7 affected.8 In a related vein, noting the inability of most developing countries to borrow in their own currencies and thus the limited ability to hedge foreign exchange risk, Femandez-Arias and Hausmann (1999) have argued that, with floating exchange rates, countries will reduce unhedged foreign currency borrowing by simply reducing the total amount of foreign currency borrowing, thereby experiencing less investment and growth.

Addressing the need to attract foreign direct investment (FDI) as a stable source of longterm capital, Benassy-Quere, Fontagne and Lahreche-Revil (1999) analyzed the locational decisions of a risk averse multinational firm, considering two foreign locations in order to reexport (hence, trade and FDI are assumed to be complements). In this model (in which two developing countries are competing for FDI inflows), it is shown that exchange rate volatility is detrimental to FDI because it increases the variance of local costs (hence profits measured in the investing country's currency), thus diverting FDI to the other country with a smaller variance; this prediction is empirically confirmed by a panel of 42 developing countries receiving FDI from 17 OECD countries during 1984-96. In particular, while the real depreciation of a developing country currency against that of the investing country is shown to increase FDI inflows (through what they call the competitiveness effect), an increase in nominal exchange rate volatility reduces FDI inflows, controlled for distance and other country characteristics. As a policy implication, the importance of stabilizing the exchange rate against the currency of one's most important FDI supplier needs to be underlined.<sup>9</sup> Finally, regarding the effect of exchange rate volatility on inflation and economic growth, Ghosh, Gulde, Ostry and Wolf (1997) investigated a data set covering 140 countries over 196090 by considering the degrees of exchange rate flexibility measured effectively in terms of officially stated classification. For both the entire sample and for the sample of developing countries,<sup>1</sup> I they find unambiguously that inflation is both lower and less variable under pegged regimes. Likewise, domestic investment is somewhat higher under pegged regimes. The results for growth, however, do not look so conclusive. For the entire sample as well as for the sample of developing countries, growth does vary very little between floating and pegged regimes, Theoretically, investment can rise or fall with greater exchange rate uncertainty. The types of industries more likely to benefit from exchange rate uncertainty are those with few alternative uses and little scrap value or with large entry costs. In contrast, the types of industries whose investment is likely to benefit from greater exchange rate stability are those with high scrap value but a low opportunity cost of waiting. Based on the estimation of aggregate investment equations for France, Germany, Italy, the United Kingdom and the United States, Darby, Hallett, Ireland and Piscitelli (1999) have found significant, negative coefficients for exchange rate volatility.

) In this connection, a recent study by Nakamura and Oyama (1998) provides an interesting insight into how the exchange rate sensitivity of FDI flows can be affected by the type of activities supported by FDI. Using the sample of eight East Asian economies (China, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan POC, and Thailand), Nakamura and Oyama (1998) have noted that Japanese FDI into these countries during 1979-97 was highly sensitive to changes in the real bilateral exchange rates, such that depreciation against the yen significantly increased FDI from Japan. The exchange rate sensitivity, however, was smaller for local market-oriented FDI inflows. On the other hand, no such strong exchange rate sensitivity was observed for American FDI into the region. For some countries, when the local currency depreciated against the US dollar, there was even a fall in FDI from the United States, suggesting that much of American FDI was in real estate and other non-manufacturing sectors where it assumed much of the character of portfolio investment. All in all, exchange rate sensitivity was the most distinguishing feature of Japanese FDI into East Asia.

1" Separate statistics are reported for high and low per capita income countries. Here, we refer to the results for the low per capita income countries (which do not include industrial countries) as characterizing "developing countries."