Abstract
Economies with exchange rate pegs generally attract higher capital inflows either through lower transaction costs of trade and finance, or by encouraging investors to exploit any interest differentials, or where foreign exchange (FX) interventions are sterilized, any previous interest differentials are preserved. This paper examines these relationships using FDI, portfolio and bank inflows for 28 emerging market economies. We find that greater fixity of the exchange rate and sterilized intervention can potentially encourage capital inflows, and that the effect is magnified when combined. Further, we find that the effect differs by region, and it is larger for higher inflows.
Highlights
The prevailing intuition behind the effects of fixed or managed exchange rates on the inflow of foreign capital is generally straightforward and well recognized
Using data for 28 emerging market economies (EMEs) in Asia and Latin America for the period 1990–2014 we find that greater exchange rate fixity does encourage capital inflows
We show that FDI, portfolio and bank inflows are generally sensitive to exchange rate regimes
Summary
The prevailing intuition behind the effects of fixed or managed exchange rates on the inflow of foreign capital is generally straightforward and well recognized. EMEs experience significant inflows of foreign capital such that they may induce a reserve flow This is because EMEs are more likely to have managed exchange rate regimes [5]. This paper is organized as follows: The section presents a simple model that sets out a possible channel through which capital inflows can be impacted by monetary sterilization under fixed exchange rates. To examine the extent to which an exogenous shock (in this instance to the current account) impacts the domestic interest rate (and capital inflows), consider the effect of a shock on the domestic interest rate as follows:. We directly test the relationship between sterilization, exchange rate regime on capital inflows
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