Capital Account Openness, Exchange Rate Flexibility and Exchange Rate Misalignment: Evidence from Developing Economies

The study endeavours to investigate macroeconomic determinants of exchange rate misalignment in developing countries with a particular emphasis on exchange rate flexibility and capital account openness. At the first stage, the Behavioural Equilibrium Exchange Rate approach has been adopted to compute exchange rate misalignment by estimating the real exchange rate model using the Cross-Sectionally Augmented Autoregressive Distributed Lags technique. In the second stage, the study employs alternative econometric techniques, namely, Pooled Mean Group, Mean Group, and Dynamic Fixed Effects, to assess the drivers of exchange rate misalignment. The empirical results show that both exchange rate flexibility and capital account openness effectively reduce RER misalignment in developing, emerging, and non-emerging economies, through different channels. RER flexibility enables market-adjusted changes, and capital account openness achieves long-run allocative efficiency through connecting the domestic market with global financial flow. Moreover, macroeconomic variables such as GDP growth, inflation, financial sector development, natural resource rents, and foreign direct investment are found to be major drivers of exchange rate misalignment in these countries. Overall, the analysis underlines the need for coherent policy coordination, focusing on capital account liberalization and a flexible exchange rate regime for managing exchange rate misalignment.