The role of exchange rates on the inflow of foreign direct investment to China

Abstract:

Since the Chinese economic reforms and opening up to free trade, China has experienced sustained and rapid economic growth during the past thirty years, showing an annual GDP growth rate close to 10%, making this GDP growth ranked as the top three in the world since 2005. This remarkable achievement caused widespread concern in the international community. Numerous studies show that a steady stream of foreign direct investment inflows is the most important factor contributing to such great growth miracle. At same time, this great contribution also leads to the international trade imbalance, which causes the external and internal pressure of appreciation of the RMB.

To alleviate the imbalance of foreign trade, enhance international competitiveness and to meet the expanding domestic demand and the needs to improve the level of opening up, China government began to adopt a managed floating exchange rate system that is based on the market supply and demand, adjusted by a basket of currencies at 21st of July 2005, which translated into the RMB appreciation. Until the end of 2011, the cumulative rise mid-rate of the RMB/USD reached 31.4% relative to the former exchange rate regime. So it’s of significant theoretical and practical meanings to conduct the research about how does this new RMB exchange regime influence future foreign direct investment in China.

In order to analyze the new relationship between exchange rate and foreign direct investment in China, this thesis builds an econometric model, which is based on the monthly data of inward FDI and level RMB/USD exchange rate from July 2005 to December 2010. Through ADF test, E-G two steps cointegration test and Granger causality test as well as linear regression model, this thesis gets to the conclusion that appreciation of RMB Exchange rate will encourage FDI inflow, and the great amount of FDI inflows will in return bring appreciation pressure to the exchange rate of RMB.

Key words: FDI, China, RMB/USD exchange rate, Unit root test, cointegration test.