Capital Inflow, Foreign Exchange Intervention, and Currency Misalignment in Emerging Market Countries

Abstract

Using samples of 25 emerging market countries (EMCs) and 22 industrial countries (ICs), we derive currency misalignment from estimating the equilibrium exchange rate based on the purchasing power parity theory and by considering the Balassa–Samuelson effect. We then examine factors affecting currency misalignment by focusing particularly on capital inflows and foreign exchange intervention (FEI). The empirical results show that unlike ICs, EMCs' foreign capital inflows — mainly the component of other investment — contribute to enhance currency misalignment through overvaluation. We also find that the resurgence of international capital inflows after 2000 and the policy responses from EMCs have a significant influence on currency misalignment. Although capital inflows could drive a currency to appreciate, aggressive FEI to engineer even larger capital outflows has kept EMCs' currencies factually undervalued. Reaping the benefits from capital inflows is still an illusion for EMCs.