Paper: Employment Growth in the Face of Exchange Rate Uncertainty: The Role of Trade and Foreign Equity Finance

Journal: Southern Economic Journal

As developing countries open their economies to international trade and capital flows, they are forced to contend with sharp movements in their domestic currencies. Efforts to dampen these movements in exchange rate involve significant costs (both implicit and explicit). This paper looks at the impact of an increase in the real exchange rate uncertainty on firm level employment growth. It uses firm level data on 960 non-financial Indian firms to study the response of employment growth to exchange rate uncertainty.

The key findings of this paper are the following.

• First, real exchange rate uncertainty has a significant and negative impact on firm level employment growth.
• Second, firm characteristics, including differences in export and import intensity, play an important role in determining the overall impact of exchange rate uncertainty on firms.
• Third, foreign equity ownership significantly mitigates the adverse impact of exchange rate uncertainty but the same cannot be said about access to domestic equity finance.

Foreign equity ownership is often promoted as a means of generating employment growth in emerging countries like India. These results indicate that the direct benefits of foreign equity inflows in terms of faster employment growth might not be significant but foreign equity ownership does mitigate the negative impact of exchange rate uncertainty on firm level employment growth; especially for technologically intensive industries. To the extent that exchange rate uncertainty itself is a result of underlying political uncertainty, it would be difficult for emerging markets like India to attract FDI without addressing the fundamental cause of uncertainty. In such cases, steps needed to attract FDI will also be the ones that help reduce exchange rate uncertainty. Further, policies to encourage exports can make firms more resilient to uncertainty thereby reducing the need for central bank intervention in the forex market.