Foreign Capital Flows, Uncertainties of Exchange Rates and Central Bank Independence: Implications for Emerging Economies

Abstract

Utilizing time series data for a panel of 22 emerging countries and applying Granger causality tests, this paper extends the relationship between central bank independence (CBI) and uncertainties of inflation by including the phenomena of exchange rates and foreign capital flows. There are two specific objectives of this investigation. The first objective is to see whether uncertainty of inflation induces volatility of exchange rates, and vice versa, under differing degrees of CBI. The second objective is to explore whether the dynamics of the former relationship influence foreign capital flows in turn and, if so, whether the extent of CBI plays any role in shaping that influence. The period of study spans the years 1968 through 2013. Conditional variances for inflation and exchange rates define proxies for uncertainties of inflation and exchange rates in the empirical analysis. Additionally, annual inflows of foreign direct investment (FDI) provide measures for foreign capital flows in the analysis. Results of causality tests for high and low CBI country subgroups show interesting differences. For the high CBI countries, uncertainty of inflation and uncertainty of exchange rates do not share any causal relationship whatsoever between them. However, a weak link runs from FDI to uncertainties of inflation in the long run. This may be indicative of the disciplined monetary policy and tamed inflation in these countries. Contrastingly, for the low CBI countries, there is strong evidence of causal links running from uncertainties of inflation to uncertainties of exchange rates on the one hand and to FDI flows on the other. In addition, there is indication of a bi-directional causal link between FDI flows and exchange rates for these countries.