Short and Long Run Effects of Exchange Rate Volatility on Foreign Direct Investment in Kenya

Abstract

Foreign Direct Investment is a significant factor in enhancing Kenya’s economic growth and development. However, exchange rate volatility appears to be a disincentive to this aspect owing to the risks it possesses to foreign direct investments. This study investigates the short and long run effects of exchange rate volatility on foreign direct investment on Kenya. The study uses annual secondary data set for the period 1980 to 2014. The study addresses two specific objectives: to investigate the effect of the short-run and to measure the effects of exchange rate volatility in the long-run. The short run effect of exchange rate volatility on foreign direct investment was achieved by estimating an error correction model, while the long run effects were estimated using a multiple regression. Results indicate that the error correction term is statistically significant at five percent, with a value of -0.73. This implies a percentage of 73 percent of disequilibrium is corrected within a year. In the long run, the exchange rate volatility coefficient is negative and statistically significant at five per cent. An increase in exchange rate volatility by one per cent unit will lead a reduction of foreign direct investment by 10.19 per cent. The empirical results obtained in this paper recommend the Kenyan government to implement exchange rate policies that promote stability of exchange rate, which could help reduce exchange rate volatility in order to attract more FDI.