Capital flows, real exchange rate misalignment and PPP tests in emerging market countries

Abstract

The economic performance of emerging markets has significant impacts on economic growth and volatility of macroeconomic indicators in various countries. Emerging markets accounted for 20-43% of global exports during the period 1970-2005, and held 70% of global foreign reserves in recent years. More than 50% of the exports from the Euro area, Japan and the United States go to emerging markets and other developing countries. The globalization of capital flows is facilitated by technological innovations and excellent information networks, coupled with sharp increases in savings that are directed into financial instruments across borders. The use of Purchasing Power Parity (PPP) as a benchmark in exchange rate policy reforms assumes the existence of a stable relationship between the exchange rate and the ratio of price levels in two countries. This article investigates whether or not long-run PPP holds in emerging markets. Johansen's cointegration technique is used with annual data in analysing the relationship between exchange rates and the CPI during the period 1951-2005. We found overwhelming support for long-run PPP in emerging markets, thus, PPP is a reliable guide for exchange rate determination and exchange rate policy reforms in these countries.