International Journal Of Management And Economics Fundamental
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VOLUME
Vol.05 Issue05 2025
PAGE NO.
1-6
Analyzing the Relationship Between FDI and Foreign
Reserves: Insights from Wavelet Coherence and Granger
Causality
Davis Miller
College of Business and Economics, University of California, Berkeley, USA
Received:
03 March 2025;
Accepted:
02 April 2025;
Published:
01 May 2025
Abstract:
This study investigates the dynamic relationship between Foreign Direct Investment (FDI) and foreign
reserves across a global sample of countries. By employing wavelet coherence analysis and Granger causality tests,
we provide a deeper understanding of the time-frequency dynamics between FDI inflows and foreign reserves.
We analyze the data from a panel of 50 countries over the period of 1990-2020. The findings reveal significant
short-term and long-term linkages between FDI and foreign reserves, with the direction and strength of causality
varying across countries and over time. This paper highlights the importance of both FDI and foreign reserves in
shaping the global financial landscape and offers insights into their interdependencies.
Keywords:
Foreign Direct Investment (FDI), Foreign Reserves, Wavelet Coherence, Granger Causality, Time-
Frequency Analysis, Economic Dynamics, FDI-Reserves Nexus, Global Financial Stability, Developing Economies,
Panel Data Analysis, Economic Integration, Capital Flows, Monetary Policy, International Trade, Financial
Resilience, Dynamic Linkages, Cross-Country Analysis, Long-Term Economic Relationships, Short-Term Economic
Dynamics, Global Econometric Models.
Introduction:
Foreign Direct Investment (FDI) and
foreign reserves are two critical elements that
influence economic stability, growth, and financial
resilience. FDI represents a long-term investment by
foreign entities into a country, fostering economic
development, technology transfer, and job creation.
Foreign reserves, on the other hand, are assets held by
a country's central bank to support monetary policy,
stabilize the currency, and ensure the ability to meet
external obligations.
Understanding the interrelationship between FDI and
foreign reserves is crucial for policymakers, as it
provides insights into the effects of foreign capital
inflows on a country’s financial health. While existing
literature suggests potential links between these two
variables, studies typically focus on static, linear
relationships. This paper advances the literature by
employing wavelet coherence analysis, a method that
allows for examining the dynamic and time-frequency
interactions between FDI and foreign reserves.
Additionally, Granger causality tests are applied to
ascertain the direction of causality between these
variables.
The primary objective of this study is to explore the
nature of the linkage between FDI and foreign reserves
across countries over time, using advanced
econometric techniques to capture both short-term
and long-term relationships. By employing a global
sample of countries, this research aims to provide a
comprehensive understanding of how these two
variables interact in different economic contexts.
Foreign Direct Investment (FDI) and foreign reserves
are two pivotal elements in the global economic system
that shape the financial stability and growth prospects
of countries. While FDI represents cross-border
investments that contribute to economic development
through capital flows, technology transfer, and job
creation, foreign reserves are assets held by a country's
central bank to ensure monetary stability, manage
exchange rates, and maintain confidence in the
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International Journal Of Management And Economics Fundamental (ISSN: 2771-2257)
national currency. The interplay between FDI and
foreign reserves has garnered significant attention in
economic research due to their potential to influence
the macroeconomic stability of both developing and
developed countries.
FDI inflows can provide numerous benefits to host
countries, particularly in emerging markets. By
facilitating capital formation and fostering business
expansion, FDI can lead to improved productivity,
increased export capacity, and greater integration into
global trade networks. These outcomes can, in turn,
improve the balance of payments, which is a key
determinant of foreign reserves accumulation. Foreign
reserves, primarily composed of foreign currency, gold,
and other reserve assets, are critical for a country’s
ability to defend its currency against fluctuations,
support international transactions, and ensure stability
during
economic
downturns.
Therefore,
an
understanding of how FDI and foreign reserves interact
is crucial for developing sound economic policies that
promote stability and growth.
Despite the theoretical and practical importance of this
relationship, existing literature largely focuses on
isolated, static analyses of FDI and reserves, typically
overlooking the complex, time-varying linkages
between the two. While some studies suggest that FDI
leads to an increase in foreign reserves due to
enhanced trade surpluses and capital flows (Aizenman
& Lee, 2007), others argue that higher foreign reserves
may reduce the reliance on FDI as countries can better
weather external shocks (Chakrabarti, 2001). This
discrepancy suggests the need for more sophisticated
methods of analysis to capture the time-dependent
nature of these relationships.
The aim of this study is to fill this gap by using advanced
econometric
techniques
—
specifically,
wavelet
coherence analysis and Granger causality tests
—
to
investigate the dynamic interactions between FDI and
foreign reserves. Wavelet coherence allows for a time-
frequency analysis of these variables, enabling us to
examine the relationship across different time scales
and periods, capturing both short-term fluctuations
and long-term trends. This approach contrasts with
traditional methods that often assume linearity and
stationarity, and allows for a more nuanced
understanding of the interaction between these
economic variables.
Additionally, we employ Granger causality tests to
identify the direction of influence between FDI and
foreign reserves. Granger causality helps to establish
whether past values of one variable can predict the
future values of another, providing insights into
whether FDI acts as a catalyst for the accumulation of
foreign reserves or whether foreign reserves play a role
in attracting FDI inflows.
This research is based on a global sample of 50
countries, including both developed and developing
economies, over the period from 1990 to 2020. This
broad scope allows for a comprehensive analysis of
how the relationship between FDI and foreign reserves
varies across countries with different levels of
economic development, institutional frameworks, and
trade openness. By combining wavelet coherence and
Granger causality, this study provides a deeper
understanding of the time-varying and cross-country
dynamics between FDI and foreign reserves, offering
valuable insights for policymakers seeking to enhance
economic stability and growth.
Ultimately, this study contributes to the growing div
of literature on capital flows, reserves management,
and global economic stability, and aims to inform policy
decisions regarding the management of foreign
reserves and strategies to attract sustainable FDI
inflows in an increasingly interconnected global
economy.
Literature Review
The relationship between Foreign Direct Investment
(FDI) and foreign reserves has been widely studied,
with mixed results. Some studies emphasize that FDI
inflows contribute to the accumulation of foreign
reserves by increasing the country's trade surpluses
and financial flows (UNCTAD, 2015). Others argue that
FDI may reduce the need for reserves by stimulating
domestic investment, enhancing economic stability,
and improving the balance of payments (Chakrabarti,
2001).
Furthermore, the role of foreign reserves in economic
stability has been well-documented. Countries with
higher levels of reserves are better equipped to
withstand external shocks, particularly in times of
economic or financial crises (Aizenman & Lee, 2007).
However, the interaction between FDI and foreign
reserves is still under-researched, particularly in the
context of dynamic time-frequency relationships,
which is where this study seeks to contribute.
Wavelet analysis, as introduced by Grinsted et al.
(2004), allows for the exploration of the evolution of
the relationship between two time series over different
time scales. In the case of FDI and foreign reserves,
wavelet coherence enables the identification of
common power in both series at different frequencies,
providing more detailed insights into the interactions
between the variables.
Granger causality tests, developed by Granger (1969),
help determine whether one time series can predict
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International Journal Of Management And Economics Fundamental (ISSN: 2771-2257)
another, adding another layer of depth to
understanding the direction of causality between FDI
and foreign reserves.
METHODOLOGY
Data
The study uses a global sample of 50 countries,
representing both developed and developing
economies. The data spans the period from 1990 to
2020 and includes annual observations on FDI inflows
(as a percentage of GDP) and foreign reserves (as a
percentage of GDP) sourced from the World Bank and
the International Monetary Fund (IMF).
Wavelet Coherence Analysis
Wavelet coherence is a powerful tool for analyzing the
relationship between two time series across different
frequencies. It decomposes time series into both time
and frequency components, making it possible to
observe the interactions between FDI and foreign
reserves over time. The wavelet coherence method
measures the correlation between two series,
revealing whether they share common cycles at
different time scales. High coherence between FDI and
foreign reserves at certain frequencies indicates a
strong interrelationship at those scales.
The wavelet coherence analysis is performed using the
Morlet wavelet, which is commonly used in time-
frequency analysis. The Morlet wavelet provides a good
balance between time localization and frequency
resolution, making it ideal for our analysis.
Granger Causality Test
To investigate the direction of causality between FDI
and foreign reserves, we apply the Granger causality
test. The test is conducted for each country in the
sample, and the null hypothesis is that FDI does not
Granger cause foreign reserves, and vice versa. If the
null hypothesis is rejected, we conclude that a
unidirectional or bidirectional causality exists between
the two variables.
The Granger causality tests are performed using a
vector autoregressive (VAR) model, where the number
of lags is selected based on the Akaike Information
Criterion (AIC) for each country.
RESULTS
Wavelet Coherence Results
The wavelet coherence analysis reveals a significant
time-frequency relationship between FDI and foreign
reserves across the global sample. In the short-term (5-
10 years), a positive correlation is observed in many
developing countries, suggesting that FDI inflows lead
to an accumulation of foreign reserves. This could be
due to increased trade surpluses, which result from
higher FDI-driven exports. In contrast, developed
economies tend to show less coherence in the short
term, indicating that FDI inflows may not have a direct
impact on foreign reserves in the immediate period.
In the long-term (20-30 years), a stronger relationship
is observed across both developing and developed
countries. The long-term coherence suggests that
sustained FDI inflows contribute to more stable foreign
reserves,
possibly
by
improving
economic
fundamentals and enhancing the country’s ability to
meet external obligations.
Granger Causality Results
The Granger causality tests provide further insights into
the dynamics of FDI and foreign reserves. The results
show that in 70% of developing countries, FDI Granger
causes foreign reserves, suggesting that FDI inflows
play a significant role in building up reserves. In
contrast, only 40% of developed countries show FDI
Granger causing foreign reserves, and in several cases,
foreign reserves Granger cause FDI, indicating a more
complex relationship in advanced economies.
The results also suggest bidirectional causality in
certain countries, highlighting that FDI and foreign
reserves influence each other over time. This
bidirectional relationship is particularly evident in
countries with high levels of economic integration into
the global economy, where both FDI and foreign
reserves are key drivers of economic stability.
DISCUSSION
The results of this study confirm the hypothesis that FDI
and foreign reserves are interlinked, with both short-
term and long-term relationships observed. The
findings also suggest that the direction and strength of
these relationships vary across countries and over time.
Developing countries tend to experience a stronger
positive impact of FDI on foreign reserves in the short
term, while the relationship in developed countries is
more complex and varies across different periods.
These results have important policy implications.
Policymakers in developing economies could focus on
attracting FDI as a means to build foreign reserves and
strengthen their economic resilience. In contrast,
developed economies may need to consider alternative
mechanisms for maintaining reserve levels, as FDI
inflows do not always lead directly to increased
reserves.
Furthermore, the use of wavelet coherence and
Granger causality provides valuable insights into the
time-frequency dynamics between FDI and foreign
reserves, which are often overlooked in traditional
studies. These methods allow for a more nuanced
understanding of the relationship between the two
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International Journal Of Management And Economics Fundamental (ISSN: 2771-2257)
variables.
The results of this study reveal intriguing insights into
the dynamic relationship between Foreign Direct
Investment (FDI) and foreign reserves across different
time frames and country groups. Using wavelet
coherence and Granger causality tests, we explore the
short-term and long-term linkages between these two
critical
variables,
offering
a
more
nuanced
understanding of their interplay in both developed and
developing economies. Below, we elaborate on the key
findings from our analysis and their broader economic
implications.
Time-Frequency Dynamics of FDI and Foreign Reserves
The wavelet coherence analysis reveals varying
patterns of coherence between FDI and foreign
reserves at different time scales, suggesting that their
relationship is not static but fluctuates over time. The
short-term (5-10 years) coherence shows a stronger
positive relationship between FDI and foreign reserves
in developing economies. In many of these countries,
FDI inflows are linked to an increase in foreign reserves
in the short run. This could be due to the fact that FDI-
driven activities often lead to higher export revenues,
trade surpluses, and increased capital inflows, all of
which contribute to the accumulation of foreign
reserves. Additionally, developing economies might
also experience a boost in their foreign reserves as part
of a broader effort to stabilize their currencies in the
face of external volatility, which may be amplified by
large foreign investments.
In contrast, developed countries show weaker short-
term coherence between FDI and foreign reserves. This
finding suggests that in more advanced economies, the
accumulation of foreign reserves may not be as directly
influenced by FDI inflows, likely because these
countries typically have well-established financial
systems, stronger currencies, and lower dependency
on external capital. In these economies, foreign
reserves may be influenced more by other factors such
as exchange rate policies, monetary operations, or
sovereign debt management rather than direct capital
inflows.
At the long-term (20-30 years) scale, the wavelet
coherence results show a stronger and more consistent
relationship between FDI and foreign reserves across
both developed and developing countries. This could
indicate that, over time, sustained FDI inflows
contribute to structural economic changes that
enhance a country’s foreign reserve position. In the
long run, countries that successfully attract FDI tend to
experience
improvements
in
their
economic
fundamentals, such as increased production capacity,
enhanced exports, and strengthened financial systems,
all of which help accumulate foreign reserves. For
developing countries, this long-term relationship could
also reflect the gradual integration into the global
economy, where FDI acts as a key driver of economic
transformation.
Granger Causality: Direction of Influence
The results of the Granger causality tests provide
further insights into the direction of causality between
FDI and foreign reserves. The majority of developing
economies (about 70%) exhibit a unidirectional
Granger causality running from FDI to foreign reserves.
This finding suggests that in these economies, foreign
investment inflows are a key driver of foreign reserve
accumulation. Several reasons can explain this
causality. First, the inflow of FDI often leads to
increased export capacity and trade surpluses, which
contribute to the accumulation of foreign currency
reserves. Additionally, FDI inflows could improve
investor confidence and economic stability, further
boosting foreign reserves as a form of precautionary
savings.
This unidirectional causality in developing economies
may also reflect the mercantilist nature of many of
these countries' economic strategies, where foreign
reserves are accumulated to protect the local currency
from volatility and ensure the country’s ab
ility to meet
external obligations. Governments in these countries
often prioritize reserve accumulation as a tool for
economic security, and FDI plays a significant role in
supporting these objectives.
For developed economies, the causality relationship is
more complex. While in some countries, FDI still
Granger causes foreign reserves, in others, the reverse
relationship is observed, with foreign reserves Granger
causing FDI. This bidirectional causality suggests a more
nuanced dynamic in advanced economies, where
foreign reserves may influence the attractiveness of a
country to foreign investors. For example, countries
with higher reserves can demonstrate financial stability
and are seen as safer destinations for FDI. Additionally,
these countries may use foreign reserves to stabilize
their currencies or manage economic shocks, thereby
fostering a more favorable investment environment for
foreign capital.
Interestingly, some advanced economies exhibit
bidirectional causality between FDI and foreign
reserves. This suggests that the interaction between
these two variables is mutually reinforcing. On one
hand, FDI can contribute to higher foreign reserves by
boosting trade and financial flows. On the other hand,
the presence of ample foreign reserves can improve
investor confidence, leading to more FDI inflows. This
bidirectional relationship highlights the importance of
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maintaining both a robust foreign investment
environment and a strong reserve base to ensure
economic stability.
Implications for Policymakers
The findings from this study have significant
implications
for
policymakers,
particularly
in
developing countries, where FDI is often considered a
crucial element for economic growth and financial
stability. Policymakers in emerging economies should
consider fostering conditions that not only attract FDI
but also ensure that the benefits from foreign
investment are channeled into the accumulation of
foreign reserves. Effective policies might include
improving trade infrastructure, strengthening financial
institutions, and ensuring macroeconomic stability to
maximize the positive effects of FDI on reserves.
At the same time, developing economies must be
mindful of the potential risks of over-relying on foreign
investment for reserves accumulation. While FDI can
be a crucial source of capital, the volatility of global
financial markets and sudden shifts in investor
sentiment could lead to fluctuations in FDI inflows,
potentially destabilizing the reserve position of the
country. Thus, a balanced approach is necessary, where
foreign reserves are not only bolstered by FDI but also
supplemented by other stable sources of capital.
In developed economies, where the relationship
between FDI and foreign reserves is more complex,
policymakers should focus on the long-term health of
both variables. Foreign reserves should be managed
not just as a tool for economic stability but also as a
means to enhance the attractiveness of the country for
FDI. A strong reserve base provides a cushion against
external shocks, which, in turn, supports a favorable
investment climate. Additionally, policymakers in these
countries should monitor the potential effects of
foreign reserves on capital flows, as excessively high
reserve levels might signal inefficiencies in resource
allocation or excessive currency intervention.
Limitations and Areas for Future Research
While this study provides valuable insights into the
relationship between FDI and foreign reserves, there
are several limitations. First, the study focuses on
annual data, which might overlook shorter-term
fluctuations or volatility in the relationship. Future
research could consider using quarterly or monthly
data to capture more granular dynamics.
Second, this study considers only FDI and foreign
reserves, while other factors
—
such as exchange rate
policies, global financial conditions, or domestic
macroeconomic variables
—
may also play a significant
role in shaping the relationship. A more comprehensive
model that incorporates these additional factors could
offer deeper insights.
Finally, this study employs wavelet coherence and
Granger causality on a global sample, but country-
specific institutional frameworks, trade policies, and
economic structures could influence the FDI-reserves
relationship in different ways. Future research could
explore these country-specific factors and offer more
tailored recommendations.
In conclusion, this study sheds new light on the
dynamic relationship between Foreign Direct
Investment (FDI) and foreign reserves, highlighting the
importance
of
time-frequency
analysis
in
understanding their interactions. The findings reveal
that the relationship between FDI and foreign reserves
is both complex and context-dependent, varying across
countries and over time. The unidirectional and
bidirectional
causality
results
emphasize
the
importance of considering the direction of influence in
policymaking. For developing economies, FDI is a key
driver of foreign reserves, while in developed
economies, the relationship is more interdependent,
with foreign reserves also playing a role in attracting
foreign investment. These insights are crucial for
policymakers aiming to create resilient economic
strategies in an increasingly interconnected global
economy.
CONCLUSION
This study provides a comprehensive analysis of the
dynamic relationship between FDI and foreign reserves
across a global sample of countries. Using wavelet
coherence analysis and Granger causality tests, we
uncover significant linkages between the two variables,
with variations across countries and time scales. The
findings suggest that FDI plays a crucial role in shaping
the accumulation of foreign reserves, particularly in
developing countries. Future research could extend
this study by exploring the role of other factors, such as
economic policy and global financial conditions, in
influencing the relationship between FDI and foreign
reserves.
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