Exchange rate volatility under sanctions: the moderating role of FDI

Economic sanctions can significantly destabilize exchange rates, creating challenges for targeted economies. This study examines how sanctions—specifically export, import, and financial sanctions—affect exchange rate volatility, and explores the moderating role of Foreign Direct Investment (FDI). Using panel data from 21 heavily sanctioned countries between 2000 and 2021, we apply both static and dynamic models, including Panel-Corrected Standard Errors (PCSE) and Generalized Method of Moments (GMM). The results show that sanctions considerably increase exchange rate volatility, particularly in smaller economies. However, FDI inflows mitigate these negative effects, providing a stabilizing influence. The study further contributes to exchange rate literature by refining key theoretical frameworks such as the Uncovered Interest Rate Parity (UIP) and the Balance of Payments (BOP) approach, integrating sanctions intensity and FDI. These insights offer practical implications for policymakers in geopolitically sensitive contexts, highlighting the importance of attracting FDI to buffer the currency market against external shocks.