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

TLDR

The study compares how capital inflows affect the real exchange rate in Asian and Latin American emerging economies from 1985 to 2000. The authors employ econometric analysis of capital inflow and RER data across these countries during that period. Latin American countries experience a much larger RER appreciation per unit of capital inflow than Asian counterparts, driven mainly by non‑FDI flows, while Asian economies mitigate pressure through fiscal contraction and nominal exchange rate adjustments, and sterilised intervention shows no lasting effect.

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.