ISSN 2520-4750 (Online) & ISSN 2521-3040 (Print)

Volume: 4, Issue: 11
Page: 53-69
2020 International Journal of Science and Business

Impacts of Inflation and Exchange

Rate on Foreign Direct Investment in
Bangladesh
Muhammad Mahmud Mostafa

Abstract:
The objective of this study is to investigate the impacts inflation and
exchange rate on foreign direct investment (FDI) in Bangladesh. To meet the
purpose of the study, time series data on dependent and independent
variables are collected from various secondary sources covering the period
1980 to 2017. For estimation purpose the study employs different
econometric techniques such as Augmented Dickey-Fuller (ADF) test,
Johansen Co-integration Test, and Vector Error Correction Model (VECM).
Apart from these, various diagnostic tests have been applied to evaluate the IJSB
goodness-of-fit of the model. Results of the study reveal that there exists a Accepted 16 October 2020
Published 20 October 2020
long-run relationship between dependent and independent variables. DOI: 10.5281/zenodo.4108244
Inflation rate is found to have a significant negative impact on FDI in the
long-run but it is insignificant in the short-run. The results also show that
exchange rate has a significant positive relationship with FDI both in the
long-run and short-run. That is, depreciation of Bangladeshi taka against US
dollar induces FDI flows in Bangladesh. Therefore, in order to increase the
flow of FDI in Bangladesh, it is essential to take necessary steps to curb high
inflation and to prevent the devaluation of oreign currencies against
Bangladeshi taka.

Keywords: FDI, Inflation Rate, Exchange Rate, Co-integration, ADF, VECM.

About Author (s)

Muhammad Mahmud Mostafa, Assistant Professor (Economics), Officer on Special Duty,

Directorate of Secondary and Higher Education, Bangladesh, Dhaka, and Ph.D. Fellow,
Institute of Bangladesh Studies, University of Rajshahi.
E-mail: [email protected].

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1. Introduction
The amount invested in a country by the resident of a foreign country, either directly or
through other related enterprises, over which the foreign investor has effective control is
referred to as foreign direct investment (FDI). Due to insufficient capital for domestic savings
and investment, a developing country like Bangladesh is always looking forward to achieving
foreign capital for creating employment opportunities for huge labor force, for importing
suitable technology and equipment for effective use of domestic raw materials, for collecting
and processing natural resources, and for achieving economic growth by reducing import
dependence and establishing export-oriented industrial enterprises. From the information of
Bangladesh Investment Board, it is obvious that the flow of foreign direct investment in
Bangladesh is not encouraging at all. After the independence of Bangladesh, the new
government adopted the policy of nationalizing all the medium and large scale industries. As
a result, there was no new foreign direct investment in the country till 1977. Later in 1980,
the Foreign Private Investment (Promotion and Protection) Act and the Bangladesh Export
Processing Zones Authority Act were passed. Nevertheless, foreign investment did not come
much in the entire eighties. Although different governments were experimenting with new
industrial policies, the flow of foreign direct investment remained very limited until 1993 as
the political situation was unstable in the country. However, since then, the registration of
companies with foreign investment has increased rapidly. The main reasons for the
comparative progress in foreign direct investment are the investment potential of Bangladesh
and the relatively stable political, social and economic condition of recent times. But foreign
investment in Bangladesh is not consistent with the rate at which the growth of the economy
is moving forward. Although the growth rate of GDP has gone up for years, it does not seem to
attract foreign investors yet. Foreign investment is yet to rise to 2% of GDP. According to the
World Investment Report 2019, the amount of FDI inflows in Bangladesh from 2013 to 2018
is 1599, 1551, 2235, 2333, 2152, and 3613 million US dollars, respectively. That is,
investment decreased by 5% in 2014 compared to 2013, increased by 44% in 2015, increased
by 4.38% in 2016, decreased by 7.76% in 2017, and increased by 67.89% in 2018 compared
to immediate previous year. This record jump in 2018 was driven by significant investments
in power generation and in labor-intensive industries such as ready-made garments, as well
as the $1.5 billion acquisition of United Dhaka Tobacco by Japan Tobacco. However, in terms
of quantity, this investment is so negligible that we have to go a long way to get closer to the
more invested countries.
For the growing importance of FDI in developing and least developed countries, economists
and policy makers have focused on examining its various determinants and their impacts on
FDI worldwide. Numerous studies have tried to determine the factors that influence FDI flows
into different countries. There are many factors that have been identified and tested either
from the microeconomics or macroeconomics perceptive. The purpose of this study to
examine the impacts of inflation rate and exchange rate on FDI inflows in the context of
Bangladesh. As seen in the previous literature, these two variables have been considered as
important determinants of FDI inflows in many countries of the world, and the results are
varying among the studies. Although there exists a great deal of literature in this area, there is
hardly any evidence of such a study in the case of Bangladesh.

2. Literature Review
A lot of work has been done to explore the relationship between FDI and inflation rate, and
exchange rate along with other macroeconomic variables in different contexts and regions.

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An overview of some of these studies is given here: Obwona (2001) attempted to identify the
key factors that motivate foreign investors to come and invest in Uganda. The study uses both
primary and secondary sources of data. Primary data were collected by questionnaire survey
and secondary time series data for the period 1975-1991 were collected from various
sources. The empirical results indicate that GDP, growth rate of GDP, trade account balance,
and public expenditure are the significant determinants of FDI flows in Uganda. The other
variables namely inflation rate, domestic savings rate, and external debt service are found
insignificant in the study. Onyeiwu and Shrestha (2004) applied the fixed and random effects
models to explore the magnitude, dynamics, and determinants of FDI in Africa using a panel
dataset for 29 African countries over the period 1975 to 1999. Regardless of whether the
impact of country- and time-specific factors were fixed or stochastic, economic growth,
inflation, openness of the economy, international reserves, and natural resource availability
were found to be the significant determinants for FDI flows to Africa. External debt and taxes
were found significant in random effects model but insignificant in fixed effects model.
Interest rate, infrastructures, and political rights were found to be insignificant for FDI flows
to Africa in both random effects and fixed effects model. Grosse and Trevino (2005) combined
institutional variables with traditional factors to demonstrate that institutions matter in the
context of foreign direct investment (FDI) in the transitional economies of Central and
Eastern Europe (CEE). For this purpose, standard OLS models, least-squares dummy variable
models, and random effects GLS models were employed on the data set of annual FDI inflows
into 13 CEE countries during 1990-1999. They found support for the positive link between
institutional variables and FDI flows into CEE. Corruption and political risk were negative and
significantly related to inward FDI, while the presence of bilateral investment treaties and the
level of restrictions on repatriation of earnings of CEE affiliates were positive and
significantly related to inward FDI. Traditional variable foreign exchange rate was significant
and negatively correlated to FDI, while market size was highly significant and positively
correlated to FDI. Inflation was found insignificant in explaining FDI. Alba et al. (2009)
examined the impact of exchange rates on FDI inflows into the United States using Markov
Zero-Inflated Poisson (MZIP) regression model. They used unbalanced industry-level panel
data from the US wholesale trade sector for the period of 1982 to 1994. They found that FDI
is interdependent over time and under a favorable FDI environment, the exchange rate has a
positive and significant effect on the average rate of FDI inflows.
Ho and Rashid (2011) investigated significant determinants of FDI in five ASEAN countries
namely Indonesia, Malaysia, Philippines, Singapore and Thailand from 1975 to 2009. The
study applied both individual and panel data analyses for this purpose. The findings depict
that economic growth and degree of openness significantly affect FDI flows in the majority of
these countries. Inflation plays a significant role on FDI flows for Thailand while exchange
rate significantly affects FDI flows in Malaysia. Manufacturing output attracts FDI into the
Philippines. In Indonesia and the Philippines employment negatively affects foreign
investments, while tourism positively affects FDI in the Philippines and Malaysia. Other
significant factors include the level of consumer income, skill and knowledge, and
infrastructure development. Anna et al. (2012) sought to find out the impacts of interest rate
and other determinants on FDI inflows in Zimbabwe in the period from February 2009 to
June 2011. Data was analyzed using the classical linear regression model (CLRM), ordinary
least squares (OLS) approach. The study found that GDP, labor cost, and risk factors (political
instability, war, and failure to observe democratic rights) are the major determinant of FDI in
Zimbabwe. The study also found out that interest rates, inflation rate, and exchange rate have

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no significant impact on FDI inflows and hence cannot be used for policy making purposes.
Sharif-Renani and Mirfatah (2012) conducted a study to evaluate the determinants of inward
FDI particularly volatility of exchange rate in Iran by using the Johansen and Juselius’s
cointegration approach covering the period 1980Q2-2006Q3. Moving average standard
deviation is used for calculating the volatility of exchange rate. The findings of this study
reveal that GDP, openness, and exchange rate have significant positive impact but volatility of
exchange rate and world crude oil prices have significant negative impact on the flow of
inward FDI in Iran. Andinuur (2013) seeks to explore linkages between inflation, foreign
direct investment and economic growth in Ghana using annual time series data covering the
period 1980 to 2011. The study employs the cointegration approach by Pesaran, Shin and
Smith (2001) and the Granger causality test suggested by Toda and Yamamoto (1995) to
empirically examine the relationships among the variables under consideration. The study
finds that there are significant relationships among inflation, foreign direct investment and
economic growth in Ghana. Inflation has a significant negative impact on FDI as well as
economic growth. Economic growth has a significant positive impact on FDI and vice versa.
Saleem et al. (2013) investigated the impact of inflation and economic growth on foreign
direct investment in Pakistan using annual time series data over the period of 1990 to 2011.
A multiple regression analysis was used to determine the relationship between the variables.
The result reveals that both inflation and economic growth have positive relation with FDI.
Bilawal et al. (2014) aimed at exploring the impact of exchange rate on foreign direct
investment in Pakistan using secondary time series data for the period of 1982 to 2013.
Correlation and regression analysis were applied through SPSS software to check the
relationship between Exchange rate and FDI. The results showed that there is a positive
significant relationship between exchange rate and foreign direct investment in Pakistan.
Alshamsi et al. (2015) attempted to examine the impact of inflation rate and GDP per capita
on inward FDI inflows into United Arab Emirates using a 33-year time series data covering
the period of 1980 to 2013. The auto regressive distributed lag (ARDL) model is applied in
this study to examine the long-run relationship between the independent and dependent
variables. The findings of the study reveal that inflation has no significant effect on FDI
inflows whereas GDP per capita (which is a proxy for market size) has a significantly positive
impact on FDI inflows.
Faroh and Shen (2015) examined the impact of interest rate on FDI flow in Sierra Leone using
multiple regression analysis based on time series data for the period of 1985 to 2012. They
found trade openness and exchange rates as the key determinants of FDI flow in Sierra Leone
having significant positive signs. Other variables GDP, inflation, and interest rate were found
to be insignificant factors causing the variability of FDI flows though the GDP and inflation
have the expected signs, interest rate with an unexpected sign. Fornah & Yuehua (2017) tried
to develop an empirical framework to identify the effect interest rate on FDI inflows in Sierra
Leone using time series data for the period of 1990-2016. For this purpose, Johansen and
Juselius cointegration techniques and vector error correction model (VECM) were applied in
this study. Empirical analysis of the data reveals that GDP growth, trade openness, interest
rate, and inflation are the major determinant of FDI in Sierra Leone. Inflation is negatively
correlated with FDI whereas other 3 variables have significant positive effect on FDI.
Exchange rate is found to be insignificant in this study. Ali et al. (2018) examined the
determinants of FDI inflows in Southern African Development Community (SADC) member
countries using data for the period 1995-2016. The study employed pooled OLS as the main
estimation method. Their results reveal that inflation, infrastructure, trade openness and

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market size are the significant determinants of FDI inflows in SADC countries. Inflation has
negative impact on FDI while infrastructure, trade openness and market size are positively
related with FDI. The results also show positive but insignificant effect of human capital on
FDI inflows to SADC member countries. Chol (2020) attempted to identify the location
determinants of FDI inflows into Sudan for the period 1980-2018 using vector auto-
regression (VAR) model and Granger causality test. The empirical results revealed that
market size, external debt, and investment incentive are positively correlated to FDI flows
into Sudan whereas inflation has a negative impact on it. No significant effect of gross fixed
capital formation and trade openness on FDI are found in this study. Jahan (2020) intended to
identify the underlying factors that affect the inflow of FDI to 24 emerging countries using
panel data covering the period 1992-2016. The fixed effects model was chosen for this study
through Hausman (1978) specification test. The empirical findings of this study demonstrate
that market size, trade openness, infrastructure facilities, natural resources availability, and
financial development level have significant positive effects and inflation have significant
negative effects on inward FDI. Labor force appears to be an insignificant determinant of FDI
flows to the emerging countries.
Quader (2009) analyzed the determinants of FDI in Bangladesh employing extreme bounds
analysis (EBA) on the annual time series data for the period 1990-1991 to 2005-2006. The
results reveal that trade openness and trade balance have significant positive effect whereas
GDP growth rate, wage rate, and tax rate have significant negative impact on the flow of
foreign direct investment in Bangladesh. The study also finds that two years lagged values of
FDI and change in the level of domestic investment have a positive significant effect on
economic growth in Bangladesh. Hasan and Nishi (2019) aim to find out the impact of some
macroeconomic variables (GDP, trade openness, inflation rate, and market size) in attracting
FDI in Bangladesh. OLS estimation method has been applied to analyze the data for the period
1997-2016 to find out the impact of different variables on FDI. The results show a positive
and significant relationship of market size and GDP on inward FDI in Bangladesh. The results
also indicate that trade openness and inflation rate have a negative but insignificant influence
on FDI. Thus, it is clear from the previous literature that the effect of inflation and exchange
rate on FDI is mixed. All these studies have shown that either FDI has a positive relationship
with these two variables, or a negative relationship exists, or there is no relationship between
them. This difference in results is observed due to the differences in the country, the accuracy
and duration of the data collected, and even the research methods applied. In the context of
Bangladesh, this research work done using long 38 years of data (1980-2017) and applying
distinct research methods will surely complement the research work of Hasan and Nishi
(2019) and Quader (2009) and play an important role in policy making.

3. Data and Variables

The study is based on secondary data. As noted earlier, the aim of this study is to examine the
impacts of inflation and exchange rate on foreign direct investment (FDI) in Bangladesh.
Therefore, the dependent variable of the study is FDI and the independent variables are
inflation rate and exchange rate. To meet the purpose of the study, time series data are
collected from various secondary sources covering the period 1980 to 2017. Table 1 shows
the variables of this study and their secondary sources in brief.

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Table 1. Description of Variables and Sources of Data

Variable Type Description Sources of Data
Foreign Direct Dependent Net FDI inflows World Development Indicators
Investment (FDI) Variable (Current US$) (World Bank)
Inflation Rate (INF) Independent Annual Percentage Change World Economic Outlook Database
Variable in Consumer Prices (International Monetary Fund)
Exchange Rate (EXC) Independent Average Exchange Rate World Development Indicators
Variable (BDT per US$) (World Bank)
Source: Author

4. Hypotheses of the Study

4.1 Inflation Rate and FDI
Price stability is a major indicator of macroeconomic stability in a country. Any form of
instability introduce a type of uncertainty that pervert investor insight of the future
profitability in the country. Inflation, defined as a continuous rise in the general price level,
reflects a decrease in the purchasing power per unit of currency. Low inflation rate is
considered a sign of internal economic stability in the host country which encourages FDI.
High inflation rate is often seen as a measure of overall economic instability which increases
the user cost of capital and negatively affects the profitability of firms in the host country (de
Mello Jr., 1997). According to Onyeiwu and Shrestha (2004), a high rate of inflation reflects
the poor economic conditions in the country that discourages the flow of FDI. So, in the
context of previous literature, our hypothesis in this case is:
H1: The lower the inflation rate, the higher the FDI inflow.
4.2 Exchange Rate and FDI
Exchange rate, the rate at which one currency is exchanged for another, is often cited as a
critical determinant of FDI. Stable exchange rate is positive for FDI. According to Froot and
Stein (1991), exchange rates can affect FDI through an imperfect capital market channel. A
weaker real exchange rate might be expected to increase vertical FDI as firms take advantage
of relatively low prices in host markets to purchase facilities (Walsh and Yu, 2010). A real
depreciation of the domestic currency raises the wealth of foreign investors relative to that of
domestic investors and thereby increases FDI. The stronger the foreign currency is in
comparison to that of the host country, the more will be the amount of foreign investment.
According to Ang (2008), appreciation of the real exchange rate appear to discourage FDI
inflows. In this case, our set hypothesis is:
H2: Appreciation of BDT exchange rate will reduce FDI inflow.
5. Methodology and Data Analysis
5.1 Econometric Model
In this study the ordinary least square (OLS) estimation method is used to determine the
relationship between foreign direct investment (FDI), and inflation rate (INF) & exchange
rate (EXC). The multiple linear regression model is specified as:

FDI = f (INF, EXC) (1)

Since our data is collected at discrete points in time, the model can be expressed as:
FDIt = f (INFt , EXCt ) (2)

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In order to handle situations where a non-linear relationship exists between the independent
and dependent variables, in a regression model, variables are often expressed in logarithmic
form. For this reason, equation (2) is expressed in Cobb-Douglas form as:
 
FDI t   INFt 1 EXCt 2 e t (3)

After converting the data into logarithm form, the model can be represented as:
LFDIt = Lα + β1 LINFt + β2 LEXCt + µt (4)
If we assume Lα = β0, the model is simplified as:
LFDIt = β0 + β1 LINFt + β2 LEXCt + µt (5)
Where,
LFDIt = Natural logarithm of foreign direct investment at time t
LINFt = Natural logarithm of inflation rate at time t
LEXCt = Natural logarithm of exchange rate at time t
e = Base of natural logarithm
µt = Error term/ random residual term/ stochastic disturbance term
β0 = Intercept/ Slope coefficient
β1 , β2 = coefficient parameters to be estimated.
5.2 Unit Root Test
Studies that involve time series analysis normally use historical data to establish
relationships between variables in order to forecast the future. But if the variables are non-
stationary and contain unit root, forecasting may not be appropriate. In such cases,
estimation may lead to spurious results which have no economic meaning. In this study the
Augmented Dickey-Fuller (ADF) test is applied to test for the stationarity in the variables.
There are three basic regression models for ADF test:
p
No constant, no trend : Yt  Yt 1    i Yt i   t (6)
i 1
p
Constant, but no trend : Yt  1  Yt 1    i Yt i   t (7)
i 1
p
Constant and trend : Yt  1   2 t  Yt 1    i Yt i   t (8)
i 1

where ∆ is the difference operator, Yt is the variable of interest, p is the number of lags, εt is
the stochastic error term, β1 is the intercept and β2 is the coefficient.
The null hypothesis is that the series is non-stationary against alternative hypothesis that the
series is stationary. If the absolute value of the ADF test statistic is greater than the absolute
critical values, we reject the null hypothesis and conclude that the series is stationary. On the
other hand, if the absolute value of the ADF is less than the absolute critical values, we fail to
reject the null hypothesis and conclude that the series is non-stationary.
5.3 Cointegration Test
The concept of cointegration was developed by Engle and Granger in 1987. Cointegration
between two time series suggests that there exists a long run relationship between them. If
the variables are integrated of the same order, then we can apply the cointegration test. This
study employs the Johansen cointegration method (1988) to test for long run equilibrium
relationships among variables because the Engle and Granger cointegration test works well
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for a single equation, but it does not extend well to a multivariate VAR model. The advantage
of Johansen method is that it permits the identification of all cointegrating vectors within a
given set of variables. Furthermore, the procedure has better asymptotic properties which
yield more robust results. The Johansen-Juselius test employs two statistics to test for
cointegration:
Trace Test Statistics : trace (r )   T i  r 1 ln (1 ˆi )
n
(9)
Null Hypothesis: The number of cointegrating vectors are less than or equal to r.
Alternative Hypothesis: The number of cointegrating vectors are more than r.
Max-eigen Value Test Statistics : max (r , r  1)   T ln (1  ˆr 1 ) (10)
Null Hypothesis: The number of cointegrating vectors is r.
Alternative Hypothesis: The number of cointegrating vectors is (r+1)
Here r equals the number of cointegrating vectors, T equals the sample size and ̂ equals the
estimated eigenvalue. If the estimated statistic (Trace and/or Max-eigen Value) is greater
than the critical value, then the relevant null hypothesis is rejected and alternative hypothesis
is accepted, meaning that there is a long run relationship between dependent variable and
independent variable(s). If there comes up a different result between trace statistic and
maximum eigenvalue test, then maximum eigenvalue result is preferred.
5.4 Vector Error Correction Model (VECM)
The vector error correction model (VECM) is a special case of vector autoregressive (VAR)
model for variables that are stationary in their first differences. In the cointegration test, if the
variables are found to be cointegrated, then VECM is used to estimate the long run causality
and short run dynamics of a time series.
Conventional ECM for cointegrated series:
yt   0  i 1  i yt i  i 0  i xt i  ECTt 1   t
n n
(11)
where,
y t   0   1 xt   t (12)
(long-run cointegrating regression)

ECTt 1  yt 1   0  1 xt 1 (13)
(cointegrating equation and long-run model)
The error correction term (ECT) relates to the fact that last period deviation from long-run
equilibrium (the error) influences the short-run dynamics of the dependent variable. Thus,
the coefficient of ECT, λ , is the speed of adjustment, because it measures the speed at which y
returns to the equilibrium after a change in x.
From equation (1), the VECM model can be written as:

LFDI t     ( LFDI t 1   0   1 LINFt 1   2 LEXCt 1 )  LFDI t 1

  LINFt 1   LEXCt 1   t (14)

The above equation is the error correction equation where ∆ shows the changes of the
variables, β is the adjustment parameter.
5.5 Residual Diagnostic Tests
The following tests are applied for residuals tests:
(1) Serial correlation → Breusch-Godfrey Test

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(2) Heteroscedasticity → Breusch-Pagan Test

(3) Normality → Jarque-Bera Test
5.5.1 Breusch-Godfrey Test
The Breusch–Godfrey is a test for serial correlation in the errors in a regression model. This
test allows you to measure correlation between error term and multiple lagged error terms at
the same time to see if they are correlated.
Null Hypothesis: There is no serial correlation
Alternative Hypothesis: There is serial correlation
Therefore, if your p-value is 0.05 or below, this means your model suffers from serial
correlation.
5.5.2 Breusch-Pagan Test
The Breusch-Pagan test, developed in 1979 by Trevor Breusch and Adrian Pagan, is used to
test for heteroscedasticity in a linear regression model. It tests whether the variance of the
errors from a regression is dependent on the values of the independent variables. In that case,
heteroscedasticity is present.
Null Hypothesis: Residuals do not suffer from heteroscedasticity
Alternative Hypothesis: Residuals suffer from heteroscedasticity
It is a chi-squared test: the test statistic is distributed nχ2 with k degrees of freedom. If the test
statistic has a p-value below an appropriate threshold (e.g. p < 0.05) then the null hypothesis
is rejected and heteroskedasticity is assumed. One way to try and avoid this issue is to
convert variables into logs ‒ this will reduce impact of extreme values in data. Another is to
use heteroscedasticity-consistent standard error estimates.
5.5.3 Jarque-Bera Test
Normality is one of the assumptions for many statistical tests. The Jarque–Bera test is a
goodness-of-fit test to see whether the skewness and kurtosis of sample data matches a
normal distribution. The test statistic is always non-negative. If it is far from zero, it signals
the data do not have a normal distribution.
Null Hypothesis: Residuals are normally distributed
Alternative Hypothesis: Residuals are not normally distributed
If a p-value of 0.05 or less is obtained, than it means that null hypothesis has been rejected,
i.e., residuals in the model are not normally distributed.
6. Empirical Results
6.1 Descriptive Statistics
From Table 2 it is seen that the standard deviation of each variable is low, the range of
variation between maximum and minimum value is also reasonable. The coefficient of
skewness of variable LFDI is less than -1 which means the distribution is highly skewed. But
the coefficient of LINF and LEXC are between -1 and -0.5 which implies that the distributions
are moderately skewed. Since the coefficient of kurtosis of all the variables are greater than
zero, it indicates a leptokurtic distribution (heavier tails) for each variable.
Table 2. Descriptive Statistics
LFDI LINF LEXC
Mean 18.01400 1.933333 3.827553
Median 18.52986 1.985849 3.870850
Maximum 21.76630 2.733393 4.405043
Minimum 0.000000 0.646056 2.737872
Std. Dev. 3.729415 0.497817 0.452650
Skewness -2.925347 -0.812189 -0.549557
Kurtosis 15.33409 3.165285 2.409775
Source: EViews output
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6.2 Results of Multicollinearity Test

One popular method to Detect Multicollinearity is the bivariate correlation between two
predictor variables. If the correlation coefficient between two variables is 0.80 or above, the
rule of thumb says you have multicollinearity. Correlation matrix in Table 3 indicates no high
correlation between any two independent variables and hence there is no problem of
multicollinearity in this model.
Table 3. Correlation Matrix
Variables LFDI LINF LEXC
LFDI 1.000000
LINF -0.222200 1.000000
LEXC 0.662390 -0.423957 1.000000
Source: EViews output
6.3 Results of Unit Root Test
Table 4 reveals that all the variables are non-stationary at their levels but become stationary
after first difference. At first difference, the calculated ADF test statistics and corresponding
p-values clearly reject the null hypotheses of unit root at 5% significance levels. This suggests
co-integration analysis to examine the long run relationship among the variables.
Table 4. Augmented Dickey-Fuller (ADF) Test Result
Var. Test for Unit Root Test ADF Test Statistic Critical Values at P- Inference
Equation 5% Level Value
Constant -3.7790 -2.9719 0.0081
Level Con. & Trend -4.6653 -3.5403 0.0034 Non-Stationary
None -0.3876 -1.9501 0.5376
LFDI
Constant -6.6201 -2.9484 0.0000
1st Diff. Con. & Trend -7.1025 -3.5875 0.0000 Stationary
None -9.9489 -1.9504 0.0000
Constant -3.3234 -2.9434 0.0209
Level Con. & Trend -3.3604 -3.5366 0.0725 Non-Stationary
None -1.0526 -1.9507 0.2583
LINF
Constant -8.0235 -2.9484 0.0000
1st Diff. Con. & Trend -8.0005 -3.5443 0.0000 Stationary
None -8.0700 -1.9507 0.0000
Constant -4.8277 -2.9434 0.0004
Level Con. & Trend -4.2229 -3.5366 0.0101 Non-Stationary
None 4.8442 -1.9501 1.0000
LEXC
Constant -3.8012 -2.9458 0.0064
1st Diff. Con. & Trend -6.0027 -3.5443 0.0001 Stationary
None -2.9757 -1.9504 0.0040
Source: EViews output
6.4 Johansen Co-integration Test Result
The first step of co-integration test is the selection of lag order. There are many methods that
can determine optimal lag period for the VAR model. From Table 5 it is seen that all the five
methods are suggesting lag 1. So, the optimal lag order for the VAR model is 1.
Table 5. VAR Lag Order Selection Criteria
Endogenous Variables: LFDI LINF LEXC Exogenous Variables: C
Lag LogL LR FPE AIC SC HQ
0 -118.6357 NA 0.209512 6.950612 7.083927 6.996632
1 -25.55830 164.8800* 0.001722* 2.146188* 2.679451* 2.330270*
2 -20.12055 8.700389 0.002139 2.349746 3.282955 2.671890
3 -11.61239 12.15451 0.002273 2.377851 3.711007 2.838056
* indicates lag order selected by the criterion
Source: EViews output
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Both trace test (Table 6) and maximum eigenvalue test (Table 7) reject the null hypothesis of
no co-integration at 5% significance level and both the test indicate 1 cointegrating equation
at 5% significance level. Therefore, it can be concluded that a significant long-run relationship
exists between dependent and independent variables. Table 8 represents the existing
cointegrating equation of the dependent variable LFDI. The coefficients are statistically
significant at 5% level. The signs of the coefficients are reversed in the long run. The equation
indicates that in the long run, LINF has a negative impact on FDI. That is, an increase in LINF
will lead to a decrease in LFDI. The equation also indicates that LEXC has a positive impact on
FDI in the long run which means that an increase in LEXC will lead to an increase in LFDI.
Table 6. Unrestricted Cointegration Rank Test (Trace)
Hypothesized No. Eigenvalue Trace Statistic Critical Value Prob.
of CE(s) (at 0.05 level)
None * 0.507156 40.06862 29.79707 0.0023
At most 1 0.274016 14.59633 15.49471 0.0680
At most 2 0.081696 3.068162 3.841466 0.0798
Trace test indicates 1 cointegrating equation(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
Source: EViews output
Table 7. Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesized No. Eigenvalue Max-Eigen Critical Value Prob.
of CE(s) Statistic (at 0.05 level)
None * 0.507156 25.47229 21.13162 0.0115
At most 1 0.274016 11.52817 14.26460 0.1297
At most 2 0.081696 3.068162 3.841466 0.0798
Max-eigenvalue test indicates 1 cointegrating equation(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
Source: EViews output
Table 8. Cointegrating Equation
Normalized cointegrating coefficients (standard error in parentheses)
LFDI LINF LEXC
1.000000 0.332691 (1.00074) -8.940348 (1.20972)
Source: EViews output

6.5 Result of Vector Error Correction Model (VECM)

From Vector Error Correction Estimates (Table 9) we obtain,
The cointegrating equation (long-run model):
ECTt-1 = 1.000000LFDIt-1 + 0.332691LINFt-1 - 8.940348LEXCt-1+ 15.75501 (15)
Where ECT is the error correction term. We obtain from equation (15),
LFDIt-1 = ECTt-1 - 0.332691LINFt-1 + 8.940348LEXCt-1 - 15.75501 (16)
Equation (16) is similar to the cointegrating equation produced by Johansen method (Table
7). We may interpret equation (16) as follows: A one unit increase in inflation rate leads to a
0.33 unit decrease in FDI in Bangladesh. Similarly a one unit increase in exchange rate will
increase FDI by 8.94 unit. The lower part of Table 9 contains 3 columns for error correction
estimates of 3 dependent variables namely D(LFDI), D(LINF) and D(LEXC). Among these 3
variables, our target dependent variable is D(LFDI). So we obtain the estimated VECM with
D(LFDI) as target variable:
∆LFDIt = - 0.966535ECTt-1 - 0.006746∆LFDIt-1 + 0.180107∆LINFt-1

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+ 26.45242∆LEXCt-1 - 1.043793 (17)

Where ECTt-1 is defined in equation (15). Equation (15) is the numerical representation of the
vector error correction model equation (14). As an interpretation it can be said that a unit
increase in FDI of lag 1 is associated with a 0.006746 times decrease in FDI on average. Again,
the coefficient of ∆LINFt-1 is 0.180107 which means that a unit increase in inflation rate of lag
1 is associated with a 0.180107 times increase in FDI.
Table 9. Vector Error Correction Estimates
Cointegrating Eq: CointEq1
LFDI(-1) 1.000000
LINF(-1) 0.332691
LEXC(-1) -8.940348
C 15.75501

Error Correction: D(LFDI) D(LINF) D(LEXC)

CointEq1 -0.966535 -0.027490 0.007421
D(LFDI(-1)) -0.006746 0.018721 -0.005183
D(LINF(-1)) 0.180107 -0.113149 0.011978
D(LEXC(-1)) 26.45242 -0.170965 0.365193
C -1.043793 -0.024495 0.026181
Source: EViews output
As we see in Table 9, the coefficient of error correction term of FDI is -0.966535 which means
that about 96.65% of disequilibrium corrected each year by changes in FDI. That is, the
previous periods deviation from long-run equilibrium is corrected in the current period as an
adjustment speed of 96.65%. It confirms the stability of the system. The coefficient of error
correction term of inflation rate is -0.027490. It implies that any divergence from equilibrium
due to changes in inflation rate is corrected in the current period at a speed of 2.75%. It
means that the speed of adjustment of inflation rate towards equilibrium is slow one.
Similarly, the speed of adjustment towards equilibrium of exchange rate is 0.74%.
6.6 Long-run Causality
In Table 9, C(1) is the error correction term or speed of adjustment towards long-run
equilibrium. The value of C(1) has to be negative and statistically significant to retain its
economic interpretation. By being negative, it tells us if there is a departure in one direction,
the correction would have to be pulled back to the other direction so as to ensure that
equilibrium is retained. Positive error correction coefficient is not a good sign for a model
because it implies that the process is not converging in the long-run and that could be
perhaps due to some instabilities in the model. So, when that happens it might actually mean
that there are some specification problem with the model and/or may be there are some data
issues that you need to actually look into. In our model, the value of C(1) is -0.966535 and the
corresponding p-value is 0.0000. That is, C(1) is negative in sign and statistically significant.
So, there is a long-run causality running from LINF and LEXC to LFDI. The value of C(1) in our
model also tells us that about 96.65% of departures from long-run equilibrium is corrected
each period.

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Table 10. Results of Ordinary Least Square Estimates

Dependent Variable: D(LFDI)
Method: Least Squares (Gauss-Newton / Marquardt steps)
D(LFDI) = C(1)*( LFDI(-1) + 0.332690812656*LINF(-1) - 8.94034843323*LEXC(-1) + 15.7550145667 ) + C(2)*D(LFDI(-1)) +
C(3)*D(LINF(-1)) + C(4)*D(LEXC(-1)) + C(5)

Coefficient Std. Error t-Statistic Prob.

C(1) -0.966535 0.201619 -4.793873 0.0000
C(2) -0.006746 0.153383 -0.043981 0.9652
C(3) 0.180107 1.002075 0.179734 0.8585
C(4) 26.45242 10.24646 2.581616 0.0148
C(5) -1.043793 0.644300 -1.620042 0.1154

R-squared 0.565113 Akaike info criterion 4.939484

Adjusted R-squared 0.508998 Schwarz criterion 5.159417
F-statistic 10.07070 Hannan-Quinn criter. 5.016247
Prob(F-statistic) 0.000024 Durbin-Watson stat 2.072386
Source: EViews output
6.7 Short-run Causality
In Table 10, C(3) and C(4) are the short-run coefficients associated with LINF and LEXC
respectively. To know whether LINF and LEXC have a short-run causality with LFDI, we need
to run the Wald Test for coefficients C(3) and C(4).

Table 11. Wald Test Results

Null Hypothesis Test Statistic Value Probability Inference
t-statistic 0.179734 0.8585
C(3) = 0 F-statistic 0.032304 0.8585 Accepted
Chi-square 0.032304 0.8574
t-statistic 2.581616 0.0148
C(4) = 0 F-statistic 6.664743 0.0148 Rejected
Chi-square 6.664743 0.0098
Source: EViews output
From Table 11 it is seen that p-value of chi-square for null hypothesis C(3) = 0 is 0.8574
(85.74%) which is more than 5%. That is, we cannot reject the null hypothesis. So, there is no
short-run causality running from LINF to LFDI. In other word, LINF is insignificant in
explaining changes in LFDI in the short-run. Wald test results also show that that p-value of
chi-square for null hypothesis C(4) = 0 is 0.0098 (0.98%) which is less than 5%. So, we can
reject the null hypothesis. This means that, there is a short-run causality running from LEXC
to LFDI. Since the value of C(4) is 26.45242 and corresponding p-value is 0.0148 (Table 10), it
can be said that LEXC has a significant positive relationship with FDI in the short-run.
6.8 Results of Residual Diagnostic Tests
Table 12. Breusch-Godfrey Serial Correlation Test Result
F-statistic 0.694158 Prob. F(1,30) 0.4113
Obs*R-squared 0.814151 Prob. Chi-Square(1) 0.3669
Source: EViews output

From Table 12 we see that p-value of chi-square is 0.3669 (36.69%) which is more than 5%.
Therefore we cannot reject the null hypothesis. So, there is no serial correlation in the model.
Table 13. Breusch-Pagan Heteroskedasticity Test Result
F-statistic 0.913424 Prob. F(6,29) 0.4993
Obs*R-squared 5.722056 Prob. Chi-Square(6) 0.4550
Source: EViews output
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We see from Table 13 that p-value of chi-square is 0.4550 (45.5%) which is more than 5%.
Therefore we cannot reject the null hypothesis. So, there is no heteroskedasticity in the
model.
14
Series: Residuals
12 Sample 1982 2017
Observations 36
10
Mean 1.10e-15
8 Median 0.424753
Maximum 4.038291
6 Minimum -12.23305
Std. Dev. 2.524391
4 Skewness -3.197024
Kurtosis 16.57060
2
Jarque-Bera 337.5676
0 Probability 0.000000
-12 -10 -8 -6 -4 -2 0 2 4

Figure 1. Jarque-Bera Normality Test Result

Figure 1 shows that the P-Value of Jarque-Bera is 0.00% which is less than 5%. We can reject
the null hypothesis. So, residuals in this model are not normally distributed. The above
diagnostic tests were performed to evaluate the goodness-of-fit of the model. The results
suggest that there is no serial correlation and heteroscedasticity in the model, but the model
is not normally distributed. The value of R-squared is 0.565113 which means that the model
explains only 56.51% of the variations of LFDI. The p-value of F-statistic (0.000024) is less
than 5% which is also a good sign for the model. We, therefore, can conclude that the model
has a moderately good fit.
7. Conclusion
The objective of this study was to examine the impacts of two macroeconomic variables
namely inflation rate and exchange rate on foreign direct investment (FDI) in Bangladesh by
using time series data for the period of 1980 - 2017. For estimation purpose the study
employs different econometric techniques such as Augmented Dickey Fuller test (ADF),
Johansen Co-integration Test, Vector Error Correction Model (VECM) etc. Empirical results of
the study indicate that inflation rate has a significant negative impact on FDI in the long-run.
This means that low inflation will lead to an increase in FDI flows in Bangladesh. The result is
consistent with the findings of Onyeiwe and Shreshtha (2004), Demirhan and Masca (2008),
Azam (2010), Andinuur (2013), Kaur and Sharma (2013), Wani and Rehman (2017), Ali et al.
(2018), Chol (2020), and Jahan (2020); but in contrast with the findings of Ho and Rashid
(2011), Jadhav (2012), Saleem et al. (2013), and Faroh and Shen (2015). However, no
significant effect of inflation rate on FDI is found in the short-run. The results also show that
exchange rate has a significant positive relationship with FDI both in the long-run and short-
run. That is, an increase in exchange rate will raise FDI inflows. Alhough this result conflicts
with our hypothesis, this finding corroborates the findings of Cuyvers et al. (2008), Osinubi
and Amaghionyeodiwe (2009), Omankhanlen (2011), Ho and Rashid (2011), Faroh and Shen
(2015), and Pattayat (2016); but negates the findings of Chakrabarti (2001), Grosse and
Trevino (2005), Walsh and Yu (2010), Uwubanmwen and Ajao (2012), Kaur and Sharma
(2013), and Miskinis and Juozenaite (2015).
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8. Policy Implications
According to IMF data, in the 39 years from 1980 to 2018, the average inflation rate in
Bangladesh was 7.63% with a minimum of 1.91% in 2001 and a maximum of 15.39% in 2011.
In 2018, the inflation rate in Bangladesh was 5.61% which is much higher than the average
inflation of 154 countries in 2018 which is 3.4%. From this, the issue of high inflation in
Bangladesh is easily conceivable. The negative relationship between inflation and FDI
indicates that high inflation hinders FDI in Bangladesh. Therefore, it is essential to take
necessary measures to control inflation in order to increase the flow of FDI in Bangladesh.
Since independence, Bangladeshi taka (BDT) has always been depreciated against the US
dollar, except once or twice. Bangladesh adopted floating exchange rate regime since May 31,
2003. In both the fixed exchange rate and floating exchange rate systems, the value of the
dollar against taka has been shown to increase continuously. Sometimes this increase was too
much which was unanticipated. Our study findings indicate that depreciation of Bangladeshi
taka against US dollar induces FDI flows in Bangladesh. Therefore, in order to encourage the
flow of FDI in Bangladesh, necessary steps must be taken to prevent the devaluation of oreign
currencies against Bangladeshi taka.
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Cite this article:

Muhammad Mahmud Mostafa (2020). Impacts of Inflation and Exchange Rate on Foreign
Direct Investment in Bangladesh. International Journal of Science and Business, 4(11), 53-69.
doi: https://doi.org/10.5281/zenodo.4108244
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