Capital Inflows and the Real Exchange Rate: A Comparative Study of Asia and Latin America

Abstract

The nexus of real exchange rate (RER) and capital inflows is examined through a comparative analysis of the experiences of emerging market economies in Asian and Latin America during the period 1985-2000. It is found that the degree of appreciation in RER associated with capital inflow is uniformly much higher in Latin American countries compared to their Asian counterparts, despite the fact that the latter experienced far greater foreign capital inflows relative to the size of the economy. The econometric evidence suggests that both the composition of capital flows and differences in the degree of response of RER to capital flows matter in explaining these contrasting experiences. While RER appreciation is a phenomenon predominantly associated with other (non-FDI) forms of capital inflows (OCFW), a given level of OCFW brings about a far greater degree of appreciation of the real exchange rate in Latin America where the importance of these flows in total capital inflow is also far greater. On the policy front, Asian countries seem to have used fiscal contraction and nominal exchange rate adjustment more effectively to cushion the RER against the appreciation pressure of capital inflows. There is, however, no evidence to suggest that sterilised intervention can generate a lasting impact on the real exchange rate.

FDI location and exchange rates. is there really a relationship between the two?

“…Exchange rate stability can help to explain FDI inflows on condition that the host country's economy is liberalized (Emmanue and Luther, 2014). Athukoraka and Rajapatirana (2003) observed that real exchange rates strengthened in response to the total capital flows whilst the same study further revealed that an increase in FDI inflow in particular led to the weakening of the real exchange rate in Asian and Latin American countries. In addition, the strengthening of the real exchange rate in response to increased capital inflows was more pronounced in Asian countries as compared to in Latin American countries, argued Athukoraka and Rajapatirana (2003).…”

“…For countries whose trade openness was above 125%, the impact of exchange rate volatility was found to be negative whereas those countries characterized by less than 125%, the influence of exchange rate volatility on FDI were found to be positive (Furceri and Borelli (2008). Athukoraka and Rajapatirana (2003) showed that real exchange rates strengthened in response to the total capital flows whilst the same study further revealed that an increase in FDI inflow in particular led to the weakening of the real exchange rate in Asian and Latin American countries. The study by Athukoraka and Rajapatirana (2003) further revealed that the appreciation of the real exchange rate in response to increased capital inflows was more pronounced in Asian countries as compared to in Latin American countries, an indication that the impact can be region specific.…”

“…Among the few researchers whose studies supported the bi-directional hypothesis which says that both exchange rate and FDI affect each other include Emmanue and Luther (2014) and Athukoraka and Rajapatirana (2003). Using Vector Autoregressive, Emmanue and Luther (2014) established that a stable exchange rate was instrumental in attracting FDI into Ghana whilst FDI inflow played a part in as much exchange rate stabilization is concerned in Ghana.…”

Capital Flows and Real Exchange Rates in Emerging Asian Countries

“…A number of empirical studies (e.g., Ito 2000, Lipsey 2000, Athukorala and Rajapatirana 2003 argue that the appreciation of RER associated with net FDI inflows could be smaller than that associated with portfolio and bank lending flows. Compared to other flows, FDI has a general tendency to concentrate more on the tradable goods sector and export-oriented industry.…”

Dutch Disease in Central and Eastern European Countries

“…The symptoms of Dutch Disease derived from foreign direct investment (FDI) inflows were initially analysed by (Athukorala and Rajapatirana, 2003) (Lartey, 2007), using dynamic panel data for a set of Sub-Saharan countries, shows that FDI is positively correlated with RER appreciation and, consequently, with losses of competitiveness in exports. Similar conclusions are obtained by (Javaid, 2011) for a group of Southeastern Asian economies.…”