Capital Inflows and Real Exchange Rates: an Empirical Analysis of East Asia and Latin America

Abstract

The conventional wisdom is that capital inflows cause appreciation. These capital inflow-induced appreciations can often have potentially deleterious effects on the economy. However, the impact of capital inflows, particularly foreign direct investment (FDI), has been disputed in the literature with some finding these flows can actually depreciate the currency. This paper examines the impact of capital inflows on the real exchange rate (RER) of eleven sample countries from East Asia and Latin America. To tackle endogeneity concerns and control for the impact of exogenous capital flows, I examine the problem using both two-stage least square regression and dynamic panel models. In addition I explore the impact of capital flows on individual countries in my sample using a vector autoregression (VAR) model. I find, in general, the conventional wisdom holds. Capital inflows appreciate the currency. I do not find evidence that FDI depreciates the RER in East Asia and Latin America. At best it does not contribute to the RER problem when compared to other types of inflows. This study also finds different responses in East Asia and Latin America with Latin American countries experiencing greater appreciation due to capital inflows than their Asian counterparts.