Do foreign investments affect foreign exchange and stock markets - the case of Taiwan

Foreign investment (FI) has been identified with a recent spate of speculative attacks on certain foreign currencies, giving rise to several financial crises. The issue of whether or not FI has destabilization or demonstration effects on the stock and foreign exchange markets has therefore received widespread attention in developing countries. The destabilization effect focuses on whether FI increases or decreases the volatility of stock prices and foreign exchange markets. The demonstration effect stresses that because FI focuses more on fundamental factors than nonfundamental factors, the major influencing factors on stock markets may change after FIs are permitted to enter into a country. The experience of Taiwan in this regard can function as a guide for other developing countries. This paper finds, regarding the destabilization effect, that FI has a positive influence on the volatility of the exchange rate and a mild influence on the volatility of stock returns. These results imply that challenges will probably emerge during the process of liberalization, such as increased volatility in stock returns and in the exchange rate. Next, with regard to the demonstration effect, our results show that prior to the inflow of FI, stock returns are mainly affected by nonfundamental factors, such as the turnover rate. After the inflow of FI, stock returns are affected by both nonfundamental and fundamental elements.