Impact Of Exchange Rate And Political Risk On Foreign Direct Investment In South Africa

Exchange rate fluctuations of the South African Rand against the pound

Table 1: Exchange rate fluctuations

(Source: Created by author)

Figure 1: Exchange rate fluctuations

(Source: Created by author)

From the above data, it can be seen that the value of South African Rand’s value is in decreasing trend against the value of pound. The decreasing trend continued from April 2012 till June 2016. However, from July 2016, it started rising very slowly and maintained the growth rate till December 2016. The pound rate was able to get an advance against the rand from South Africa as the value of rand continued to decline. The outcome indicated that the economy of South Africa started to slow down owing to the rising in rate of inflation and reduced growth in wage rate. However, there is always the chance exist for improvement with the improvement of the situation in South Africa’s economy. Further, the data is expected to be improved if the market focuses on the uncertainty level and political developments (Ghosh, Moise & Kalipeni, 2017).

As the market of South Africa has a free market economy, it influences foreign investment in private as well as public sectors. The expected growth rate of South Africa is high, as compared to other countries. The volatility of exchange rate plays a crucial role in the decision taking approach of the domestic as well as foreign investors those are investing in the economy of South Africa. Using the free-floating exchange rate in the investment of South Africa have exposed the rand to any type of shocks from the global economy (Bodie, 2013). The effective exchange rate and the various kinds of investment in the country are inter-related over the long –run. That means, the changes in these variable will have an impact over each other and therefore, the alteration of these variables must be assessed regularly. If the government wish to improve the status of economy of the country, then the rate of exchange must be analysed carefully to assure that it does not appreciate or depreciate at a certain point where it happens to be an obstruction to the international as well as domestic investment (Farole & Winkler, 2014).

Foreign direct investment is an investment that is made in abroad and the country in which the investment is made they control the investing company. It is dependent on the endowment factors of the nation, for example, infrastructural availability, human capital, scientific knowledge, developmental and research activities play crucial role in the deciding about FDI (Alfaro & Charlton, 2013).

Impact of exchange rate on foreign direct investment

Political risk is stated as serious depression that is harmful for the economic performance of any nation. Political risk is troublesome in nature and is burden to the policy makers of macro-economic in executing their policies. Political risks encountered by the foreign investors are explained as the probability or risk of taking place of various political issues that are expected to alter the probability of profits from on a particular investment (Holmes et al, 2013). The major political risks associated with foreign investment are:

• Instability in the local economy and high rate of inflation
• Unfair and unequal treatment from the government
• Risk of alteration in the government regulation.
• Obligation in profit transfer
• Political unwillingness in structuring the policies

Risk from government – whenever the government put an obligation in the economic activities that is market-oriented, it affects the inflows of foreign investment. The political risk not only caused by internal conflict but also affect ted by the operation of government organization and the inter-governmental relations (Gilman, 2013).

Economics – there is a close relationship between economical and political factors that includes urbanization, inequalities of income that have considerable effects on the political instability. Higher the gap in income level, more the instability in the economy will take place (Chan, 2016).

Violence – political instability is more associated with the violent and disruptive activities in the country. These risks include coups, assassinations, strikes, riots, government crises, revolutions, guerrilla activities and anti-governmental demonstrations. Civil war is the major contributor towards the political risk.  Adverse governmental alterations involve the total alterations in the ruling party or the collapse of state general.

Democracy – The countries which are progressive and where the government are elected democratically the country is regarded as more stable at the political aspect. The reason behind this is that these governments and their policies are regarded as stable. Therefore, it will attract more foreign investor to invest in these countries like South Africa. Thus the demographic prospects of the government have large impact on the political risk exposure of a nation. South Africa is regarded as democratic and is exposed to low political risk (Fajgelbaum, Grossman & Helpman, 2014).

Risk involved in a nation and FDI are inversely related as the political factors of a nation have a great impact on the decision of the investors. The investors prefers those countries for investment which have lower rate of corruption and national risk level and have better enforcement for contract. Further, the investors feel that the countries which have better protection for property rights are better for investment. These factors state that a stable political environment, where there are respects for regulations and laws regarding human rights, labour laws and environmental laws attract more FDI.  The political factors affect the foreign investment mainly in the following ways:

• Through increasing the uncertainty as well as cost of business as the MNCs will invest only if they are considerably compensated for the risk of not achieving the targeted profit from the investment
• The uncertainty involved with the political risks increase the risk related to required return from the investment and reduce the number of projects that were earlier considered as attractive.

Identification of political risk for FDI

Mainly, there are two ways to deal with the political risk to mitigate it. They are:

• A smaller stake in the ownership of MNC decreases the investment amount and put it in risk in the host nation
• Surrendering the large ownership stake reduces the expropriation risk. This will be so as due to the fact that the local partners politically will have strong connection with the government of host country. Therefore, where the greater risk is involved, the MNC are expected to maintain lower ownership stake.

The aim of the political risk management approach is to protect profits, reputation and assets of the MNC through reducing the likelihood of taking place of loss or decreasing the loss before it takes place. The other risks that are involved with the political risks are market risk, credit risk and political risk. Thus, it follows that in case of increase in political risks, the MNCs will react and their decision will affect the investment. However, it is identified that the political risks are often not taken into consideration, partly due to complex in measuring and implementing them into the decision of operation and investment. MNCs can reduce the probability of risk through outsourcing the risk by opting to political risk insurance. The providers of these insurance are   participants from private market and government agencies. Further, the firms can use various strategies to revolve the risks and uncertainties involved in the host countries into the opportunities and the procedures of risk management can assist the decision makers to adjust with the uncertainties and risks systematically.

South Africa has high potential, developed infrastructure and competitive and domestic economy. The democracy of the nation is also established with the transparent and fair elections and has much appreciation for the law. South Africa has put the economic reforms in better way that led the stabilisation of macro-economic stability and at the same time it reduced the customs and tax obligations. Further, it has an active and large stock exchange (Sbia, Shahbaz & Hamdi, 2014).

Predictability and stability of economy gives the nation an advantage over other developing nations in pulling investment. Despite of various challenges like shortages of infrastructure and health related issues the investment in South Africa is increasing at a fast pace. The reason behind this is that various nations are active in various businesses in South Africa. For example, investors from brazil are active in West Africa, Indian companies are actively conducting their property development, tourism and manufacturing related business there and china are carrying out resource extraction and infrastructure related business all over Africa (Akoto, 2016).

The parent company generally invest in the form of FDI through incorporation of wholly owned or partially owned organizations, acquiring stakes in the associated forein organizations, through acquisition or merger in the foreign company and taking part in the equity joint ventures. As the MNCs generally invest in long-term projects, they mainly look for long-term finance through debt or equity with the consideration of risks and costs associated with the source. Various organizations raise the finance in form of equity and engage into debt financing in foreign nations (Lee, 2013). Various sources of debt and equities are:

• Local offerings in domestic currencies
• Private placements in domestic currency’s financial foundations
• International offerings in multiple nation’s currencies
• Private placement in the financial institutions of the host country (Akpan et al., 2014).

Impact of political risk on FDI

Figure 2: FDI growth rate

(Source: South Africa Foreign Direct Investment | 1956-2017 | Data | Chart, 2017)

It can be seen from the above graph that the performance of FDI in South Africa has significantly gone up over the last few years. Between 1990 and 1993, the average inflows were quite depressing and amounted to US$ 46 million per annum. However, after the transition period of 1994, it gone up and amounted to US$ 1.861 billion per annum in 2002; over the last three years, the growth rate in FDI has increased from 1661 to 1873 in January 2017. It is very clear from the trends that the growth in FDI in South Africa from its inception has grown significantly and investors find South Africa better option for investment (Lederman, Mengistae & Xu, 2013).

Reference:

Akoto, W. (2016). On the nature of the causal relationships between foreign direct investment, GDP and exports in South Africa. Journal of International Development, 28(1), 112-126.

Akpan, U. S., Isihak, S. R., & Asongu, S. A. (2014). Determinants of foreign direct investment in fast-growing economies: a study of BRICS and MINT.

Alfaro, L., & Charlton, A. (2013). Growth and the Quality of Foreign Direct Investment. In The Industrial Policy Revolution I (pp. 162-204). Palgrave Macmillan UK.

Bodie, Z. (2013). Investments. McGraw-Hill.

Chan, S. (Ed.). (2016). Foreign direct investment in a changing global political economy. Springer.

Fajgelbaum, P., Grossman, G. M., & Helpman, E. (2014). A Linder hypothesis for foreign direct investment. The Review of Economic Studies, rdu027.

Farole, T., & Winkler, D. (Eds.). (2014). Making foreign direct investment work for Sub-Saharan Africa: local spillovers and competitiveness in global value chains. World Bank Publications.

Ghosh, J., Moise, I. K., & Kalipeni, E. (2017). 13 The role of regional integration in foreign direct investment in Southern Africa. Advances in Geoeconomics, 4.

Gilman, M. G. (2013). The financing of foreign direct investment: A study of the determinants of capital flows in multinational enterprises. Bloomsbury Publishing.

Holmes Jr, R. M., Miller, T., Hitt, M. A., & Salmador, M. P. (2013). The interrelationships among informal institutions, formal institutions, and inward foreign direct investment. Journal of Management, 39(2), 531-566.

Lederman, D., Mengistae, T., & Xu, L. C. (2013). Microeconomic consequences and macroeconomic causes of foreign direct investment in southern African economies. Applied Economics, 45(25), 3637-3649.

Lee, J. W. (2013). The contribution of foreign direct investment to clean energy use, carbon emissions and economic growth. Energy Policy, 55, 483-489.

Sbia, R., Shahbaz, M., & Hamdi, H. (2014). A contribution of foreign direct investment, clean energy, trade openness, carbon emissions and economic growth to energy demand in UAE. Economic Modelling, 36, 191-197.

South Africa Foreign Direct Investment | 1956-2017 | Data | Chart. (2017). Tradingeconomics.com. Retrieved 6 April 2017, from https://www.tradingeconomics.com/south-africa/foreign-direct-investment

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