Exchange Rate Volatility and Foreign Direct Investment under Democracy and Diplomatic Governance of Pakistan
DOI:
https://doi.org/10.68024/6fe4rh42Keywords:
Exchange rate volatility, foreign direct investment, Political regimesAbstract
This study examines the relationship between exchange rate volatility and foreign direct investment (FDI) in Pakistan, paying particular attention to how this relationship differs under democratic versus military governance. Using annual data spanning 1973–2020 (with regression estimation drawing on the 1990–2019 WDI sample), the study first generates a volatility series for the exchange rate using a GARCH(1,1) model, then applies the Autoregressive Distributed Lag (ARDL) approach to estimate both long-run and short-run effects on FDI, controlling for GDP, inflation, and trade openness. The GARCH results show that exchange rate volatility is highly persistent, with shocks decaying slowly over time. The ARDL bounds test confirms a long-run relationship among the variables in both models estimated. In the baseline model, exchange rate volatility is found to exert a significant negative effect on FDI, while currency depreciation and trade openness have significant positive effects; these relationships hold in the long run but disappear in the short run, where coefficients are statistically insignificant. When a political regime dummy is introduced to distinguish democratic from military rule, exchange rate volatility continues to depress FDI, but its coefficient becomes positive and loses statistical significance during democratic periods, suggesting that political regime moderates investor sensitivity to currency fluctuations. These findings indicate that exchange rate stability, rather than depreciation alone, is central to attracting foreign investment, and that the political environment shapes how investors respond to currency risk. The study recommends that Pakistani policymakers prioritize exchange rate stabilization and political continuity as complementary strategies for sustaining FDI inflows.
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