Toronto - In a world facing rising economic uncertainty and instability, look to cross-border investment activity for solid clues about what's next for economic growth and foreign exchange rates.
That's a key finding by Steven Riddiough, an associate professor of finance at the University of Toronto Scarborough and Rotman School of Management, and Huizhong Zhang from Australia's Monash University. They assessed nearly a quarter century of data on cross-border deals involving more than 40 countries and identified a predictive relationship between changes in a country's foreign investment activity and future changes in its economic growth and currency values.
It's a useful discovery for global investors and anyone setting policies that depend on accurately gauging the economic future. Although it's generally thought that foreign exchange rates are driven by changes in fundamental economic indicators like economic growth, researchers have had trouble showing a strong relationship between them in practice.
Cross-border merger and acquisition announcements, however, act as an easily identifiable "signal" for changing expectations within the market about economic fundamentals, say the researchers. That's because they are the moment when companies reveal previously private "micro-level" information about on-the-ground conditions affecting expectations for their industries. Once that information is out for everyone to see, it begins to affect other market players' economic expectations, which in turn influences currency values.
Micro-economic information like that is otherwise hard to get, said Prof. Riddiough. "Most economic announcements that might signal future growth are macro in nature -- economy-wide information on growth, labour markets, inflation, interest rates, and so on," he said. In contrast, "firms are at the coal face of the economy, giving them a real-time perspective on current and future economy-wide trends."
He and Prof. Zhang found that unusually high amounts of investment flowing out of a country to another were followed by a weakened domestic currency in the month after, and about a 1% drop in the originating country's economic growth rate within five years. However countries who were on the receiving end of unusually high foreign investment saw about a 1% bump in their rate of economic growth within five years, and an increase in the relative value of their currency over the following month.
The study looked at data on all cross-border investment deals between 40 developed and emerging market countries and the United States between 1994 and 2018. The U.S. was chosen as the anchor economy because it is the most active in the world when it comes to cross-border investment and provided a common currency (U.S. dollars) for the researchers' evaluations.
Instead of looking at the results of individual investment deals, the researchers focused on overall trends in investment activity and what happened afterwards. Their findings were most relevant to predicting changes for domestic economies.
"It is more about outflows than inflows," said Prof. Riddiough. "When domestic firms are undertaking more international M and A investment it tends to signal future weakness in the domestic economy and a weakening of the domestic currency. Vice versa, when domestic firms undertake less international M and A investment than typical, it tends to predict stronger future home conditions."
The study appears in the Review of Financial Studies .
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