FDI, Foreign Affiliate Operations, and the Transfer Process: Macroeconomic Adjustment to FDI Inflows in the Case of Costa Rica

The theoretical and empirical literature on the macroeconomic effects of capital inflows posits that a net inflow of foreign capital leads to an equilibrium real exchange rate (RER) appreciation through an expansion in aggregate demand. But this literature fails to distinguish between the different types of flows, or their specific mechanisms of influence. This paper analyses the adjustment process to FDI inflows in the case of Costa Rica, and focuses on whether, to what extent and through what mechanisms such adjustment requires a RER appreciation. It argues that a study of the process of macroeconomic adjustment to a net inflow of FDI -the transfer process- should not be detached from an investigation into the trade and financial practices of the foreign-owned firms towards which FDI flows. A two-sector model is developed to capture the basic interactions between foreign investment, domestic investment and the RER. It shows that the sectoral allocation of FDI, the response of domestic investment to exogenous changes in the foreign capital stock, the input composition of foreign capital, and the financial practices of foreign investors, are crucial determinants of the long-run equilibrium RER. The paper also includes two empirical parts. The first one provides an overview of the general trends of aggregate FDI inflows into Costa Rica between 1970-99, and analyses some data on the trade and financial patterns of foreign affiliates operating in the country. The second undertakes an econometric examination of the impact of FDI on output, investment, exports, imports and the RER, using cointegration techniques. The study is based on annual data for the period 1970-99. It is found that FDI exerts a strong negative impact on the equilibrium RER.