Impacts of foreign and domestic investment on real exchange rates in India

Foreign investment can mitigate the foreign exchange constraint of developing countries. It can also influence the economy's international competitiveness through appreciating or depreciating exchange rates. The exchange rate impact of domestic investment is also not straightforward and depends on some critical factors. These issues of investment often pose a policy dilemma. Against this backdrop, this paper assesses the relative impacts of foreign direct investment (FDI), domestic investment (DI), and external debt on India's real effective exchange rate and the rupee/dollar real rate for the liberalized regime for trade, investment, and exchange rates. The autoregressive distributed lag bounds testing approach to cointegration, followed by its error correction representation, finds that real exchange rate variations are associated with FDI, debt, DI, and some control variables. FDI and debt depreciate real exchange rates, indicating that these have not exacerbated the economy's international competitiveness. However, DI causes real appreciation. These findings are consistent across estimations involving alternative specifications of control variables. Offsetting impacts of FDI and DI is an interesting finding. This can stabilize the exchange rates by undermining appreciating or depreciating exchange rate trends.