Abstract
This paper examines the nexus between capital flows and real exchange rate (RER) in emerging Asian countries using a dynamic panel-data model for 2000-2009. In contrast to previous studies, capital flows here are separated into foreign direct investment (FDI), portfolio investment, and other investment (bank loans) flows. Inflows and outflows are also treated separately in the model. The estimation results show that compositions of capital flows matter in determining impacts of the flows on the RER. Portfolio investment and other investment (including bank loans) bring in a faster RER appreciation than FDI. However, the magnitudes of appreciation among capital flows are close to each other. The increasing importance of merger and acquisition activities in FDI makes the flows behave closer to other forms of capital flows, especially portfolio investment. The estimation results also show that capital outflows bring about a greater degree of exchange rate adjustment than capital inflows. All in all, the results imply that the swift rebound of capital flows in the region could result in excessive appreciation of the (real) currencies, especially when capital flows are in a form of portfolio investment and bank loans.
Highlights
The swift and strong rebound of capital inflows in emerging Asian countries after the current global financial crisis has added new impetus to the debate on how countries receive benefits from capital inflows and avoid costs that are associated with them
Column B reports the estimation results when net capital flows of all types (FDI, portfolio, and other investment) are divided into inflows and outflows
The estimation result clearly shows the statistical insignificance of net foreign direct investment (FDI) flows on real exchange rate (RER) in the first period, but the relationship between these two variables becomes statistically significant in the following period. This is in contrast to the results shown for net portfolio investment and other investment flows in which a 1% increase in these net inflows leads to an immediate appreciation of RER by 0.15% and 0.10%, respectively
Summary
The swift and strong rebound of capital inflows in emerging Asian countries after the current global financial crisis has added new impetus to the debate on how countries receive benefits from capital inflows and avoid costs that are associated with them. Stronger currency appreciation has become evident in emerging Asian economies in response to the strong rebound of capital inflows, portfolio investment flows. Excessive liquidity associated with the strong rebound of capital inflows began to set new levels of asset prices. Central banks in the region including in the PRC and Taipei,China have begun to tighten capital control policies, while other central banks closely monitor movements of capital flows. In the Republic of Korea; Taipei,China; and Thailand, the central banks have intervened excessively in the foreign exchange market to slow the appreciation of the currency. Central banks are still reluctant to raise policy rates even though inflation has begun to show an upward trend, so as to reduce the risks of encouraging speculative capital inflows
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