II led the Japanese government to restrain FDI
outflows through legislation controlling foreign exchange transactions (Tak-
agi, 1995). In the early 1970s, when the current account balance seemed
destined to remain in surplus, the Japanese regulatory stance toward outward
FDI began to relax. Throughout the 1970s regulations controlling outward
flows of capital, including FDI, varied according to the direction of pressure
on the exchange rate. When the Yen was appreciating outward investment
was encouraged, and during periods of depreciation outward investment was
discouraged (Takagi, 1995). For example, when the value of the Yen in-
creased dramatically following the Plaza Accord in 1985 the Ministry of
International Trade and Industry (MITI) determined that a specific amount
of industrial investment abroad would be more beneficial than domestic
investment, in terms ofjob creation and long-term economic benefits, and
drafted a plan for restrucruring of Japanese domestic industry through FDI
(Doner, 1993).

Changes in the exchange rate also affect FDI flows. As described above,
the exchange rate affects the balance of trade which, in turn, stimulates
regulatory changes aimed at controlling FDI flows. Changes in the exchange
rate also have more direct affects on FDI flows. The most direct link between
the exchange rate and FDI is through the affect exchange rate changes on the
price of export goods. An appreciation of the Yen raises the cost of produc-
tion in Japan, thereby making many Japanese products less competitive in
world markets. Many firms, particularly those in declining industries, re-
spond to these competitive pressures by relocating to countries where pro-
duction costs are lower.

The appreciation of the Yen has also encouraged Japanese FDI indi-
rectly by creating a surplus in Japan's trade balance. Consequently, explicit

Asia Pacific Journal of Marketing and Logistics 43

 or implicit threats of new trade barriers from Japan's major trade partners
Impacts of increase. FDI is then undertaken as a means of circumventing anticipated
Currency trade barriers (Encarnation, 1986).
Fluctuations on Method
Japanese Foreign
Direct Investment The objective of this paper is to model Japanese stock of FDI on a regional
basis and assess the extent to which FDI is affected by changes in the
exchange rate. Following a Iiterature review and based on the availability of
data, we develop a simultaneous equation structural model of Japanese FDI
stock. The model developed attempts to estimate Japanese stock of FDI in
three major regions; namely the United States, Europe, and the rest of the
world. The focus of the present paper is to try to gauge the effect of changes
in the exchange rate on Japanese stock of FDI in the major western industri-
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alised countries. Japanese stock of FDI in the US and Europe accounts for
approximately 60 percent of the total stock of Japanese FDI in the world.

The analysis in this study is carried in the following four steps:

(1) specify and estimate appropriate econometric models for the
stock of Japanese FDI in the three regions under consideration.

(2) simulate these models to generate sample forecasts for the

relevant dependent variables in order to validate the models

(3) use the estimated models to generate forecasts of Japanese stock

of FDI for the three regions under consideration to the year 2000
under various exchange rate scenarios.
Modelling Japanese FDI

Most attempts to analyse FDI so far have focused on the determinants of FDI
from a firm perspective. Although this type of analysis provides valuable
information, it still does not provide a comprehensive picture. This is because
FDI is also highly influenced by external factors. Firm's decisions to invest
overseas are based on an understanding of the macro environment and its
effects on FDI and the business as a whole.

The conceptual approach to modelling the determinants of FDI at the

firm level has involved the examination of regression models of the follow-
ing forms:

FDI = f( X i ,c)

wherexiare firm-specific variables. Traditionally, the data used for empiricai

tests are cross sectional; usually collected across firms and sectors. Only few
attempts have been made to analyse Japanese FDI at the macro level.
Iwamoto (1990), for example, used time series data of Japanese investment

44 APJML
 in the United States between 1977 and 1988 and explicitly used the exchange
rate as one explanatory variable for FDI. Neither this nor later studies of Impacts of
Japanese FDI in the United States by Mann (1993) and Healy & Palepu Currency
(1993) were able to establish a significant relationship. On the other hand, Fluctuations on
Froot & Stein (1991), did find that appreciation of the yen led to increased Japanese Foreign
Japanese FDI flows into the United states.
Direct Investment
In this paper it is hypothesised that FDI follows the Nerlovian partial
adjustment process which assumes that there is an optimal, desired long run
amount of FDI. It is assumed that collectively firms aim to achieve a desired
stock of capital in their foreign investment portfolio at a given point in time.
This desired stock of FDI ( FDIt* ) is specified as a linear function of the
current account balance x as follows:
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FDIt* =B0+ B1xt + ut. (1)

However, because of inertia and uncertainty, the desired level of stock

of FDI is not always achieved. Thus, the gap between the actual stock of FDI
and the desired level cannot be filled immediately. Instead, in each period
the stock of FDI is partially adjusted as shown below:

FDIt - FDIt-1 = 6(FDIt* - FDIt-1) (2)

where FDIt is the actual FDI stock at time t and d is the coefficient of
adjustment.

Equation (2) postulates that the actual change in FDI in any given time
period t is some function δ of the desired change for that period. If δ = 1 it
means that actual stock of FDI is equal to the desired stock. If δ = 0 there is
no change in the stock of FDI over time. Typically δ will be between 0 and
1 since achievement of a desired level is likely to be incomplete because of
rigidity and contractual obligations.

Equation (2) can also be written as:

FDIt = SFDIt* + (1 - 8) FDIt-1 (3)

Rearranging and substituting (1) into (3) gives:

FDIt = δ B0 + δ B1xt + (1 - δ) FDIt-1 + δut (4)

Equation (4) is the partial adjustment model and represents the short run
demand for FDI. Once equation (4) is estimated, one can derive the long run
function, equation (1), by estimating the adjustment coefficient δ and com-
bining equations (1) and (4).

Asia Pacific Journal of Marketing and Logistics 45

 The econometric model of Japanese stock of FDI consists of three
Impacts of behavioural equations that explain Japanese stock of FDI in US, Europe and
Currency the rest of the world (ROW) respectively and follows the partial adjustment
Fluctuations on model of equation 4. The total stock of Japanese FDI is derived through an
Japanese Foreign identity. In all three equations, the stock of Japanese FDI is determined as a
Direct Investment function ofthe exchange rate lagged two years, the share market index lagged
one year, the Japanese current account balance with the particular region
lagged one year, a time trend to account for momentum in the accumulation
of FDI stock and a lagged dependent variable. The parameter estimate of the
lagged dependent variable is the adjustment coefficient (1 - 8).

The overall model is estimated using annual data for the period 1970
-1993. Given the structure of the model which assumes that FDI in one region
is influenced by FDI activities in other regions, we estimate the overall model
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using Zellner's seemingly unrelated regression technique (Zellner 1962).

The estimated econometric equations are summarised in Table 1:

The results in Table 1 shows that all explanatory variables have the a
priori expected sign and are also statistically significant at the 0.01 level in
most cases. The estimated coefficient of adjustments are 0.11,0.06 and 0.04
for the US, Europe and ROW respectively. This implies that on aggregate,

Table 1: Econometric Equations of the Stock of Japanese FDI: SUR Results-1970-1993

7. Japanese Stock of FDI in US

FDIUS,= -14.12 + 43.56XR+2+ 0.09 SHARE+1 + O.12CAB1+1 -0.48T + 0.89 FDIUS1-1
(4.0) (3.59) (5.11) (4.9) (2.59) (38.8)

DH = 2.11

2. Japanese Stock of DI in Europe

FDIEU,= -5.51 + 19.39 XR+2 + 0.04SHARE1-1 + 0.05CAB1-1-0.34T + 0.94FDIEU1-1
(3.5) (3.48) (5.13) (4.3) (3.98) (41.5)

DH = 2.7

3. Japanese Stock of FDI in ROW

FDIROW, = -2.96 +14.68XR+2+ O.036SHARE1-1 + 0.057 CAB1-1 - 0.01 T + 0.96 FDIROW1-1
(1.21) (1.81) (3.13) (3.36) (0.12) (34.1)

DH=2.7

4. Japanese Total Stock of FDI

FDITOT1= FDIUS +FDIEU + FDIROW

System Weighted MSE: 0.996 (df=48)

System Weighted R-Square: 0.998

Note: subscripts at the end of a variable denote an annual lag. T values are shown in parentheses.
DH is the Durbin-h value. Variable definitions are as follows: FDi,t = Japanese stock of FDI in US.
EU, ROW and TOT respectively; XR= the exchange rate (Yen per US dollar); SHARE= Japanese
share market index: CAB= the current account balance and T = time trend.

46 APJML
 Japanesefirmscan achieve 11,6 and 4 percent of the gap between actual and
the desired stock of FDI each period. Impacts of
Currency
The variable that this paper focuses on is the exchange rate. In all three Fluctuations on
equations, the exchange rate is statistically significant (p = 0.001) and also Japanese Foreign
has the right sign. It is worthwhile to point out that the exchange rate variable
used in the European equation is the US/Yen exchange rate. Several other Direct Investment
exchange rates which we thought were more relevant to European economies
were experimented with (for example a weighted average of the major
currencies of the 12 EU countries) but such composite indices did not
perform well.

Model Validation and Simulation

All equations estimated above explain the within sample variation of FDI
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stock quite well judging by the system R-Square and MSE. In addition,
dynamic simulations of these models also reveal that these models perform
reasonably well in tracking historical values of Japanese stock of FDI over
the sample period judging by the performance statistics summarised in Table
2:
Using the parameter estimates, the models are simulated under various
scenarios in order to assess the extent to which changes in the exchange rate
affect the levels of Japanese stock of FDI to the year 2000. The three
scenarios considered are:

Table 2: Within Sample Simulation Performance Statistics

Variable Definition MPE MAPE RMSE

FDIUS Japanese Stock of FDI in US 1.81 8.76 12.6

FDIEU Japanese Stock of FDI in EU 0.47 3.01 4.44
FDIROW Japanese Stock of FDI in ROW -0.18 5.62 8.22
FDITOT Japanese total Stock of FDI 0.30 2.77 3.93

MPE = Mean Percent Error; MAPE= Mean Absolute Percent Error; RMSE= Root Mean
Square Percent Error

Asia Pacific Journal of Marketing and Logistics 47

 Impacts of
Currency
Fluctuations on
Japanese Foreign
Direct Investment
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48 APJML
 (1) Scenario 1: This is the base scenario and assumes that the Yen
-dollar exchange rate remains constant from 1993 (the last year Impacts of
for which actual data is recorded) to 2000. This scenario is based Currency
on an assumption that the Japanese external adjustment is nearly Fluctuations on
complete (Yoshitomi, 1991) and that the 1993 exchange rate Japanese Foreign
reflects economic fundamentals that will prevail to the year Direct Investment
2000.

(2) Scenario 2: the Yen appreciates at an annual rate of 5 percent.

(3) Scenario 3: the Yen depreciates at an annual rate of 5 percent.

The results of these two latter scenarios are then compared to the base
scenario in order to assess the impact of changes on the exchange rate on
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Japanese stock of FDI. These comparisons are shown in graphical form in

Figures 2 - 5 .

Discussion of Results and Concluding Remarks

The forecasts generated through dynamic simulation show that, relative to

the base scenario, Japanese stock of FDI continues to increase under both
exchange rate scenarios. Under the first scenario where the Japanese Yen
depreciates by 5 percent annually, Japanese stock of FDI world wide in-
creases by a corresponding 5.7 percent annually through to the year 2000.
However, when the Yen appreciates, Japanese stock of FDI grows much
faster. The results show that an annual appreciation of the Yen by 5 percent
results in the Japanese stock ofFDI to increase by a corresponding 7.5 percent
annually.

The results show that Japanese stock ofFDI continues to increase, albeit
at a slower rate, with the depreciation of the Yen. This phenomenon cannot
be explained by appreciating assets in the host country because we have not
included asset appreciation as a component of our FDI stock variable.
Similarly, we cannot explain continuing FDI growth in terms of retained
earnings because these are also not included in our FDI variable. One
possible explanation is that in some instances FDI is undertaken as a means
of compensating for shrinking exports. In this case the depreciation of the
Yen should Iead to an increase in exports, thereby reducing some of the
incentives to undertake FDI. Another explanation may be that investment
opportunities in Japan may be diminishing so that Japanese firms looking for
growth opportunities are forced to invest abroad despite relative adverse
circumstances.

The depreciation of the Yen also leads to increases in Japanese exports.

However, sharp increases in Japanese exports in the past is known to have
resulted in numerous trade frictions with other countries (eg. the US and

Asia Pacific Journal of Marketing and Logistics 49

 European nations). As a way of circumventing further trade frictions as a
Impacts of result of increases in Japanese exports, Japanese Multinationals have in-
Currency vested heavily in offshore markets as a means of servicing overseas markets
Fluctuations on from overseas. Thus, FDI has continued to increase in the past despite the
depreciation of the Yen.
Japanese Foreign
Direct Investment
From a public policy standpoint, currently there is ongoing debate about
further liberalisation of investment in the world through the Multilateral
Agreement on Investment (MAI) of the World Trade Organisation. These
discussions have focused largely on the removal of barriers to investment.
One of the factors that has been overlooked in these discussions and has not
been given due consideration is the exchange rate and its impacts on FDI.
The results in this paper show clearly that currency fluctuations can affect
the flow of FDI. Clearly nations can use the exchange rate as a strategic
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weapon to influence FDI. Thus, further liberalisation of FDI must fully

consider the implications of currency fluctuations and establish rules to
monitor currency movements world wide.

*Don Crow, Lecturer in International Business at the Auckland Institute of

Technology, sadly passed away in October 1997. One of his main research
interests included foreign direct investment and he has inspired many col-
leagues and students to this topic.

50 APJML
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