Cross-border investment and the decline of exchange rate volatility: implications for Euro area bilateral investments

Abstract

Exchange rate volatility has undergone a secular decline since the collapse of the Bretton Woods system. We conjecture that this phenomenon may have led to a generalized decreased need for risk exchange hedging in financial markets. Indeed, we find that the negative association between bilateral foreign portfolio investments and the volatility of the exchange rate has markedly weakened over time. This finding, which is particularly significant for large countries and in the post-crisis period, can also help explain the decline in bilateral investments among EMU member countries. We observe, in fact, that, after 2012, the distinctive fall of Euro-area bilateral equity investments is significantly explained by the global declining effect of exchange rate volatility on financial markets. A lower exchange rate volatility, associated with the ensuing generalized reduction in the perceived exchange rate risk, may have posed a challenge to the economic relevance of the full exchange risk hedging system represented by the common currency area, and hence to the attractiveness of reciprocal investments.