A Model of the Transfer Problem with Application to LDCs

This paper studies a form of Dutch Disease known as the Transfer Problem in developing countries. On the theoretical side we present a simple model to show that the real exchange rate depends on the "real fundamentals" such as terms of trade or productivity differentials and "financial fundamentals" such as capital inflows. We show that the effects of capital inflows on the real exchange rate depend mainly on the propensity of governments to subsidize the tradable or the non-tradable sectors. In the empirical section we take into account the heterogeneity of the sample, the dynamic of the real exchange rate and the non stationary nature of the data. Capital inflows could include foreign aid, remittances or foreign direct investment. Furthermore, we demonstrate empirically that real fundamentals - not capital inflows - are the main driving forces of real exchange rate movements in the low developing countries. The Balassa-Samuelson effect by itself accounts for 57% of RER variations while capital inflows account only for 19% of RER variations. The Transfer Problem theory is not rejected but its impact on RER movements in the LDCs is weak.