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How can Foreign Direct Investment (FDI) and International Reserves of a Country affect the Exchange Rate?
2023-02-06 • Updated
For a more assertive speculation in the foreign exchange market, it is necessary to use different tools and analyzes that can predict, to some extent, the movement of currencies and the sentiment of investors in a given country. Generally, day traders tend to make more use of technical analysis indicators to predict these movements. However, for traders who look more to the long term, it is interesting to also take into account macroeconomic indicators of the countries (the so-called 'fundamental analysis'), such as Foreign Direct Investment (FDI) and the level of International Reserves, which can be useful tools in forecasting exchange rate movements. In this article, we will talk precisely about these two topics.
FDI and Foreign Exchange
One way of analyzing the degree of external vulnerability of a country and its relationship with the exchange rate can be found in the need for external financing, which is equal to the deficit in current transactions – (minus) the flow of Foreign Direct Investment (FDI) to the country. Whenever the flow of direct investment from abroad is greater than the current transactions deficit, this demonstrates a situation of tranquility and, therefore, large variations in the exchange rate should not be expected. Otherwise, whenever the flow of foreign direct investment is not enough to cover an eventual deficit in current transactions, the country's currency will tend to devalue against its international peers.
International Reserves and Foreign Exchange
Another important issue to be observed is the Net International Reserves, which represent the amount of foreign currency that the country holds and that are readily available to meet the financing needs of its external accounts or for occasional intervention in foreign exchange markets, for example. Governments can use their foreign exchange reserves as a form of protection in times of crisis, when usually foreign capital leaves the country, exports tend to drop and exchange rates devaluate. In summary, a healthy state of International Reserves tends to be a factor that can reduce large variations in the exchange rate, because the Central Bank can use them to intervene in the market and avoid sudden fluctuations in the exchange rate of a currency.
Data about FDI and International Reserves
- Data on Foreign Direct Investment can be found for example on the World Bank website.
- Data on States' International Reserves can be found on the International Monetary Fund's website.
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