6 developing countries than industrial countries. For the industrial countries, it is well known that the extensive literature on the impact of exchange rate volatility on trade is inconclusive, possibly because of its likely small impact (for a survey of the literature, see McKenzie 1999). Recent research does show that the impact of exchange rate volatility on trade is negative but small. Dell'Ariccia (1998), for example, shows in a gravity model (in which the volume of trade between two countries increases with the product of GDPs and decreases with distance) that exchange rate volatility has a negative, though small, effect on bilateral trade flows among 14 member countries of the European Union during the period 1975-94 (see also Gagnon 1993). All in all, at least for industrial countries, exchange rate volatility is not usually considered to have a negative impact on trade.

For developing countries, however, the negative effect of exchange rate volatility on trade appears to be more pronounced, although the scope of existing empirical work is somewhat limited (Calvo and Reinhart 2000a; McKenzie 1999). For example, Kumar and Dhawan's (1991) work on Pakistan's exports to Germany, Japan, and the United States for 1974-85 suggests that exports were significantly adversely affected by variability in nominal bilateral exchange rates. Looking at the effect of real exchange rate variability on the exports of Chile, Colombia, Peru, the Philippines, Thailand and Turkey, Caballero and Corbo (1989) have obtained the clear evidence of generally significantly negative and substantial impact. Arize, Osang and Slottje (2000) have used quarterly data for 13 emerging market economies (including Indonesia, Korea, Malaysia, the Philippines, Taiwan Province of China [POC], and Thailand) during 1973-96 to confirm the significantly negative effect of real effective exchange rate volatility on exports. In addition, Calvo and Reinhart (2000a) and McKenzie (1999) cite additional studies that indicate the evidence of significantly negative effects of exchange rate volatility on trade, including the imports of some member countries of the Association of South East Asian Nations (ASEAN). Further systematic research is needed to clearly establish the negative impact of exchange rate volatility on trade in developing countries.

Exchange rate volatility may have a greater negative impact on domestic investment, because its longer-term orientation can magnify the effect of uncertainty.<sup>6</sup> This may be particularly true in the case of East Asian countries where much of foreign direct investment (FDI) is directed towards manufacturing (re-)exports as opposed to domestic sales.<sup>7</sup> Given uncertainty, firms may find it optimal to wait rather than to commit themselves to a decision in one way or another. Waiting thus becomes an alternative to investing or not investing. In this environment, Dixit and Pindyck (1994) argued that the net present value (NPV) rule should be modified to include the cost of waiting, such that the NPV of a project is given by the PV of expected returns less the value of the option to invest later. By incorporating exchange rate uncertainty to the Dixit-Pindyck model, Darby, Hallett, Ireland and Piscitelli (1999) have shown that there is a threshold level of exchange rate uncertainty beyond which investment is adversely

> 6On the other hand, to the extent that purchasing power parity is more likely to hold in the long run, uncertainty associated with exchange rate volatility may have a smaller role to play in investment decisions.

> 7 If FDI is directed towards domestic sales, greater exchange rate uncertainty may cause local production to replace exports to that market, thus increasing FDI flows. If FDI is directed towards (re)exports, exchange rate uncertainty increases the riskiness of that particular host country as a production base. See Ito, Isard, Symansky and Bayoumi (1996) and Benassy-Quere, Fontagne and Lahreche-Revil (1999), as discussed below.