Capital Inflows and the Real Exchange Rate: Evidence from Emerging Market and Developing Economies

Capital inflows play a crucial role in financing savings-investment gaps, which could result in higher economic growth and better living standards, but capital inflows are associated with the risk of real exchange rate (RER) appreciation. The empirical evidence on the nexus between capital flows and RER is limited and inconclusive. This study empirically investigates the impacts of capital inflows on the RER for a sample of 114 emerging market and developing economies (EMDEs) from 1991-2015. This study's large sample, making it one of the most comprehensive studies, renders us to undertake a more granular analysis on the capital inflows–RER nexus, which has not been conducted in the literature. The study employs the two-step system generalized method of moment technique to estimate dynamic panel data models. The results show that capital inflows exert the RER appreciation impacts in EMDEs. However, the composition of capital inflows matters. When gross capital inflows are analyzed at disaggregated levels, only foreign direct investment (FDI) generates RER appreciation effects while the other forms of capital inflows, including portfolio equity, portfolio debt, and other investment, do not. Further, the absorptive capacity of the capital-recipient economy plays a role in mediating the capital inflows-RER relationship. There is a positive feedback loop between capital inflows and exchange rate flexibility although the evidence is weak. In a more flexible exchange rate regime, capital inflows cause RER to appreciate further. In contrast, the empirical results show substantial evidence that financial development helps dampen the RER appreciation impacts of capital inflows. When a capital-recipient economy possesses a certain threshold of financial sector development, the appreciation impacts of capital inflows are neutralized. The findings have important policy implications. First, although it is generally considered that FDI positively contributes to economic growth in the capital-recipient economy, the FDI movements should be actively monitored and analyzed because the FDI inflows can cause the RER appreciation that could, in turn, reduce export competitiveness. Second, financial sector development should be a policy priority for EMDEs because it plays a crucial role in weakening the RER appreciation effects caused by capital inflows.